On May 1, 2009, the Internal Revenue Service issued Revenue Rulings 2009-13 and 2009-14 describing six different situations, each involving a life insurance transaction and its income tax consequences.
Rev. Rul. 2009-13 focuses on the tax consequences to the insured upon the surrender or sale of a life insurance policy.
Situation 1 in Rev. Rul. 2009-13 involves the surrender of a life insurance policy by the insured for its cash surrender value—The taxpayer, A, purchased a life insurance policy on his own life in Year 1 and paid $64,000 in premiums during Year 1 through Year 8. On June 15 of Year 8, Taxpayer A surrendered the policy to the issuer for $78,000, which was the cash surrender value of the policy. The IRS assumes the cash surrender value reflects a $10,000 subtraction for the “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract.
The ruling concludes that under Internal Revenue Code Section 72(e)(5)(A), Taxpayer A must include $14,000 in his gross income which is equal to the excess of the amount received ($78,000) over his investment in the policy ($64,000). The entire gain is taxable as ordinary income.
Situation 2 in Rev. Rul. 2009-13 involves the sale of a cash value life insurance policy by the insured to an unrelated third party for a cash payment—The facts in Situation 2 are the same as in Situation 1, except Taxpayer A sold the contract for $80,000 to Buyer B, an unrelated party who would suffer no economic loss on Taxpayer A’s death (for example, Buyer B is a life settlement company). The ruling concludes that Taxpayer A is taxed on the difference between the amount realized from the sale ($80,000) and Taxpayer A’s adjusted basis in the contract.
The ruling states that Taxpayer A’s adjusted basis in the contract is $54,000, which is equal to the premiums Taxpayer A paid ($64,000) reduced by the cost-of-insurance charges ($10,000). Interestingly, the ruling does not provide a method for calculating cost-of-insurance but rather simply states, as it did in Situation 1, that $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. Thus, Taxpayer A realized a taxable gain of $26,000.
Most notably, although the policy was a capital asset that was held for more than one year, the ruling applies the “substitute for ordinary income doctrine” to conclude that this gain is ordinary income to the extent of the amount that would have been recognized as ordinary income if the policy had been surrendered (that is to say, $14,000). (The “substitute for ordinary income doctrine” converts capital gains into ordinary income where the asset sold is itself properly attributable to income.) Thus, Taxpayer A had $14,000 of ordinary income and $12,000 of capital gain.
Situation 3 in Revenue Ruling 2009-13 involves the sale of a term life insurance policy by the insured to an unrelated third party for a cash payment—The facts in Situation 3 are the same as in Situation 1 except that the life insurance policy was a level premium 15-year term policy with no cash surrender value. The monthly premium was $500 and Taxpayer A paid a total of $45,000 in premiums through June 15 of Year 8, on which date Taxpayer A sold the policy for $20,000 to an unrelated party who would suffer no economic loss on Taxpayer A’s death.
The ruling concludes that A is taxed on the difference between the amount realized ($20,000) and Taxpayer A’s adjusted basis in the contract. As in Situation 2, Taxpayer A’s adjusted basis in the contract was equal to the total premiums paid reduced by the cost of insurance charges.
Significantly, the ruling states that where there is no other proof, the cost of insurance charges for a term policy with no cash surrender value is presumed to be equal to the entire premium paid. Accordingly, Taxpayer A’s basis in the policy was only equal to the unexpired portion of his most recent premium, or $250.
Thus, Taxpayer A realized a $19,750 gain on the sale. Because the policy had no cash surrender value, the “substitute for ordinary income doctrine” did not apply and the gain was a capital gain.
Revenue Rul. 2009-14 focuses on the tax consequences to a purchaser of a life insurance policy from the insured upon a subsequent sale of the policy or the insured’s subsequent death:
Situation 1 in Rev. Rul. 2009-14 concerns the tax consequences upon receipt of death benefits by a third-party purchaser who purchased a life insurance policy from the insured—The facts are similar to the facts in Situation 3 in Rev. Rul. 2009-13. After Buyer B purchased the policy from Taxpayer A on June 15, 2008 for $20,000, Buyer B named himself beneficiary and continued to pay the premiums. After Buyer B had paid $9,000 in additional premiums, Taxpayer A died on Dec. 31, 2009, and the insurer paid B $100,000 in death benefits.
Under IRC Section 101(a)(1), life insurance proceeds paid by reason of the death of the insured are not ordinarily includible in gross income. But under IRC Section 101(a)(2), such proceeds are generally taxable if the policy was acquired in a transfer for value except to the extent of the sum of (1) the consideration paid to purchase the policy and (2) the premiums and other amounts subsequently paid by the transferee.
Thus, Buyer B must include $71,000 in gross income, which is equal to the total death benefit he received ($100,000) less the purchase price of the policy ($20,000) and the premiums he paid ($9,000). Because receipt of the death benefit did not constitute a sale or exchange, Buyer B’s income was ordinary income.
Situation 2 in Rev. Rul. 2009-14 involves the resale of a term life insurance policy by the third-party who purchased it from the insured—The facts in Situation 2 are the same as in Situation 1 except that on Dec. 31, 2009, while Taxpayer A was still alive, Buyer B resold the policy for $30,000 to a person unrelated to Taxpayer A or Buyer B.
The ruling concludes that Buyer B recognized a gain of $1,000, which was equal to the amount realized upon the sale ($30,000) less Buyer B’s basis in the policy. Buyer B’s basis in the policy was equal to the consideration paid by Buyer B to Taxpayer A for the policy ($20,000) plus the premiums paid by Buyer B after the purchase ($9,000). Buyer B did not have to reduce his basis by the cost of insurance because Buyer B, as a party wholly unrelated to Taxpayer A who did not purchase the contract for protection against any economic loss upon his death, did not benefit from this coverage.
Because the policy had no cash surrender value, the “substitute for ordinary income doctrine” did not apply and the gain was a capital gain. Presumably, however, if the policy in this situation had been a cash value policy as opposed to a term policy, some portion of this gain would have been ordinary income.
Situation 3 in Rev. Rul. 2009-14 concerns the tax consequences upon receipt of death benefits by a foreign third-party purchaser who purchased a life insurance policy issued by a U.S. insurer from a U.S. insured—The facts in Situation 3 are the same as in Situation 1 except that Buyer B was a foreign corporation not engaged in trade or business within the United States.
Like the purchaser in Situation 1, Buyer B must recognize $71,000 of ordinary income that is subject to tax in the United States. Because this income is “fixed or determinable annual or periodical” income within the meaning of IRC Section 881(a)(1), Buyer B is subject to tax under IRC Section 881 with respect to this income if it is “from sources within the United States.”
Although the IRC does not specify the source of income resulting from the payment of death benefits pursuant to a life insurance policy, the ruling concludes that based on comparison and analogy to classes of income that are specified in the statute, the income was “from sources within the United States” because the insured was a U.S. citizen and the insurer was a domestic corporation.
Note: Rev. Ruls. 2009-13 and 2009-14, like all revenue rulings, will generally be applied retroactively. But Rev. Rul. 2009-13 states that the holdings with respect to Situations 2 and 3 will not be applied adversely to sales occurring before Aug. 26, 2009.
Here’s your pocket summary of the Rev. Ruls.: