NEW RULES ON TAXATION OF THE
SALE AND REDEMPTION OF LIFE
INSURANCE POLICIES
Revenue Ruling 2009-13, issued April 1, 2009, effective
August 26, 2009 AND Revenue Ruling 2009-14,
Issued May 1, 2009.
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The IRS has clarified the
character and amount of
income that must be realized
and recognized with the
surrender and sale of life
insurance policies.
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Example #1
Facts:
 January 1 of year #1. Ralph purchases a universal life insurance policy,
with the right to:




Change beneficiaries,
Borrow against the plan, and
Surrender the policy.
June 15th of year #8. Ralph surrenders the life insurance contract for its
cash surrender value of $78,000.

The aggregate premiums Ralph paid on the policy were $64,000.

The cash surrender is net of “cost of insurance” for period year #1
through year #8. The cost of insurance is determined to be $10,000.

During the 8 years Ralph did not receive any distributions or loan
proceeds stemming from the policy.

Ralph is a cash basis taxpayer and not terminally ill.
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Example #1 (Cont.)
Internal Revenue Code (IRC) §72(e)(5) states that amounts
received are included in gross income to the extent they exceed
investment in the contract.
Income Recognized
$78,000
◊ Ralph paid premiums of
$64,000
Realized income of
$14,000
◊ Cost of policy was approximately reflected in cash surrender value,
London Shoe Co., 80 F.2d at 233.
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Example #1 (Cont.)
What is the Character of the Income?
Capital Gain or Ordinary Income
Insurance policy holdings do qualify as a capital asset under
IRC § 1221. However, IRC § 61(a)(10) states “Proceeds
received by an insured upon surrender of or at maturity of a
life insurance policy constitutes ordinary income to the
extent such proceeds are in excess of the cost of policy.”
Result – Ralph has realized and recognized $14,000 in
ordinary income from the surrender of his policy.
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Example #2
Facts:
Same as Example #1 except Ralph sells his policy to
Brian for $80,000
Brian is unrelated to Ralph and will not suffer economic
loss upon Ralph’s demise.
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Example #2 (Cont.)
Income Realized
Sales price to Brian
$80,000
Adjusted basis of the policy:
Total premiums paid
Cost of insurance, year #1 through year #8
$64,000
$10,000
$54,000
$26,000
Gain on Sale
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Example #2 (Cont.)
What is the Character of the Income?
Capital Gain or Ordinary Income
“Substitute
for ordinary income” doctrine – U.S. Supreme Court, property within the meaning
of IRC §1221 (capital asset) does not include claim on rights to ordinary income. U.S. v.
Midland-Ross Corp., 381 US 260 (1958).
Thus, ordinary income that has been earned but not recognized cannot be converted to
capital gain by sale or exchange.
Application of “substitute for ordinary income” doctrine is limited to amount that would be
recognized as ordinary income if a contract was surrendered.
Total gain on sale
Substitute for ordinary income
(Cash Surrender Value – minus premiums paid)
$26,000
Balance is long term capital gain, per IRC §1222
$12,000
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$14,000
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Example #3
Sale of Term Life Insurance Contract
Facts:
 January 1 of year #1, Ralph purchases level premium 15 year
term life insurance contract.


No cash surrender value (CSV)
Monthly premium is $500

As of June 15 of year #8 Ralph has paid in aggregate
premiums of $45,000.

On June 15 of year #8, Ralph sells the insurance contract to
Brian for $20,000.


Brian is not related to Ralph, and
Brian will not suffer economic loss upon Ralph’s demise.
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Example #3 (Cont.)
Income Realized
Sales Price
$20,000
Adjusted Basis:
Total premiums paid
Cost of insurance, year #1 through year #8
◊ 89.5 months X $500
Basis in Policy
$45,000
$44,750
Gain on sale
◊
$250
$19,750
The cost of insurance provided to Ralph each month is
presumed to equal the monthly premium.
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Example #3 (cont.)
What is the character of the income?
Capital gain or ordinary income
Since there is not CSV in a term life policy, there is no inside
basis that would qualify as “substitute for ordinary income”
doctrine.
Therefore, given that an insurance policy is a capital asset,
the entire gain $19,750, is recognized as a long term capital
gain.
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Tax consequences to a taxpayer upon receipt of death benefits
or sale of life insurance contracts purchased for profit.
Example #4
Facts:
 January 1 of year #1, Ralph purchases level premium 15 year term life insurance
contract.
Ralph is the owner and the insured
No cash surrender value (CSV)
Monthly premium is $500.
 June 15, year #8, Brian purchased the policy from Ralph for $20,000
 At purchase there are 7 years, 6 months and 15 days remaining on the term of the
policy.
 Brian exercises his right as policy owner to change beneficiary to himself.
 December 31, year #9 Ralph dies and the policy pays out $100,000 to Brian.
 From the purchase date, June 15th yr. #8, to the date of death, Brian has paid
$9,000 in premiums to maintain the policy.
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Example #4 (Cont.)
Income Realized
IRC § 101(a)(a) provides generally that gross income does not include
amounts received under life insurance contracts if such amounts are paid by
reason of death of insured.
In case of transfer for value however, IRC § 101(a)(2) provides amounts
excluded from income shall not exceed an amount equal to the sum of the
actual value of consideration paid and premiums and other amounts
subsequently paid by transferee.
Cash receipt/death benefit
Adjusted basis:
Original purchase price
Cost to maintain policy
$100,000
$20,000
$ 9,000
$29,000
Gain
$71,000
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Example #4(Cont.)
What is the Character of the Income?
Capital Gain or Ordinary Income
The $71,000 gain is taxed as ordinary income to
Brian. Due to IRC § 61(a)(10) which states all income
for insurance policies are ordinary income and IRC §
101 does not exempt insurance proceeds to
transferees (Brian) for value.
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Example #5
Facts:
Same as Example #4 except Ralph did not die but rather Brian sold the policy to Mary for
$30,000.
Income Realized
Sales Price to Mary
Adjusted basis:
Original purchase price
Cost to maintain policy
$30,000
$20,000
$ 9,000
$29,000
Gain
$ 1,000
NEW RULE – This revenue ruling requires a secondary market purchaser to capitalize
premiums paid to prevent a term life insurance (with out CSV) contract from lapsing.
The IRS will not challenge capitalization of such payments paid before the issuance of this
policy.
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Example #5 (Cont.)
What is the Character of the Income?
Capital Gain or Ordinary Income
Note example #2 required the taxpayer to recognize ordinary
income to the extent of the cost of insurance. This was to account
for the benefit the insured received for coverage on his life while he
owned the policy. However, in this instance Brian is not at risk of
economic loss should the insured die; therefore the benefit to the
insured is irrelevant. Hence, the substitute for ordinary income
doctrine under U.S. v. Midland-Ross Corp. and its progeny does not
apply.
Brian would realize and recognize $1,000 in long term capital gain.
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