When we sell life insurance to our clients, we like to think our clients will keep their policies until they die. But the reality is that a significant amount of life insurance is eventually surrendered or sold by policy owners. When clients surrender or sell their life insurance policies, it is important that they have an understanding of the tax results of their actions.
How much life insurance is surrendered or sold? Data from the American Council of Life Insurers showed a 6.8 percent voluntary termination rate for 2010, and that 21 percent of those terminated policies were surrendered.
In addition, a study showed that during 2008, policies with a collective face value of $11.8 million were sold to investors.
With so much activity in the way of surrenders and sales, it is important that policy owners have an understanding of the tax consequences.
In 2009, the IRS issued two Revenue Rulings that dealt with the tax treatment of proceeds received upon the disposition of a life insurance policy.
Rev. Rul. 2009-13 deals with the income tax consequences on the surrender or sale of a life insurance policy by a person who purchased it for insurance protection.
Rev. Rul. 2009-14 deals with the income tax consequences to an investor that receives death proceeds or the proceeds from reselling a policy purchased for profit.
Rev. Rul. 2009-13 — This ruling involves three fact patterns.
1. A purchases a policy on his life and pays $64,000 in premiums before surrendering it for $78,000. A is taxed on the $14,000 of gain as ordinary income under Internal Revenue Code § 72(e).
2. Instead of surrendering the policy, A sells it for $80,000 to B, who has no insurable interest in A. This transaction is taxed under IRC § 1001 as a sale or exchange of the policy, and therefore gain is determined as the sales price minus A’s adjusted basis. For this purpose, A’s adjusted basis is the cumulative premiums paid (investment in the contract) minus the cost of insurance. Assuming the cost of insurance is $10,000, A’s adjusted basis is $54,000 ($64,000 cumulative premiums minus $10,000 cost of insurance). Consequently, A’s taxable gain is $26,000 ($80,000 minus $54,000). Of this amount, $14,000 is taxed as ordinary income and $12,000 as capital gain. In that regard, the characterization of $14,000 of the gain as ordinary income is based on the “substitute for ordinary income doctrine” under which the amount of ordinary income is limited to what would have been taxed as ordinary income had the contract not been surrendered. Further, the remaining $12,000 of gain is treated as capital gain because life insurance is generally a capital asset.
3. A buys a 15-year level-term policy on himself and pays $500 a month in premiums. After eight years and paying $45,000 in premiums, he sells the policy to B in the middle of a month for $20,000. (Assume that B is an investor who has no insurable interest in A.) For this purpose, the IRS ruled that the cost of insurance on a term policy is the premiums paid and the adjusted basis is the unearned premium. Consequently, since the policy was sold in the middle of the month, one-half of the $500 monthly premium is unearned and represents A’s basis in the policy of $250. This means that A’s taxable gain on the sale is $19,750 ($20,000 minus $250). Further, all of A’s gain is capital gain since he could not have surrendered a term policy for a cash value.
Rev. Rul. 2009-14 — This ruling was drafted as a continuation of Fact Pattern 3 above with the following three scenarios.
1. After buying the term policy from A for $20,000, B pays an additional $9,000 in premiums before A dies, and the insurer pays B $100,000 in death benefits. Since there is no exception to the transfer for value rule under these circumstances, the entire gain of $71,000 ($100,000 minus $29,000) is ordinary income.
2. Assume that before A dies, B resells the policy to C for $30,000. For this purpose, B’s basis in the contract is what he paid A ($20,000) plus additional premiums paid by B ($9,000) for a total basis of $29,000. Further, since B bought the policy for investment purposes, there is no reduction in his basis for the cost of insurance. This means that B’s taxable gain is $1,000 ($30,000 minus $29,000), and it is all capital gain because he could not have surrendered a term policy to the issuing company for a cash value.
3. Assume that A sells the term policy on his life for $20,000 to a foreign corporation, which pays an additional $9,000 in premiums before A dies. Because there is no applicable exception to the transfer for value rule, the corporation has ordinary income of $71,000 ($100,000 minus $29,000).
Here is a summary of how the IRS applied the law to the above fact patterns.
» Upon the surrender of a cash value life insurance policy, the amount received is ordinary income to the extent it exceeds the cumulative premiums paid.
» If a cash value policy is sold to a third party, there is ordinary income to the extent that the cash value exceeds premiums paid with the balance of the gain treated as capital gain.
» The total gain on the sale of a cash value policy (ordinary gain and capital gain) is determined by using as basis the total of premiums paid less the cost of insurance.
» On the sale of a term policy, basis is the unearned premium and the entire gain is capital gain.
Generally, the two options for disposing of a life insurance contract are to surrender it or sell it. Either way, consideration must be given to determining whether there is a gain on the contract for income tax purposes. That calculation requires figuring the difference between what the policy holder received and what they are deemed to have given for the contract. In the latter regard, what is considered to have been given depends on whether the transaction is a surrender governed by IRC § 72 or a sale covered by IRC § 1001.
In the case of surrenders, IRC § 72(e)(6) states that the amount given is the “investment in the contract.” That amount consists of the aggregate amount of premiums or other consideration paid, minus the total amount previously received under the contract that was excluded from gross income.
Turning to the sale of a policy, the amount given pursuant to IRC § 1011 is the “adjusted basis.” This comprises the cost of the policy as modified for “expenditures, receipts losses or other items properly chargeable.” In determining what is properly chargeable, the IRS has stated in Rev. Rul. 2009-13 that since a life policy may have both investment characteristics and insurance characteristics, it is necessary to reduce the adjusted basis of the contract by the “cost of insurance” before the sale of the policy. This approach results in a reduction of adjusted basis and a greater potential for taxable gain on the sale of a policy.
The problem is that the IRS' reasoning in Rev. Rul. 2009-13 represents an inconsistent interpretation of existing case law and its own regulations. Worse yet, while requiring that the cost of insurance must be deducted from adjusted basis, the IRS does not offer a safe harbor method for determining what the cost of insurance is for a policy that is being sold.
The practical solution for a policyholder is to contact the issuing company and ask for the cost of insurance on the contract. Alternatively, some companies’ illustrations contain schedules of the cost of insurance on their policies.