IRS Posts Life Settlement Rulings: Revenue Ruling 2009-13
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In this Revenue Ruling, the Service set out to establish the amount and character of an individual’s income recognized upon the sale of surrender of life insurance contracts, as described in certain types of situations. Officials describe 3 examples, involving:
- A policyholder who is also the insured. The policyholder surrenders a policy from a U.S. insurer in policy Year 8. The policy has a cash surrender value of $78,000.
- A policyholder who sells a similar policy in policy Year 8.
- A policyholder who sells a policy with no cash value in policy Year 8.
Situation 1: On January 1 of Year 1, A was the insured on a life insurance contract with a member of A’s family named as the beneficiary. A had the right to change the beneficiary, to take out a policy loan, or surrender the contract for its cash surrender value. On June 15 of Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract. A had paid premiums totaling $64,000 with regard to the life insurance contract. A had not received any distributions from the contract and had not taken a loan against the policy’s cash surrender value.
The Service held that A’s income upon surrender of the contract is determined under §72(e)(5). Under §72(e)(5)(A), the amount received is included in gross income to the extent that it exceeds the investment in the contract. A’s “investment in the contract,” as determined by §72(e)(6) was $64,000; consequently, A recognized $14,000 of income on the surrender of the contract, which is the excess of $78,000 received over $64,000.
As determined by Rev. Rul. 64-51, the proceeds from the surrender of a life insurance contract constitutes ordinary income to the extent that such proceeds exceed the cost of the policy. Therefore, A has $14,000 of ordinary income resulting from the surrender of a life insurance contract on A’s life.
Situation 2: The facts are the same as in Situation 1, except that on June 15 of Year 8, A sold the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death.
The Service held that it is necessary to determine A’s amount realized from the sale and A’s adjusted basis in the contract. Under §1001(b), A’s amount realized from the sale of the life insurance contract is the sum of money received from the sale, or $80,000. Under §§1011 and 1012, the adjusted basis for determining gain or loss is generally the cost of the property, adjusted as provided in §1016. Section 1.1016-2(a) says that §72 has no bearing on the determination of the basis of a life insurance contract that is sold, because §72 only applies to amounts received under the contract.
The Service then held that in order to measure a taxpayer’s gain upon the sale of a life insurance contract it is necessary to reduce basis by that portion of the premiums paid for the contract for the provision of insurance before the sale of the contract. The Service found that the cost of the policy is not the total amount paid in premiums, since continuing insurance protection is part of the consideration for the contract. The part of the premiums which represents annual insurance protection has been earned and used and must therefore be subtracted from the taxpayer’s basis in the contract.
In Situation 2, A paid total premiums of $64,000 under the life insurance contract through the date of the sale, and $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. Accordingly, A’s adjusted basis in the contract as of the date of sale, under §§1011 and 1012, was $54,000. A must recognize $26,000 on the sale of the insurance, which is the excess of the amount realized on the sale ($80,000) over A’s adjusted basis ($54,000).
The Service then turned to establishing the character of the $26,000 gain A recognized on the sale of the insurance. The Service held that some or all of the gain on the sale may be ordinary income if the “substitute for ordinary income doctrine” applies. In the case of a sale of a life insurance policy, the Service held that the substitute-for-ordinary income doctrine is limited to the amount that would have been recognized as ordinary income if the contract were surrendered (i.e. to the inside buildup under the contract). Therefore, if the gain recognized on the sale of a life insurance contract exceeds the “inside buildup” under the contract the excess may qualify as gain from the sale or exchange of a capital asset. In Situation 2, the inside buildup under A’s life insurance contract immediately prior to the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). That makes $14,000 of the $26,000 is ordinary income to A and the remaining $12,000 is capital gains to A.
Situation 3: The facts are the same as in Situation 1, except that the contract was a level premium fifteen year term life insurance contract without any cash surrender value. The monthly premium for the contract was $500. Through June 15 of Year 8, A paid premiums totaling $45,000 with regard to the contract. On June 15 of Year 8, A sold the life insurance contract for $20,000 to B, a person unrelated to A and who would not suffer economic loss upon A’s death.
The Service held that in Situation 3, the amount realized from the sale of the term life insurance contract is the sum of money received from the sale, or $20,000. A’s adjusted basis in the life insurance contract for purposes of determining its gain or loss on sale is equal to the total premiums paid under the contract, less charges for the provision of insurance before the sale. The cost of insurance provided to A each month is presumed to be equal to the monthly premium under the contract or $500. The cost of the insurance protection provided to A during the 89.5-month period that A held the contract was $500 times 89.5 months or $44,750. Therefore, A’s adjusted basis in the contract on the date of the sale to B was $250 ($45,000 total premiums paid, less 44,750 cost-of-insurance protection).
Accordingly, the Service held that A must recognize $19,750 of gain on the sale of the term life insurance contract to B, which is the excess of the amount realized ($20,000) over A’s adjusted basis ($250). The term life insurance contract held no cash surrender value, so there was no buildup under the contract to which the substitute for ordinary income doctrine could apply. Therefore, the $19,750 of income that A must recognize on the sale of the contract is long-term capital gain within the meaning of §1222(3).
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