The Internal Revenue Service has released much anticipated revenue rulings that specifically address the amount and character of the income to sellers and buyers of life insurance policies surrendered or sold for profit, as typically occurs in life settlements.
Revenue Ruling 2009-13 (seller-owner)
Situation 1: On January 1, 2001, Andy bought a cash-value life insurance policy on his life. Andy surrendered the policy on June 15, 2008 for its $78,000 cash surrender value, including a $10,000 reduction for the cost of insurance protection. Andy paid policy premiums totaling $64,000 and was not terminally or chronically ill on June 15, 2008. The Service ruled that Andy was required to recognize $14,000 of ordinary income upon surrender of the life insurance policy ($78,000 amount realized minus $64,000 investment in the policy). [IRC Sec. 72(e).]
Situation 2: The facts are the same as stated above in Situation 1, except Andy sold (instead of surrendered) the policy for $80,000 to "B", a person who had no insurable interest in Andy's life and would suffer no economic loss upon Andy's death.
With respect to the amount of income that Andy would be required to recognize, the Service first stated the general rule that gain realized from the sale or other disposition of property is considered to be the excess of the amount realized over the adjusted basis for determining gain. Consequently, the amount realized by Andy from the sale of his life insurance policy was determined to be $80,000.
Next, the Service observed that "adjusted basis" for determining gain or loss is generally the cost of the property minus expenditures, receipts, losses, or other items properly chargeable to capital account. The Service then pointed out that IRC Section 72 has no bearing on the determination of the basis of a life insurance policy that is sold because, according to the Service, that section applies only to amounts received under the policy.
The Service then noted the fact that the Code and the courts recognize that a life insurance policy, while only a single asset, may have both investment and insurance characteristics. Citing existing case law, the Service declared that in order to measure a taxpayer's gain upon the sale of a life insurance policy, the basis must be reduced by the portion of the premium paid for the policy that has been expended for the provision of insurance before the sale.
Against that backdrop, the Service determined that Andy had paid premiums totaling $64,000 under the life insurance policy through the date of sale, but $10,000 would have to be subtracted from the policy's cash surrender value as cost of insurance charges. Thus, the Service concluded, Andy's adjusted basis in the policy on the date of sale was $54,000 ($64,000 premiums paid minus $10,000 expended as the cost of insurance). Accordingly, the Service ruled Andy would have to recognize $26,000 of income upon the sale of the life insurance policy.
As for the character of Andy's recognized income, the Service noted that the "substitute for ordinary income" doctrine (which essentially holds that ordinary income that has been earned, but not recognized by a taxpayer, cannot be converted into capital gain by a sale or exchange) is limited to the amount of income that would be recognized if the policy were surrendered (i.e., to the inside build-up under the policy). Consequently, if income recognized on a sale or exchange of a policy exceeds the "inside build-up" under the policy, the excess may qualify as gain from the sale or exchange of a capital asset.
In Situation 2, because the inside build-up in Andy's life insurance policy was $14,000 ($78,000 cash surrender value minus $64,000 aggregate premiums paid), that amount would constitute ordinary income under the doctrine. But because the property had been held by Andy for more than one year, the remaining $12,000 would be considered as long-term capital gain. [IRC Secs. 1001, 1011, 1012, 1222. London Shoe Co. v. Comm., 80 F.2d 231 (2nd Cir. 1935); Century Wood Preserving Co. v. Comm., 69 F.2d 967 (3rd Cir. 1934); United States v. Midland Ross, 381 U.S. 54 (1965).]
Situation 3: The facts are the same as stated above in Situation 1, except that the policy was a 15-year level premium term life insurance policy with a $500 monthly premium. Andy paid $45,000 total premiums through June 15, 2008, and then sold the policy on the same date to B for $20,000. Absent other proof, the cost of the insurance provided to Andy each month was presumed to equal the monthly premium under the policy ($500). Thus, the cost of insurance protection provided to Andy was $44,750 ($500 monthly premium times 89.5 months). Therefore, Andy's adjusted basis in the policy on the date of sale was $250 ($45,000 total premiums paid minus $44,750 cost of insurance protection). Accordingly, the Service concluded that Andy was required to recognize $19,750 long-term capital gain upon the sale of the term life policy, ($20,000 amount realized minus $250 adjusted basis).
Effective date: The Service has declared that the holdings set forth above in Situation 2 and Situation 3 will not be applied adversely to sales occurring before August 26, 2009.
Revenue Ruling 2009-14 (Purchaser)
Situation 1 and Situation 2 below are primarily based on the facts as stated above in Situation 3 of Revenue Ruling 2009-13.
Situation 1: B purchased a 15-year level term life insurance policy on Andy's life for $20,000 on June 15, 2008 when the remaining term of the policy was seven years, six months, and 15 days. B named itself beneficiary of Andy's policy immediately after acquiring it. B purchased the policy with a view to profit, and the likelihood that B would allow the policy to lapse was remote. B had no insurable interest in Andy's life, was unrelated to Andy, and would not suffer economic loss upon Andy's death. B paid monthly premiums totaling $9,000. Upon Andy's death on December 31, 2009, the insurance company paid $100,000 to B. The Service determined that the purchase of the policy by B was a transfer for value with none of the exceptions being applicable. Accordingly, the Service ruled, B was required to recognize $71,000 of ordinary income on the receipt of death benefits with respect to Andy's life insurance policy ($100,000 minus [$20,000 + $9,000]). [IRC Sec. 101(a)(2).]
Situation 2: The facts are the same as immediately stated above except that (a) Andy did not die, and (b) on December 31, 2009, B sold the policy to C (an unrelated person to Andy or B) for $30,000. The Service then remarked that unlike Situation 2 of Revenue Ruling 2009-13 (see above), no reduction to basis for the cost of insurance charges was necessary because unlike Andy, B did not purchase the policy for protection against economic loss. Instead, B acquired and held the policy solely with a view to profit. Accordingly, the Service ruled, B would be required to recognize only $1,000 of long-term capital gain on the sale of the life insurance policy ($30,000 minus [$20,000 + $9,000]).
Rev. Rul 2009-13, 2009-22 IRB ___; Rev. Rul. 2009-14, 2009-22 IRB ___.
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