Life Insurance Policies – Income Tax Treatment on Surrender or Sale

May 4, 2009

Life settlements (sales by the owners of life insurance policies) to third parties have become popular as a way to dispose of unneeded policies for amounts greater than cash surrender value. Such transactions are sometimes known as “senior settlements” or “stranger-owned insurance” and can be very attractive to investors in many cases. Much confusion has existed surrounding the income tax consequences of policy surrenders and life settlements.

On May 1, 2009 the Internal Revenue Service issued two revenue rulings to clarify the proper income tax treatment relating to the surrender, sale, and purchase of life insurance policies. In particular, the rulings address the determination of the owner’s basis in a policy and whether any part of the gain on a surrender or sale of the policy is a capital gain. The rulings analyze the applicability of various Internal Revenue Code provisions, court cases, and previous IRS rulings to a few basic fact patterns but do not provide guidance for all situations that may arise.

The first ruling, Rev. Rul. 2009-13, discusses three scenarios regarding the surrender or sale of a policy by the owner/insured and states that Situations 2 and 3 will not be applied adversely to sales occurring before August 26, 2009.

  • Situation 1. The owner/insured surrendered a whole life policy to the insurance company for its cash surrender value. The ruling holds that the owner/insured recognizes ordinary income to the extent the surrender value exceeds the aggregate premiums paid on the policy.
  • Situation 2. The owner/insured sold a whole life policy to an unrelated third party investor for an amount in excess of its surrender value. As in Situation 1, the ruling holds that the owner/insured recognizes ordinary income to the extent the surrender value exceeds the aggregate premiums paid on the policy. However, the portion of the sales price in excess of the surrender value is treated as a long-term capital gain by the owner/insured.
  • Situation 3. The owner/insured sold a level term policy to the unrelated third party investor. Because the term premiums equal the cost of the insurance protection received by the owner/insured, and the policy has no surrender value, the entire sales price will be long-term capital gain to the extent it exceeds the nominal basis in the policy resulting from a prepaid portion of the premium for the month of sale.

The second ruling, Rev. Rul. 2009-14, provides guidance to investors who purchase life insurance contracts under three fact patterns.

  • Situation 1. The facts are the same as in Situation 3 in Rev. Rul. 2009-13 above involving term insurance, and upon the insured’s death the entire gain upon receipt of the proceeds is taxed to the investor as ordinary income. Although the policy is a capital asset in the hands of the investor, amounts received upon surrender or as death benefits from the insurer do not produce a capital gain.
  • Situation 2. In this fact pattern, the investor sold the term policy to another unrelated person instead of holding it to maturity. The investor’s gain is taxed as long-term capital gain. In calculating basis, the full premiums paid by the investor are added to basis without reduction for the cost of insurance protection.
  • Situation 3. The facts are the same as in Situation 1 of this ruling, except that the investor is a foreign corporation that is not engaged in a trade or business within the United States (including the trade or business of purchasing, or taking assignments of, life insurance contracts). Nevertheless, the ruling holds that the foreign investor’s gain is ordinary income from sources within the United States, as the insured is a United States citizen residing in the United States and the insurer is a domestic corporation.

Because the various situations discussed in these rulings are quite basic, some uncertainty will continue with more complex fact patterns. However, the detailed analysis found in the rulings will serve as helpful guidelines in determining the proper tax treatment in those more complex situations.

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