For too long, the IRS left insureds, policy owners, and others in the life settlement industry unsure of the amount and character of gain to be recognized on sale or surrender of a life insurance policy. Revenue Rulings 2009-13 and 2009-14, both issued May 1, 2009, finally provide some concrete answers to long-asked questions.
When an individual purchases a life insurance policy covering his or her own life, everyone understands that the death benefit from such policy is excluded from income and not taxable. If that life policy is sold or otherwise “transferred for value” before the insured’s death, then section 101(a)(2) of the Internal Revenue Code (the “Code”) limits the death benefit exclusion to the amount paid for the policy, plus any subsequently paid premiums and other expenses. While this may seem clear enough, section 101(a) addresses only whether to include or exclude the death benefits as taxable income. The section left unanswered several key questions: What kind of income is the death benefit? Is it ordinary income? Or capital gain? And what about income on surrender of a purchased policy, or a second sale of the life policy? Due to the large disparity in tax rates for ordinary income (roughly 35% federal tax rate) and long-term capital gain (15% federal tax rate), the answer to these questions have a significant financial impact on all parties involved.
Revenue Ruling 2009-13
In Revenue Ruling 2009-13, the IRS addressed three scenarios in which the original insured surrendered or sold his life insurance policy prior to death. In the first, the insured purchased a cash value policy, and in year eight, he surrendered it to the issuer for $78,000. Up to the point of surrender, the insured paid $64,000 in premiums. The IRS ruled the insured had a $14,000 taxable gain (i.e., the $78,000 surrender value minus $64,000 of premiums), which gain was entirely ordinary income. The IRS made clear that surrender of a life insurance contract does not produce capital gain.
The second scenario in Revenue Ruling 2009-13 assumed the same facts, except that in year eight, the insured sold the policy to an unrelated person for $80,000. In that case, the IRS concluded the insured had $26,000 of income, based on having paid $64,000 in premiums over the years, but also having enjoyed $10,000 in “cost of insurance” (i.e., the value of the eight years of insurance coverage the insured enjoyed), which reduced the insured’s basis in the policy to $54,000. Of the gain, the IRS ruled that $14,000 was ordinary income as it represented the “inside build-up” under the policy just prior to sale. The remaining $12,000, i.e., the excess over the inside build-up, was long-term capital gain.
In the third scenario, the IRS assumed the same facts as above, except this time the policy was a level premium, term life policy with no cash surrender value. The insured sold it in year eight to an unrelated person for $20,000, after having paid $45,000 in premiums. Upon calculating that the insured had enjoyed $44,750 in “cost of insurance” protection over the eight years of coverage, the IRS ruled that the insured had only a $250 basis in the policy, and thus had income of $19,750. However, because the policy was a term policy with no “inside build-up” and because the policy was a capital asset in the hands of the insured, the entire gain was capital (and, thus, eligible for the lower 15% tax rate).
This Revenue Ruling clarifies the longstanding belief of many tax advisors (based on a 1941 tax court ruling)1 that gain from sale of a universal life or whole life policy would result in two different types of tax rates: ordinary income tax to the extent of inside build-up, and capital gains tax on amounts exceeding inside build-up of the policy. However, Revenue Ruling 2009-13 has left everyone scratching their heads at the determination of “cost of insurance” – this is not a number an average policyholder will know, nor is it a number that is readily found with the insurance carrier or some other source.
Revenue Ruling 2009-14
Revenue Ruling 2009-14 picked up where Revenue Ruling 2009-13 left off and more directly addressed issues affecting the life settlement industry. Revenue Ruling 2009-14 also addressed three different factual scenarios. The first assumed the taxpayer purchased a $100,000 term policy from the insured for $20,000 and paid $9,000 of additional premiums before the insured died. The IRS acknowledged that such life settlement policy was a capital asset in the hands of the taxpayer; however, the IRS held that any gain from life policies held to maturity will not result in capital gain to the taxpayer. Rather, based on section 101(a)(2) of the Code, receipt of the death benefit produces ordinary income to the owner of the policy.
In the second scenario, the facts were the same, but before the insured died, the taxpayer sold the policy to another unrelated party for $30,000. In that case, the selling taxpayer had only $1,000 of long-term capital gain ($30,000 amount realized less $29,000 cost of policy and premiums paid). The selling taxpayer did not have to reduce its tax basis in the policy based on “costs of insurance” charges; unlike the situations in Revenue Ruling 2009-13, the selling taxpayer was not the insured or related to the insured, and did not purchase the policy for protection against any economic loss upon the insured’s death. As a result, the IRS held cost of insurance inapplicable. Further, because the gain was generated from sale of a capital asset (the policy) and not death of the insured, the character was capital and not ordinary and, thus, eligible for the lower long-term capital gain tax rate (15%).
In the last scenario, the taxpayer was a foreign corporation (not engaged in a trade or business within the U.S.) that purchased a $100,000 term policy from the insured for $20,000 and paid $9,000 in premiums before the insured died. The IRS ruled that upon the insured’s death, such taxpayer would recognize $71,000 of ordinary income, which would be considered from sources within the U.S. as “fixed or determinable annual or periodical” income under section 881(a)(1) of the Code. While section 881(a)(1) does not expressly include proceeds from a life settlement transaction, the IRS reasoned the life settlement proceeds were analogous to income from the sale of personal property located in the U.S. as well as insurance premiums received on a life insurance contract covering the life of a U.S. resident, both of which are U.S. source income.
Conclusion
For better or for worse, we now know more about how the IRS will calculate and characterize the income generated by the surrender or sale of a life insurance policy, whether by the insured or by an unrelated, third-party purchaser of the policy.
With regard to calculation of gain:
- On surrender of a policy, the policy owner/taxpayer has to include in income the amount realized, less the premiums paid.
- On the insured’s death, death benefits are excluded from income of the policy owner/taxpayer unless the policy has been transferred for value. If transferred for value prior to the insured’s death, the exclusion for death benefits is limited to the amount paid for the policy, plus any subsequently paid premiums.
- With regard to income generated by a sale of an insurance policy (i.e., not death benefits), the policy owner/taxpayer must include the amount realized, less its basis in the policy; and if the policy owner/taxpayer is the insured, the “cost of insurance” the insured has enjoyed will reduce his/her basis in the policy.
With regard to character of the gain, death benefits - to the extent included in income - will be ordinary income, as will any gain realized on the surrender of a life policy. Conversely, income from the sale of a life insurance policy will generate capital gain (at least to the extent it is in excess of any “inside build up” in a cash value policy).
Foreign taxpayers should keep in mind that death benefits from the death of a U.S. citizen will generally be considered ordinary income, from sources within the U.S., as “fixed or determinable annual or periodical.” While not discussed in Revenue Ruling 2009-14, this will mean death benefits paid to a non-U.S. taxpayer potentially will be subject to a 30% withholding tax on payment, unless the non-U.S. taxpayer may reduce withholding under an applicable international tax treaty.
Revenue Rulings 2009-13 and 2009-14 provide those in the life settlement industry with significantly greater certainty in the tax treatment of life settlement transactions. More importantly, fund managers and financial planners will now have greater accuracy in creating financial projections and assessing potential after-tax return on investment. While these Revenue Rulings did not answer all tax questions they are an excellent beginning. Armed with better financial and tax information, we expect to see increased investment in this unique financial asset.
William M. Winter is a Partner in the firm’s Tax and Insurance Practices. His practice focuses on addressing U.S. tax matters for growing businesses, with an emphasis on helping U.S. and foreign companies successfully expand their business overseas. Mr. Winter received his bachelor’s degree from University of Illinois and law degree from Emory University School of Law.
Alison R. Solomon is an Associate in the firm’s Tax practice. Ms. Solomon’s areas of practice include corporate and partnership tax, captive insurance company planning, and tax controversy work. Ms. Solomon received her bachelor’s degree from Vanderbilt University, her law degree from Emory University School of Law and her Masters of Law in Taxation from the University of Alabama School of Law.
1 Jules J. Reingold, BTA Memo 1941-319 (June 20, 1941) (holding a life insurance policy was a capital asset and gain from sale of such policy was capital gain).