Assume Ellen owns a cash value life policy on which she has paid $64,000 in premiums over 10 years. 
She has never taken out withdrawals or loans, and the cash value is now $78,000. She decides to surrender the policy, pocket the $78,000, and include $14,000 on her tax return as ordinary income.
The taxes are no surprise, as the law in this area has been well settled for years.
But let's say Ellen decides to sell her policy to a life settlement company instead. A variety of theories have been advanced for how such a transaction should be taxed, but finally, the Internal Revenue Service has provided some guidance. This is Revenue Ruling 2009-13. It outlines the tax consequences to those selling their policies, beginning with the simple surrender of a permanent, cash value life policy as described above.
In Situation 1, the IRS confirms that the seller (A) must recognize $14,000 of ordinary income, the amount by which the cash value exceeds "investment in the contract."
Situation 2 uses the same policy but adds the following facts:
o Instead of surrendering the policy for $78,000, A sells it to B for $80,000.
o B is described as "a person unrelated to A and who would suffer no economic loss upon A's death"–a description that certainly fits a life settlement company.
o The actual cost of insurance protection over the years has totaled $10,000.
This time the IRS analyzes the transaction as "the sale or other disposition of property" rather than as "amounts not received as annuities," and talks about "adjusted cost basis" rather than "investment in the contract."
o A's basis in the contract must be adjusted to reflect the hypothetical $10,000 cost of insurance. Thus, A's adjusted cost basis drops from $64,000 to $54,000.
o The total gain is $26,000 ($80,000 sale price minus adjusted basis of $54,000). This has two elements: 1) The amount of gain ($14,000) that would have been ordinary income had the policy been surrendered is ordinary income; and 2) The balance of the gain ($12,000) is treated as capital gain.
