36 / What are the income tax consequences when the owner of a life insurance or endowment contract sells the contract?

Editor’s Note: The 2017 tax reform law reversed the IRS position in Revenue Ruling 2009-13,  and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the “cost of insurance”) in the case of a policy sale. Therefore, on sale of a cash value insurance policy, the insured’s basis is no longer reduced by the cost of insurance.¹ This new rule for determining basis is effective retroactively, to transactions entered into after August 25, 2009.²

Prior to 2009, the question of whether the cost of insurance protection should be subtracted or not from the premiums paid was unsettled. A commonly held view was that the cost of insurance protection should not be subtracted from the premiums paid (thus decreasing the amount of taxable gain). Conversely, in 2005 guidance, the IRS had indicated that on a sale of a life insurance policy, it would consider the basis of the contract to be the premiums paid minus the cost of insurance protection – thus, increasing the amount of taxable gain.³

In 2009, the IRS issued Revenue Ruling 2009-13 (discussed in Q 37, Q 38 and Q 39), which aimed to provide definitive guidance to policyholders who surrender or sell their life insurance contracts in life settlement transactions.⁴ According to the revenue ruling, the basis is not adjusted for the cost of insurance protection when a policy is surrendered (Situation 1), but the cost of insurance protection is subtracted from the premiums paid when the policy is sold (Situations 2 and 3). The 2017 tax reform legislation reversed this IRS position retroactively, for transactions entered into after August 25, 2009, and provides that basis will not be adjusted in the case of a policy sale.