37 / How is gain on the surrender of a cash value life insurance policy calculated after 2008?

Editor’s Note: The 2017 tax reform legislation 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

Revenue Ruling 2009-13 explains how to calculate the amount and character of gain upon the surrender or sale of a life insurance policy by the insured.³ The example below illustrates the results upon surrender of a cash value policy (Situation 1). For examples illustrating the treatment of the sale of a cash value life insurance policy and the sale of a term life insurance policy, see Q 38 and Q 39.

Revenue Ruling 2009-13: Situation 1

Facts: On January 1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John’s family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John 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 provided by the insurer (for the period ending on or before June 15, 2008). Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy’s cash surrender value. John was not terminally or chronically ill on the surrender date.

Amount of income recognized. The IRS determined that the “cost recovery” exception (to the “income first” rule) applied to the non-annuity amount received by John.⁴ Under that exception, a non-annuity amount received under a life insurance contract (other than a modified endowment contract) is includable in gross income to the extent it exceeds the “investment in the contract.” For this purpose, “investment in the contract” means the aggregate premiums (or other consideration paid for the contract before that date) minus the aggregate amount received under the contract before that date that was excludable from gross income. The IRS ruled that John must recognize $14,000 of income: $78,000 (which included a $10,000 reduction for cost of insurance) minus $64,000 (premiums paid).

Character of income recognized: The IRS concluded that the $14,000 was ordinary income, not capital gain. The IRS determined that the life insurance contract was a “capital asset” described in IRC Section 1221(a). However, relying on earlier guidance, the IRS reiterated that the surrender of a life insurance contract does not produce a capital gain,⁵ and further determined that IRC Section 1234A (which applies to gains from certain terminations of capital assets) does not change this result.

See Q for the new reporting requirements that apply when a life insurance contract is sold in a life settlement transaction.