38 / How is gain on the sale of a cash value life insurance policy calculated after 2008? How did the 2017 tax law change the rules governing gain on the sale of a life insurance policy?

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 explained 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 the sale of a cash value life insurance policy (Situation 2) prior to the clarification that reversed this position in the 2017 tax reform legislation. For examples illustrating the results upon the surrender of a cash value policy (Situation 1) and the sale of a term life insurance policy (Situation 3), see Q 37 and Q 39.

Revenue Ruling 2009-13: Situation 2

In Situation 2, the IRS took the position that the cost of insurance protection must be subtracted from the premiums paid when determining the adjusted basis in the contract. The 2017 tax reform legislation reversed this IRS position retroactively, for transactions entered into after August 25, 2009.

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 sold the policy on June 15, 2008, for $80,000 to a B, a person unrelated to John and who would suffer no economic loss upon John’s death. 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, which, at the time, was $78,000, 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). John was not terminally or chronically ill on the sale date.

Amount of income recognized. The IRS first stated the general rule that gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis for determining gain.⁴ The IRS determined that the amount John realized from the sale of the life insurance policy was $80,000.⁵

The adjusted basis for determining gain or loss is generally the cost of the property minus expenditures, receipts, losses, or other items properly chargeable to the capital account.⁶ The IRS specifically pointed out that Section 72, which involves the taxation of certain proceeds of life insurance contracts, has no bearing on the determination of the basis of a life insurance policy that is sold because that section applies only to amounts received under the policy, which was not the case in this situation.

Next, the IRS noted that both the IRC and the courts acknowledge that a life insurance policy – while only a single asset – may have both investment and insurance characteristics.⁷ The IRS then stated that to measure a taxpayer’s gain on the sale of a life insurance policy, the basis must be reduced by the portion of the premium paid for the policy that has been expended for the provision of insurance before the sale.⁸

Against that backdrop, the IRS determined that John had paid premiums totaling $64,000 through the date of sale, and that $10,000 would have to be subtracted from the policy’s cash surrender value as cost of insurance charges. Thus, John’s adjusted basis in the policy as of the date of sale was $54,000 ($64,000 premiums paid - $10,000 expended as the cost of insurance). Accordingly, the IRS ruled that John would have to recognize $26,000 of income upon the sale of the life insurance policy, which is the excess of the amount realized on the sale ($80,000) over John’s adjusted basis in the contract ($54,000).

Character of income recognized. The “substitute for ordinary income” doctrine (which essentially holds that ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange) was held by the IRS to be applicable in this situation. The IRS stated, however, that the doctrine is limited to the amount of income that would be recognized if a policy were surrendered (i.e., to the inside build-up under the policy). Thus, if the income recognized on a sale (or exchange) of a policy exceeds the “inside build-up” under the policy, the excess may qualify as gain from the sale or exchange of a capital asset.⁹

In Situation 2, because the “inside build-up” in John’s life insurance policy was $14,000 ($78,000 cash surrender value - $64,000 aggregate premiums paid), the IRS concluded that that amount would constitute ordinary income under the doctrine. Because the policy was a capital asset (under Section 1221) and had been held by John for more than one year, the remaining $12,000 of income represented long-term capital gain.¹⁰

Effective date: The IRS has declared that the holding in Situation 2 will not be applied adversely to sales occurring before August 26, 2009.¹¹

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Planning Point: Prior to the 2017 tax changes, a life settlement, or seemingly any transfer for value to a party lacking insurable interest, constituted a transaction possibly subject to income taxation. Revenue Ruling 2009-13 concluded that the policy basis is first reduced by the “cost of insurance” (COI) charges (a proposition which is no longer valid). The amount received in excess of basis is ordinary income up to the policy cash surrender value. Amounts in excess of cash surrender value are capital gain.

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