39 / How is gain on the sale of a term 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 term life 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 term life insurance policy (Situation 3), as previously enforced by the IRS. However, as noted in the editor’s note above, the IRS position has explicitly been superseded by statute. For examples illustrating the results upon surrender of a cash value policy or the sale of a cash value policy, see Q 37 and Q 38.

Revenue Ruling 2009-13: Situation 3

In Situation 3, the IRS took the position that the cost of insurance protection must be subtracted from the premiums paid. This position is no longer valid, and the cost of insurance may not be subtracted.

Facts: On January 1, 2001, John Smith bought a 15-year level premium term life insurance policy on his life. The policy had a $500 monthly premium. 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 paid $45,000 total premiums through June 15, 2008, at which point he sold the policy for $20,000 to a B, a person unrelated to John and who would suffer no economic loss upon John’s death. John was not terminally or chronically ill on the sale date.

Amount and character of income recognized: The IRS stated that absent other proof, the cost of the insurance provided to John each month was presumed to equal the monthly premium under the policy ($500). Consequently, the cost of insurance protection provided to John during the 89.5-month period was $44,750 ($500 monthly premium times 89.5 months). Thus, John’s adjusted basis in the policy on the date of sale to B was $250 ($45,000 total premiums paid – $44,750 cost of insurance protection). The IRS concluded that John was required to recognize $19,750 long-term capital gain upon the sale of the term life policy ($20,000 amount realized – $250 adjusted basis).⁴

Effective date: Pre-reform, the IRS has declared that the holding in Situation 3 will not be applied adversely to sales occurring before August 26, 2009.⁵

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Planning Point: Under the 2017 tax reform legislation, the otherwise available exceptions to the transfer for value rule generally do not apply if the sale was a reportable policy sale (i.e., most commercial transfers) for tax years beginning after 2017.

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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.