40 / How is gain on the sale or surrender of a life insurance policy before 2009 calculated?

Gain up to the amount of the contract’s cash surrender value should be taxed to the seller as ordinary income. According to the decided cases, the amount of taxable gain is determined in the same way as upon surrender of a contract ( Q 51). In other words, gain is determined by subtracting the net premium cost (i.e., gross premiums less dividends to the extent excludable from income) from the sale price.¹ Therefore, under applicable case law, the cost of insurance protection is not deducted from the premiums paid. While later guidance indicated that on a sale of a life insurance policy, the IRS considered the basis of the contract to be the premiums paid minus the cost of insurance protection, the 2017 tax reform legislation superseded this position by statute in providing that the cost of insurance protection cannot be subtracted from basis (effective with respect to transfers entered into after August 25, 2009).²

Before Revenue Ruling 2009-13 (see Q 37 to Q 39), the issue of whether gain in excess of the contract’s cash surrender value (such as in a life settlement) is ordinary income or capital gain was unsettled. Some argued that the entire gain should be ordinary income. But others contended that gain in excess of the contract’s cash surrender value should receive capital gain treatment. In support of the argument that a portion of a life settlement should be treated as a capital gain, proponents pointed to a footnote in the Phillips case in which the IRS conceded that in certain situations the sale of a life insurance contract might result in capital gain treatment.³ However, in a technical advice memorandum, the IRS pointed out that even if a life insurance contract is treated as a capital asset, the entire gain from the sale of a contract should be treated as ordinary income.⁴

In another case, the Tax Court held that settlement proceeds ($500,000) received by the taxpayer (a former corporate executive) with respect to a life insurance policy represented an extinguishment of the taxpayer’s claim to ownership of the policy, as opposed to a sale or exchange of a capital asset. Accordingly, the proceeds were taxable as ordinary income.⁵