43 / How is the purchaser of a life insurance or endowment contract taxed?

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. See Q 36 to Q 39.

If a purchaser receives lifetime proceeds under a life insurance or endowment contract, the purchaser is generally taxed in the same way as an original owner would be taxed, but with the following differences. The purchaser’s cost basis is the consideration the purchaser paid for the contract, plus any premiums the purchaser paid after the purchase, less any excludable dividends and unrepaid excludable loans received by the purchaser after the purchase.¹ It also should be noted that the purchase of a life insurance policy will, under some circumstances, result in loss of the income tax exemption for the death proceeds, under IRC Section 101(a)(2), the so-called “transfer-for-value” rule (see Q 279 through Q 290).

Revenue Ruling 2009-14

In 2009, the IRS released guidance regarding the different tax consequences for an investor (B) upon the receipt of either (1) death benefits or (2) sale proceeds with regard to a term life insurance policy that the investor purchased for profit.²

Situation 1 – Receipt of Death Benefits by Third Party Who Purchases Term Life Policy from Insured: John Smith is a U.S. citizen residing in the United States. B (a U.S. “person” within the meaning of Section 7701(a)(30)) purchased a 15-year level premium term life insurance policy on John’s life for $20,000 on June 15, 2008, when the remaining term of the policy was seven years, six months, and 15 days. B named himself beneficiary of John’s policy immediately after acquiring it. B purchased the policy with a view to profit, and the likelihood that B would allow the policy to lapse was remote. B was unrelated to John, had no insurable interest in John’s life, and would not suffer economic loss upon John’s death. B paid monthly premiums totaling $9,000. Upon John’s death (December 31, 2009), the insurance company paid $100,000 to B.

The IRS determined that the purchase of the policy by B was a transfer for value that did not qualify for any of the potential exceptions to the rule. Accordingly, the amount received because of John’s death was excludable from gross income under IRC Section 101(a)(1), although under IRC Section 101(a)(2) the exclusion would be limited to the sum of the actual value of the consideration paid for the transfer ($20,000) and other amounts paid by B ($9,000), or $29,000. Therefore, the IRS ruled that B was required to recognize $71,000 of gross income, which is the difference between the total death benefit received ($100,000) and the amount excluded under IRC Section 101 ($29,000). With respect to the character of the gain, the IRS determined that neither the surrender of a life insurance or annuity contract, nor the receipt of a death benefit from the issuer under the terms of the contract, produces a capital gain. Accordingly, the IRS ruled that the $71,000 of income recognized by B upon the receipt of the death benefits under the contract was ordinary income.

Situation 2 – Resale of Policy by Third Party Who Bought Term Life Policy from Insured: The facts here are the same as immediately stated above, except that: (a) John did not die; and (b) on December 31, 2009, B sold the policy to C (unrelated to John or B) for $30,000. The IRS found that in this situation, unlike Situation 2 of Revenue Ruling 2009-13 ( Q 38), no reduction to basis for the cost of insurance charges was necessary because unlike John, B did not purchase the policy for protection against economic loss. The IRS therefore distinguished this situation from Revenue Ruling 2009-13 (which has now been overruled in part by the 2017 tax reform legislation) because B acquired and held the policy solely with a view to profit. Accordingly, the IRS required B to recognize only $1,000 on the sale of the life insurance policy ($30,000 – [$20,000 + $9,000]). Because the term life insurance policy was not property excluded from capital gain treatment under IRC Sections 1221(a)(1) through 1221(a)(8), and because it had been held for more than one year, the IRS characterized the $1,000 of gain recognized by B under IRC Section 1001 as long-term capital gain (citing Revenue Ruling 2009-13). In addition, because the policy was a term policy without any cash value, the substitute for ordinary income doctrine (under United States v. Midland-Ross Corp.³) did not apply.