51 / What are the income tax consequences when the owner of a life insurance or endowment contract takes the lifetime maturity proceeds or cash surrender value in a one lump sum cash payment?

Amounts received on complete surrender, redemption, or maturity of a life insurance or endowment contract are taxed under the cost recovery rule ( Q 10). If the maturity proceeds or cash surrender value exceeds the cost of the contract, the excess is taxable income in the year of maturity or surrender, even if the proceeds are not received until a later tax year.¹ (For computation of “cost,” see Q 531.) The gain is ordinary income, not capital gain.²

The IRC provides that aggregate premiums are the investment in the contract, which is used for computing gain upon the lifetime maturity or surrender of a life insurance or endowment contract ( Q 531).³ Consequently, although the portion of the premiums paid for current life insurance protection is generally a nondeductible personal expense, that portion nevertheless may be included in the investment in the contract for the purpose of computing gain upon the surrender or lifetime maturity of the policy.

Example. Mr. Green purchases a whole life policy in the face amount of $100,000. He uses dividends to purchase paid-up additions. Over a 20-year period, gross premiums amount to $47,180. Of this amount, $13,018 represents the net protection portion of the premiums, and $34,162 the investment portion. At the end of the 20-year period, Mr. Green surrenders his policy for its cash surrender value of $48,258 (cash value of the original $100,000 policy plus cash value of insurance additions). His investment in the contract is $47,180 (not $47,180 less $13,018). Thus, his taxable gain is $1,078 ($48,258 - $47,180), not $14,096 ($48,258 - $34,162).

In a 2009 Revenue Ruling, the IRS reiterated the above conclusion, ruling that a policy owner who surrenders a policy in a life settlement transaction is not required to subtract the cost of insurance charge from the policy owner’s investment in the contract. In the revenue ruling, the cash surrender value of the subject policy was $78,000 (the IRS assumed that the cash surrender value already reflected the subtraction of the cost of insurance protection ($10,000)). The amount of premiums paid was $64,000. According to the IRS, the taxpayer’s recognized gain was only $14,000 ($78,000 surrender proceeds – $64,000 investment in the contract), all of which was declared ordinary income by the IRS.⁴ (For a more detailed analysis, see Situation 1, “Surrender of Cash Value Policy,” in Q 37.)

The 2017 tax reform legislation has changed this result with respect to sales of life insurance policies, however. Under the 2017 law, the cost of insurance protection is not subtracted when determining the policy’s basis (the 2017 rule is retroactive and applies to transactions occurring before August 25, 2009).⁵

Prior to this clarification, with respect to a viatical settlement, the IRS ruled privately that at the time of the assignment to a viatical settlement company, the basis of a whole life policy was equal to premiums paid less the sum of the cost of insurance protection provided up to the assignment date and any amounts, such as dividends, that were received under the contract but were not included in gross income. The cost of insurance protection in the private letter ruling was found to equal the aggregate premiums paid less the cash value of the policy. This ruling implies that, at least according to the IRS, the terms “basis” and “investment in the contract” do not mean the same thing.⁶ This result would no longer be viable under the new law.

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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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For a discussion of the exception to the general rule that gain on endowment maturities and cash surrenders is taxable income, see Q 139 on government life insurance.