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.)