62 / Does the surrender or sale of a life insurance or endowment contract ever result in a deductible loss?

A loss deduction can be claimed only if the loss is incurred in connection with the taxpayer’s trade or business or in a transaction entered into for profit.¹ If the surrendered contract is a life insurance policy, ordinarily there will be no deductible loss, even though the cash surrender value is less than the net premium cost. The IRC expressly provides that a taxpayer’s investment in the contract is the “aggregate premiums paid,” but this may be different than the contract’s “basis” ( Q 37, Q 51). The IRC, however, is silent with respect to cost basis for computing loss. Several courts have held that the portion of the premiums paid for life insurance protection cannot be included in the cost basis. They reason that this portion is not a recoverable investment, but a nondeductible expense.² There can be no loss, therefore, if the cash surrender value equals the policy reserve. But if the contract is surrendered in a policy year in which the reserve exceeds the cash surrender value, the difference may be allowable as a loss, provided the policy was purchased in connection with the taxpayer’s trade or business or in a transaction entered into for profit.³ Apparently the Tax Court considers the purchase of a personal cash value policy as a transaction entered into for profit to the extent of the policy’s investment feature.⁴ A Texas district court, however, does not consider it a transaction for profit even to this extent.⁵

A different situation exists where, because of the insurance company’s insolvency, the policy owner receives less than the stated cash surrender value. In this case, the difference between the amount received and the stated cash surrender value is a deductible loss.⁶

1.     IRC § 165.