8 / Are annual increases in the cash surrender value of a life insurance policy taxable income to the policyholder?

The Internal Revenue Code does not explicitly provide for the tax treatment of increases in the cash surrender value of a life insurance policy unless those values are accessed, directly or indirectly. In a case involving a cash basis taxpayer, the Tax Court held that the cash values were not constructively received by the taxpayer where the taxpayer could not reach them without surrendering the policy. The necessity of surrendering the policy constituted a substantial “limitation or restriction” on their receipt.¹ Likewise, the Tax Court has held that the cash surrender values of paid-up additions are not constructively received by the policyholder.² Similarly, it would appear that the same “limitation or restriction” would prevent accrual for an accrual basis taxpayer, because income does not accrue until “all the events have occurred” that fix the right to receive the income.³ The same rule applies whether the policy is a single premium policy or a periodic premium policy.

Tax on the “inside buildup” of cash surrender values generally is not deferred in the case of contracts issued after December 31, 1984 that do not meet the statutory definition of a “life insurance contract” ( Q 65).⁴ In such cases, the excess of the sum of (1) the increase in net surrender value (cash surrender value less any surrender charges) during the taxable year and (2) the cost of life insurance protection for the year over premiums paid under the contract during the year is taxable to the policyholder as ordinary income.⁵ “Premiums paid” generally means those paid under the contract less amounts received but excludable from income under IRC Section 72(e) (e.g., dividends).⁶ The cost of life insurance protection is the lesser of the cost of individual insurance on the life of the insured determined on the basis of uniform premiums or the mortality charge, if any, stated in the contract.⁷ If the contract originally meets the statutory definition and then ceases to do so, income on the contract for all prior years is included in gross income in the year it ceases to meet the definition.⁸ See Q 36 and Q 37 for a discussion of the new rules for determining basis under the 2017 tax reform legislation.

If a variable insurance contract is an insurance contract under applicable state law and would otherwise meet the definitional requirements of IRC Section 7702, the annual increases in cash surrender value may nevertheless be taxed under the rules in the above paragraph if the underlying segregated asset account is not adequately diversified ( Q 553).

If a policy does not meet the IRC Section 7702(a) definition of a life insurance contract, the income on the contract for the year is considered a nonperiodic distribution and is subject to certain reporting and withholding requirements. The same is true for a variable life insurance contract that does not meet the diversification requirements of regulations under IRC Section 817(h).⁹

The “inside buildup” of cash surrender values of corporate-owned life insurance is generally included in the calculation of the alternative minimum tax ( Q 316). (Note that the corporate AMT was repealed for tax years beginning after 2017).

On December 7, 2015, the U.S. Congressional Joint Committee on Taxation issued a report containing a change of its procedure:

Historically, the Joint Committee staff has included in its report on tax expenditures some items for which no provision of the Federal tax law specifically allows an exclusion, but which are nonetheless excluded from income. Among these are the exclusion of all Medicare benefits from taxation, the exclusion of investment income on life insurance and annuity contracts, and the exclusion of cash public assistance. This report no longer includes tax expenditure estimates for these items. [Emphasis added.]

By no longer listing the exclusion of inside buildup of life insurance and annuities as a “tax expenditure,” the Committee appears to join the broadly held and long-standing view that despite specific provisions of the Internal Revenue Code exempting (or deducting) such buildup, the proper taxation of life insurance and annuities does not include such amounts.