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).