Fed Tax: Life Insurance Settlements
Fed Tax: IRS Answers
New guidance on life insurance settlements
Stuart R. Josephs, CPA
Rev. Rul. 2009-13 (IRB 2009-21, May 26, 2009) answers this question: What income is recognized upon the surrender or sale of the life insurance contracts described in the three situations below?
Situation 1
Facts: On Jan. 1, Year 1, individual A entered in a life insurance contract with cash value. A was the insured and his relative the beneficiary. A had the right to change the beneficiary, take out a policy loan or surrender the contract for its cash surrender value (CSV). The contract in A’s hands was not property excluded from the definition of a capital asset [under IRC Sec. 1221(a)(1)-(8)].
On June 15, Year 8, A surrendered the contract for its $78,000 CSV, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the contract’s surrender. Through that date, A paid premiums totaling $64,000 and was not terminally or chronically ill [as defined by Sec. 101(g)(4)]. A neither received any distributions under the contract nor borrowed against its CSV.
Holding: A must recognize ordinary income of $14,000 ($78,000 less $64,000).
Situation 2
Facts: The same as Situation 1, except that on June 15, Year 8, A sold the contract for $80,000 to B, a person unrelated to A $and who would not suffer economic loss upon A’s death.
Holding: A must recognize income upon the contract’s sale, as follows:
Sales proceeds $80,000
Less—contract’s basis:
Premiums paid $64,000
Less—cost of insurance
charges $10,000
Basis $54,000
Total income recognized $26,000
Of this amount, $14,000 is ordinary income and $12,000 is long-term capital gain.
Situation 3
Facts: The same as Situation 1, except that the contract was a level premium 15-year term life insurance contract without CSV. The contract’s monthly premium was $500. Through June 15, Year 8, A paid premiums totaling $45,000.
On June 15, Year 8, A sold the contract for $20,000 to B, a person unrelated to A and who would not suffer economic loss upon A’s death.
Holding: A must recognize long-term capital gain upon the contract’s sale, as follows:
Sales proceeds $20,000
Less—contract’s basis:
Premium paid $45,000
Less—cost of insurance
charges (see below) $44,750
Basis $ 250
Long-term capital gain $19,750
Absent other proof, the cost of the insurance provided to A each month is presumed to equal the monthly $500 premium. Thus, the cost of A’s insurance protection during the 89.5 months that A held the contract is $44,750 ($500 X 89.5).
Effective Date: Situations 2 and 3’s holdings will not be applied adversely to sales occurring before Aug. 26, 2009.
Companion Ruling
Rev. Rul. 2009-14 (IRB 2009-21, May 26, 2009) answers this question: What are B’s tax consequences upon receiving death benefits or sales proceeds regarding a term life insurance contract that B purchased for profit in three situations described below.
Situation 1
Facts: A is a U.S. citizen-resident; B is a U.S. person. On June 15, 2008, B purchased from A for $20,000 a life insurance contract on A’s life, issued by a domestic corporation, IC, to A on Jan. 1, 2001. This contract was a level premium 15-year term contract without CSV.
On June 15, 2008, the contract’s remaining term was seven years, six months and 15 days. The monthly premium was $500, due and payable on the first day of each month.
As the contract’s owner, B named itself the beneficiary immediately after acquiring the contract. B had no insurable interest in A’s life and, except for purchasing the contract, had no relationship to A and would not suffer economic loss upon A’s death. B purchased the contract with a view to profit.
The contract in B’s hands was not property excluded from the definition of a capital asset. The likelihood that B would allow the contract to lapse by not paying the remaining premiums was remote.
On Dec. 31, 2009, A dies and IC pays $100,000 under the contract to B. Through this date, B pays premiums totaling $9,000.
Holding: B must recognize $71,000 of ordinary income.
Situation 2
Facts: The same as Situation 1, except that A does not die and, on Dec. 31, 2009, B sells the contract to C, who is unrelated to A or B, for $30,000.
Holding: B must recognize $1,000 of long-term capital gain.
Situation 3
Facts: The same as Situation 1, except that B is a foreign corporation not engaged in a U.S. business.
Holding: B must recognize $71,000 of ordinary income from U.S. sources, subject to Sec. 881(a)(1)’s flat 30 percent tax.
Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice that specializes in assisting practitioners in resolving their clients’ tax questions and problems. Josephs is chair of the Federal Subcommittee of CalCPA’s Committee on Taxation.
