May 1, 2009

IRS Rules on Taxation From Sale of Life Insurance to Investors

IRS Logo The IRS released on May 1, 2009, two Revenue Rulings dealing with how life insurance policies are taxed when they are surrendered or sold to an investor. The rulings mention both cash-value contracts and term contracts. The first ruling deals with how the original owner of the policy is taxed. The second deals with how the investor is taxed.

This article only outlines the situations the two rulings describe and how the IRS says each is taxed. A future article will delve into the reasoning the IRS used to get to their conclusions.

Rev. Rul. 2009-13 – Taxation of the Policy Owner

Rev. Rul. 2009-13 deals with how owners of life insurance are taxed when they sell or surrender the policy.

Situation 1: Owner buys life insurance on his own life. He is the owner and his family is the beneficiary. Owner pays $64,000 in premiums over 8 years and then surrenders the policy for $78,000. During the 8 years he pays $10,000 in “cost-of-insurance” charges.

Result 1: Owner has $14,000 of ordinary income ($78,000 received minus $64,000 premiums paid).

Situation 2: The same facts except that Owner sells the policy to Investor for $80,000. Investor is not related to owner and has no insurable interest in Owner.

Result 2: Owner has $26,000 taxable income. That consists of $14,000 ordinary income ($78,000 cash surrender value minus $64,000 premiums paid) and $12,000 long-term capital gain income ($80,000 sales price minus $78,000 cash surrender value.)

Situation 3: Same facts except the policy is level premium 15-year term life insurance with a $500 a month premium. Owner pays $45,000 in premiums during the 8 years and then sells the policy to Investor for $20,000.

Result 3: Owner has $19,750 long-term capital gain income ($20,000 sales price minus $250 adjusted basis. The adjusted basis is the $45,000 total premiums paid minus the cost-of-insurance protection. The cost-of-insurance is the $500 monthly term premium times the 89.5 months premiums paid – that is, $44,740.)

Rev. Rul. 2009-14 – Taxation of an Investor

This ruling deals with how an investor who buys life insurance is taxed. It assumes the investor does not have an insurable interest in the life of the person insured under the contract.

Situation 1: Owner buys a level premium 15-year term life insurance on his own life with a monthly $500 premium. He is the owner and his family is the beneficiary. After paying $45,000 in premiums, Owner sells the policy to Investor for $20,000. Investor, a “United States person,” does not have an insurable interest in Owner’s life. Investor pays another $9,000 premiums and the insured then dies. Investor receives a $100,000 death benefit.

Result 1: Investor has ordinary income of $71,000 (the $100,000 death benefit minus both the $20,000 paid for the policy and the $9,000 premiums paid after buying the policy).

Situation 2: Same facts except that Investor pays the added $9,000 premiums and then sells the policy to Investor2 for $30,000.

Result 2: Investor has $1,000 long-term capital gain (the $30,000 sales prices minus a $29,000 adjusted basis. The adjusted basis is the $20,000 he paid Owner plus the extra $9,000 premiums).

Situation 3: Same facts as Situation 1 except that Investor is a foreign corporation.

Result 3: Investor has $71,000 ordinary income. It is treated as income from sources within the United States.

Walt