Sapers & Wallack
Bulletins: AALU Washington Reports
IRS Rules On Tax Treatment Of Life Insurance Policy Dispositions Primarily Where The Disposition Is To Or By A Third Party
May 7, 2009
SEE THE CIRCULAR 230 DISCLAIMERS APPENDED TO THE CONCLUSION OF THIS WASHINGTON REPORT.
The Internal Revenue Service recently released two revenue rulings (Rev. Rul. 2009-13 and Rev. Rul. 2009-14) that set forth the Service’s views on how life insurance policies (both cash value and term) are taxed primarily when the policies are sold to an unrelated third party or disposed by such a third party. The rulings address the amount of income on the sale or surrender of the policy and on the payment of the policy’s death benefits. They consider also the character of that income, i.e., whether it is ordinary income or capital gain. The Revenue Service was prompted to address these issues by Senate Select Committee on Aging Chairman Herb Kohl (D-WI) in a letter he submitted a few months ago to the Treasury.
I. Rev. Rul 2009-13
The first ruling, Rev. Rul. 2009-13, focuses on the income tax results to the insured in three different situations.
A. Situation 1
Situation 1 involves a cash value contract that is surrendered by “A”, the insured, to the insurance company for its cash surrender value, $78,000. The ruling states that the “cost of insurance” charges, which were for the period ending on the surrender of the contract, had been taken into account (i.e., subtracted) in
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the establishment of the cash surrender value. “A” had paid total premiums of $64,000 and had not received any prior distributions, nor had he borrowed against the cash surrender value.
In Situation 1, the Service provided a straight forward analysis of the Revenue Code’s §72(e) as applicable to amounts “received *** under an annuity, endowment or life insurance contract.” It concluded that A’s “investment in the contract” was $64,000 (the amount of total premiums paid by A to the time of surrender). A, therefore, recognized income of $14,000 on surrender of the contract, which was the difference between the $78,000 amount received over the $64,000 investment in the contract. The IRS determined that income to be ordinary in nature and not capital gain.
B. Situation 2
Situation 2 was stated to be the same as Situation 1 with the following difference: Instead of surrendering the contract, A sold it for $80,000 to B, a person who was “unrelated to A and who would suffer no economic loss upon A’s death.”
The Service began its analysis of Situation 2 by determining that §72, which was applicable to Situation 1, had no relevance here because that section deals only with amounts received “under an annuity, endowment or life insurance contract” and, in the Service’s view, not with a sale to a third party. The IRS then moved on to court cases from the 1930s stating that life insurance policies combine both investment and insurance features. Relying primarily on a 1934 case (Century Wood Preserving Co. v. Comr. 59 F 2nd 967 (3d Cir.1934)), the IRS held that the taxpayer’s nominal (i.e., Situation 1 §72) basis (the amount of premium paid) had to be reduced by the value of the annual insurance protection that had been earned and used. As a consequence, the IRS held that A’s basis was $64,000 reduced by $10,000 which represented the “cost-of-insurance” charges. As a result, A’s adjusted basis in the contract was $54,000; therefore, A had a gain of $26,000 (the $80,000 received minus the $54,000 adjusted basis).
In determining the ordinary or capital nature of the gain, the IRS applied the so-called “substitute for ordinary income” judicial doctrine under which capital assets do not include any property that would have a claim or right to ordinary income. The Service then concluded that the “substitute for ordinary income” doctrine is limited to that portion of the gain that would have been recognized as ordinary income if the contract had been surrendered, i.e., it is equal to the inside buildup under the contract. The gain in excess of that portion which is taxed as ordinary income is entitled to capital gain treatment.
Applying this to the facts of Situation 2, the Service stated that the inside buildup was $14,000, the same as in Situation 1 (the $78,000 cash surrender value less the $64,000 in aggregate premiums paid). Thus, $14,000 of the total $26,000 gain on the sale of the policy was ordinary income under the “substitute for ordinary income” doctrine and the balance, $12,000, was long-term capital gain.
C. Situation 3
The third Situation in Rev. Rul. 2009-13 was the same as Situation 1 except that the contract was a level premium 15-year term contract with no cash surrender value. The monthly premium was $500 and through June 15 of year 8, A paid premiums totaling $45,000 on the contract. On June 15, A sold the contract for $20,000 to B, a person who was unrelated to A and who would suffer no economic loss upon A’s death.
Because this was a term policy, the IRS stated that, absent other proof, the cost of the insurance provided to A each month is presumed to equal the monthly premium which is paid to and earned by the
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issuing company under the contract. In other words, the $500 premium is treated as being consumed by A each month as the value of A’s insurance protection. Because the policy was sold in the middle of June, A had a $250 basis remaining ($45,000 in premiums paid but only $44,750 in cost of insurance). Since A received $20,000 from B, all of that $20,000 less the $250 basis was income on the sale of the policy, that is, $19,750 was income.
Because there was no inside buildup in the contract (since it was a term policy), the “substitute for ordinary income” doctrine did not apply. Therefore, the full $19,750 was long-term capital gain for A.
The Revenue Service held that the rulings for Situations 2 and 3 will not be applied adversely to sales occurring before August 26, 2009. In short, they made the latter two holdings prospective from that date.
II. Rev. Rul. 2009-14
Rev. Rul. 2009-14 also analyzed three different situations, all of which focused on the taxation of B, the unrelated party who purchased the life insurance contract from A.
A. Situation 1
On June 15, 2008, B purchased for $20,000 from A, who was the insured and a US citizen, a life insurance policy issued by a domestic corporation. The contract was a level premium 15-year term life insurance contract without cash surrender value. At the time of purchase, the remaining term of the contract was 7 years, 6 months and 15 days. The monthly premium was $500. B had no insurable interest in A and purchased the contract with a view to profit.
On December 31, 2009, A died and the insurance company paid $100,000 to B. At that time, B had paid monthly premiums of $9,000 to keep the contract in force. The main focus of the IRS analysis in this Situation was the §101(a) transfer for value provisions. The Service concluded that the sale was such a transfer. B did not qualify for any of the transfer for value exceptions (there was no carryover basis and no other relationship with the insured that would qualify for any of the available exceptions).
Under section 101(a)(2), the exclusion for the death benefit received by B ($100,000) is limited to the actual value of the consideration paid for the transfer ($20,000) plus the other amounts paid by B (the $9,000 of additional premiums) for a total of $29,000. As a consequence, B’s income from the death benefit was $71,000 (the $100,000 death benefit minus the $29,000 basis), all of which was held to be ordinary income.
B. Situation 2
Situation 2 is the same as Situation 1 except that A did not die on December 31, 2009. Instead B sold the contract to C (a person who is unrelated to A or B) for $30,000.
In contrast to the Revenue Service analysis of Situation 1, here the Service held that the transfer for value rules have no bearing on Situation 2 because they apply only to amounts received by reason of the death of the insured. Further the Service stated that, under the section 263 regulations, it was authorized to publish guidance that identified future benefits as an intangible for which capitalization is required. Therefore, Rev. Rul. 2009-14 requires that a secondary market purchaser capitalize premiums which are
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paid in order to prevent a term life insurance contract from lapsing. Consequently, the Service will not challenge the capitalization of such premiums before the issuance of Rev. Rul. 2009-14.
Based on this holding, the IRS concluded that B’s adjusted basis was $29,000 (i.e., the total of the amount paid ($20,000) and the capitalized premiums paid ($9,000).
The IRS distinguished Situation 2 in Rev. Rul. 2009-13 (above), noting that B (unlike A in Situation 1) was not required to reduce its basis in the life insurance contract for the value of the life insurance protection provided. That adjustment is only required of A, since A is the one who enjoys the value of the life insurance protection. Therefore, B’s income on the sale to C was $1,000 (i.e., the $30,000 of proceeds received less the adjusted basis of $29,000). The revenue ruling further held that this $1,000 of gain is long-term capital gain and that the “substitute for ordinary income” doctrine is not applicable because the policy is a term contract without any inside build-up upon which to hinge application of the doctrine.
C. Situation 3
Situation 3 was the same as Situation 1 except that B was a foreign corporation not engaged in business in the US. As a consequence, the question focused on the source of the income, i.e., was it within the United States? If not, the income would likely be nontaxable in the US.
The IRS indicated that whether the income was sourced in the US was not specified by statute or regulation and that, therefore, it (the Service) had to determine the source of income by comparison to and analogy with other classes of income. After minimal analysis, it concluded that, because A was a US citizen residing in the US and the insurance company was a US corporation, the income was from sources within the United States and therefore would be subject to US taxation.
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These two rulings and their holdings present some interesting, even surprising and, arguably, questionable conclusions. The following are a number of initial impressions from an early reading of the rulings. Doubtless, upon more mature reflection by AALU and upon hearing from members, we will have further comments and indeed may substantially revise those that are set forth here.
1. Of the six Situations considered by the Revenue Service, one (Situation 1 of Rev. Rul. 2009-13) deals with a receipt of cash by the insured through surrender of the policy, two (Situations 1 and 3 of
Rev. Rul. 2009-14) deal with receipt of death benefits on maturity of the policy (in both cases, receipts claimed by and paid to a person who purchased the policy from the insured, to whom the purchaser is unrelated). The remaining three Situations (Situations 2 and 3 of Rev. Rul. 2009-13 and Situation 2 of Rev. Rul. 2009-14) consider the sale of the policy (in two cases, by the insured to an unrelated third person and, in the third Situation, by an unrelated third person, who had originally purchased the policy from the insured, to yet another purchaser also unrelated to either the insured or the first purchaser). It may be worthwhile to note that while all of these situations involve income recognition and a division of that income among ordinary income and capital gain, none of the situations and their tax treatment in the rulings impair the §101(a) tax-free result in a sizable slice of circumstances (likely, in a majority of circumstances) involving economic gain to non-transfer for value recipients.
2. The policy surrender circumstance (Situation 1 of Rev. Rul. 2009-13) generates income in an amount we would not challenge. However, we would take issue with the rationale cited by the Revenue
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Service for the ordinary income conclusion. The Service cites Rev. Rul. 64-51 (which, in turn, cites §61(a)(10)) for that conclusion. That ruling deals with a question of withholding of tax from income derived by an insured non-resident alien individual from sources within the US — a far cry from the facts considered in the two revenue rulings we are examining. Further, it cites §61(a)(10) for the proposition that “income from life insurance and endowment contracts” is ordinary income. In fact, that section simply says that such income is included in “gross income.” Gross income can be ordinary income, capital gain or nontaxable. If §1234A which addresses contract terminations, applies to the surrender (i.e., termination) of a life insurance contract, the income would be treated as capital gain (subject to further consideration of the “substitute for ordinary income” judicial doctrine) because the surrender would be treated by §1234A as a sale or exchange, a prerequisite to capital gain treatment. In contrast, the IRS, with less than solid reasoning or citation of authority, has taken the position that §1234A does not apply to life insurance,
3. The transfer for value conclusions reached in the circumstances concerning death benefit payments to purchasers who are unrelated to the insured (Situations 1 and 3 of Rev. Rul. 2009-14), also seem, at least partially correct in that they lead to the result that income should be recognized at that time and in the amount determined. The ordinary income result is correct only if the Service’s rejection of the application of §1234A is also assumed to be correct — a debatable assumption.
4. The other three Situations (Situations 2 and 3 of Rev. Rul. 2009-13 and Situation 2 of Rev. Rul. 2009-14) present a mixed and complex bag of conclusions which warrant close review and analysis. The amount of income recognition and the capital gain character of the income recognized in Situation 2 of Rev. Rul. 2009-14 both seem correct. Full basis credit is provided by the Revenue Service and capital gain treatment is appropriate. In contrast, the amount of income recognized in Situations 2 and 3 of Rev. Rul. 2009-13 and the partial ordinary income result of Situation 2 seem questionable. In both situations, the Revenue Service claims that §72 and its basis rules do not apply because in neither case was the income “received *** under an annuity, endowment or life insurance contract.” Even if one accepts that theory (a questionable acceptance) the theory does not, by itself, impose the proposed cost of insurance adjustment which, in the case of cash value policies is predicated on a few cases that are more than 70 years old and seem to focus primarily on whether loss (not income) is recognized. In the case of the sale of the term policy in Situation 3 of Rev. Rul. 2009-13 the Service predicates its cost of insurance basis adjustment on the application of §263 which deals with expenditure capitalization. It should be noted that the §263 capitalization election is required by the rulings in order to avoid basis adjustment, but the requirement applies only prospectively. The partial ordinary income result of Rev. Rul. 2009-13′s Situation 2 is also subject to question because of the §1234A issues raised in paragraphs 2 and 3 above.
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