Sapers & Wallack
Bulletins: AALU Washington Reports
NY State Bar Association Comments On Federal Income Tax Treatment of Life Insurance Purchased in the Secondary Market
December 31, 2008
The New York State Bar Association Tax Section has submitted members’
comments (“Comments”) to the Treasury and Internal Revenue Service on issues raised
“when a life insurance policy is purchased from an insured (or someone with an
insurable interest in an insured) by an investor with no insurable interest.” Among the
issues raised are the character of gains or losses on the sale of life insurance policies for
both the original policy owner and the buyer, the adjusted basis for purposes of
determining gain or loss, and the operation of the section 264(f) interest disallowance
rule. The NYSBA recommends that Treasury and the IRS issue guidance addressing
these issues.
While recognizing that there are non-tax policy issues that arise when investors purchase life
insurance from insureds (e.g., insurable interest laws), the NYSBA Comments do not address these issues.
Their Comments are limited to the current tax law treatment; they do not attempt to harmonize the tax
treatment to that which applies to similar investments in financial instruments, and do not address the
application of the split dollar regulations.
Although the Comments use the term “investor-owned life insurance,” it appears that the NYSBA is
dealing in general with the life settlement or secondary market segment of the life insurance industry and is
not primarily addressing stranger-originated life insurance (STOLI).
More specifically, the NYSBA recommends:
- The IRS and Treasury should clarify that Section 1234A of the Internal Revenue Code
does not apply to amounts received under a life insurance policy from the insurance company when
the policy matures upon the death of the insured, or is surrendered or cancelled. Absent an actual
sale or exchange, amounts received upon surrender or cancellation should be taxable as ordinary
income.Courts have consistently held that the surrender or redemption of a life insurance
policy by the insurance company does not involve a “sale or exchange” that historically has
been presumed to be the predicate for capital gains treatment.Section 1234A was enacted subsequent to the cases holding that the surrender of a
life insurance policy does not give rise to a sale or exchange. Because that section provides
capital gain treatment upon the termination of a right with respect to “property which is . . . a
capital asset,” an argument can be made that a life insurance policy, as “property,” represents
an obligation with respect to itself such that Section 1234A applies.In TAM 200452033 (see our Bulletin No. 05-2), the IRS rejected the application of
Section 1234A to the gains realized by the taxpayer when the insurance company paid the
taxpayer the cash surrender value of the policies “to the extent [that] amounts received by
Taxpayer upon the surrender of the Contracts are attributable to ordinary income accretions
to the Contract’s value,” However, because the IRS limited its rejection of the application of
Section 1234A to the taxpayer’s gains attributable to these accretions, the TAM suggests (but
does not state) that Section 1234A may apply to any amounts realized in excess of the cash
surrender value of the contract immediately before the surrender of the contract. It is the
NYSBA’s position that the section should not apply to any part of the profit realized on
policy surrender. It therefore recommends that the IRS confirm that Section 1234A does not
apply to the surrender or maturity of a life insurance contract. - The IRS and Treasury should adopt (independent of the conclusion recommended
above) a bifurcated approach to the character of income realized on the sale of a life insurance policy
in the secondary market. Under this approach, the amount of gain realized on the sale would be
ordinary income to the extent of the policy’s cash surrender value and any additional amounts would
be treated as capital gains.The Supreme Court has held that capital gain treatment is inappropriate where the
amount received is a substitute for ordinary income. A number of cases have held that
ordinary income is realized upon the sale or exchange of a life insurance contract to a third
party shortly prior to its maturity based on the theory that the sale or assignment is an
“anticipatory assignment of income,” and income earned on the internal build-up of a life
insurance contract is normally taxable as ordinary income under Section 72(e). In none of
these cases, however, did the amount realized exceed the cash surrender value of the policy
at the time of the sale.In the secondary market, the purchaser of a life insurance policy may purchase a
policy for more than the policy’s cash surrender value because that purchaser believes the
cash surrender value of the policy does not reflect the policy’s actual economic value. Thus,
while case law has established that a sale of a life insurance policy for its cash surrender
value results in ordinary income to the seller, if the seller receives an amount greater than the
cash surrender value, an argument may be made that the excess gain is entitled to capital
gains treatment.Treating gains received on the sale of a life insurance policy in the secondary market
as ordinary income to the extent of the cash surrender value would be consistent with the
policy that a taxpayer should not get a better result from selling a policy than surrendering it
in a transaction governed by Section 72. Any excess received above the cash surrender value,
however, is arguably more logically treated as capital gain because this treatment better
reflects the increase in the policy’s value based on a change in the factors such as the credit
risk of the insurance company, actuarial tables, and other relevant information such as the
age and health of the insured.Support for this position is claimed to be provided by PLR 9443020 (see our Bulletin
No. 94-93), involving the tax treatment of a viatical sale of a life insurance policy. In this
PLR, as authority for its conclusion, the Revenue Service cited Section 1016(a)(1) regarding
basis adjustments for items chargeable to “capital accounts” (along with Section 72(e)). - The IRS and Treasury should confirm that a secondary market investor in life
insurance acquires a basis in the policy equal to the sum of the purchase price and the aggregate
premiums paid on the policy (without reduction for amounts allocated to the “cost of insurance”).The NYSBA’s position is claimed to be supported by several Code and regulatory
provisions, including: Treas. Reg. Section 1.263(a)-4(b)(1)(i) (which requires capitalization
of amounts paid to acquire or create an “intangible”); Section 264(a) (which, despite its
disallowance of a deduction for insurance premiums paid, does not alter the capitalization of
amounts paid to acquire a life insurance policy on the secondary market; Section 72(e)
(which, although it does not apply to the sale of life insurance contracts, indicates Congress’
intent that the aggregate premiums paid, without reduction for the cost of insurance, should
reduce income recognized by taxpayers who surrender policies); and Section 101(a)(2)
(under which a transferee for value receives “credit” for all of the premiums paid and not
only the premiums in excess of the cost of insurance); and Section 264.The Comments note that, when a taxpayer has sold a policy for gain, courts have held
that the taxpayer’s basis in the policy for purposes of determining gain is equal to the
aggregate premiums paid by the taxpayer on the policy. It is the cases in which a taxpayer
has sold a policy for a loss in which the courts have consistently denied basis to the taxpayer
for the cost of insurance protection.The Treasury and Revenue Service have generally adopted the approach of the “loss”
cases to assert the denial of basis for the cost of insurance protection. See generally, ILM
200504001, discussed in our Bulletin No. 05-19 and PLR 9443020, discussed in our Bulletin
No. 94-93, supra. The government’s position also is reflected in the approach to this issue
taken in the recent final split-dollar regulations (see our Bulletin No. 03-95).The Comments note that “[i]f the result in private letter ruling 9443020 and Chief
Counsel Advice 2005-04001 are extended into the secondary market, inequities and
distortions will result. A taxpayer that surrenders a policy to the insurance company would
enjoy a lower income tax liability than a taxpayer who sells its policy and is required to
reduce its basis in the contract to reflect the amount of insurance protection. Such a situation
would result in vastly different tax liabilities for similarly situated taxpayers.” - The IRS and Treasury should confirm that the phrase “loan in respect of such policy
or contract” under Section 264(f) (which generally denies interest deductions on indebtedness used,
directly or indirectly, to purchase certain life insurance policies) includes indebtedness in respect of
the policy for which interest expense is denied under Section 264(a). This clarification would ensure
that taxpayers do not suffer double disallowances of interest expenses.The Comments note that Section 264(f)(6) coordinates Section 264(a) and Section
264(f). The coordination rule is intended to ensure that a taxpayer is denied an interest
deduction only once (i.e., either under Section 264(a) or under Section 264(f)). The
coordination rule is modeled after (and virtually identical to) Section 265(b)(6), which
provides a similar coordination rule between Section 265(a) and (b).Section 264(f)(6) provides that interest expense disallowed under Section 264(a) is
not taken into account for purposes of applying Section 264(f) and that the fraction for
determining the amount of interest expense to be denied under subsection (f) is adjusted by
reducing (but not below zero) the denominator under Section 264(f)(2)(B) by the amount of
indebtedness associated with the interest expense denied under Section 264(a).According to the NYSBA, “[i]t would be helpful if the IRS confirmed that the
numerator of the fraction is similarly reduced.”The Comments also note that Section 264(f) does not indicate how it applies to a
foreign taxpayer that is engaged in a trade or business in the United States but whose life
insurance policy is not held in connection with the U.S. business.
The NYSBA concludes that “[a]s a result of the rapidly growing and evolving secondary market for
life insurance policies as investments, the tax issues relating to the sale of life insurance policies have
become increasingly important. The current scheme of taxation related to the sale of life insurance policies
is unclear and the existing authorities often fail to provide a cogent methodology for computing the
appropriate tax.” In contrast, it should be noted that the Bar’s assumption of growth in the secondary
market is not necessarily correct in light of recent developments, such as the financial crisis and the
lengthening of mortality assumptions by companies which issue life expectancy reports in conjunction with
the sale of life insurance policies in the secondary market.
Any AALU member who wishes to obtain a copy of the NYSBA Comments may do so through the
following means: (1) use hyperlink above next to “Major References,” (2) log onto the AALU website at
www.aalu.org and enter the Member Portal and select Current Washington Report for linkage to source
material or (3) email Anthony Raglani at raglani@aalu.org and include a reference to this Washington Report.
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