IRS Guidance for Investors in Life Insurance Contracts
In Rev. Rul. 2009-14,1 the IRS provided guidance to investors purchasing life insurance contracts regarding the tax consequences of the receipt of the death benefit or proceeds from the sale of such contracts. The Revenue Ruling discusses the tax consequences of three different situations, as follows.
In Situation 1, an investor purchased for $20,000 a 15-year level premium term life insurance contract without any cash surrender value from an individual. Premiums were payable monthly on the life insurance contract. The investor had no insurable interest in the insured and would not incur an economic loss upon the individual's death. The investor purchased the life insurance contract solely for a profit motive. After purchasing the life insurance contract, the investor paid the monthly premiums of $500. The insured died 18 months after the investor purchased the life insurance policy, and the investor received the death benefit of $100,000.
The IRS began its analysis by noting that Section 61(a)(10) states that except as otherwise provided, gross income includes all income from whatever source derived, including income from life insurance contracts. Section 72(e) governs the income tax treatment of amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity. Section 72(e)(5)(A) provides that if a non-annuity amount is received under a life insurance contract (other than a modified endowment contract) or is received under a life insurance contract on the complete surrender, redemption, or maturity of the contract, then the amount received must be included in gross income but only to the extent the amount received exceeds the investment in the contract.
Section 72(e)(6) defines the term “investment in the contract” as the aggregate amount of premiums or other consideration paid for the contract, less the aggregate amount received under the contract that was not included in gross income. Section 72(g) provides that in the case of a transferee for value, in determining the investment in the contract, the value of the consideration paid for the contract, plus premiums and other consideration paid after the transfer, is taken into account.
Section 101(a)(1) provides that gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. However, Section 101(a)(2) provides that in the case of a transfer for valuable consideration, the amount excluded from gross income will be equal only to the sum of the consideration paid and the premiums and other amounts subsequently paid by the transferee. The “transfer for value” rule of Section 101(a)(2) does not apply in the case of a transfer involving a carryover basis or in the case of a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.
Applying the rules discussed above, the IRS stated that because the investor in Situation 1 purchased the life insurance contract, the investor's acquisition of the contract was a “transfer for a valuable consideration” within the meaning of Section 101(a)(2) and that none of the exceptions in Section 101(a)(2) applied. Accordingly, under Section 101(a)(2), the amount excluded from gross income was limited to $29,000, which is the sum of $20,000 of consideration paid for the transfer and the aggregate monthly premiums paid by the investor after the purchase of the life insurance contract of $9,000 ($500 a month for 18 months). Therefore, the investor must include in gross income $71,000, which is the difference between the death benefit received of $100,000 and the amount excluded under Section 101 of $29,000.
Next, the IRS addressed the character of the income recognized by the investor upon the receipt of the death benefit. The IRS acknowledged that neither Section 61(a) nor Section 72(e) specifies whether the taxable portion of the death benefits received by a transferee for value is to be treated as ordinary income or as capital gain. Thus, IRS stated the character of the income that the investor recognized upon receipt of the death benefit is capital gain only if it qualifies under the general rules of Sections 1201 through 1260.
Section 1221(a) provides that the term “capital asset” means property held by the taxpayer (whether or not connected with a trade or business), but does not include items described in Sections 1221(a)(1) through 1221(a)(8). The IRS stated that in the hands of the investor, the life insurance contract was not described in Sections 1221(a)(1) through 1221(a)(8), and was thus a capital asset in the hands of the investor. However, while the life insurance contract was a capital asset in the hands of the investor, the IRS nevertheless concluded that neither the surrender of a life insurance or annuity contract nor the receipt of a death benefit from the issuer produces a capital gain. Accordingly, the IRS held that the $71,000 of income recognized by the investor upon the receipt of the death benefit was ordinary income. Query whether this aspect of the Ruling may be challenged by an investor who can establish that he or she is not in the trade or business of purchasing life insurance contracts on unrelated parties.
In Situation 2, the facts were the same as in Situation 1, except that the insured did not die but rather the investor sold the life insurance contract to another investor for $30,000. Gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis. The investor's amount realized from the sale of the life insurance contract was the sum of $30,000 received from the sale. The cost basis of the life insurance contract was equal to the $20,000 paid by the investor to the insured to acquire the contract. With respect to the monthly premiums paid by the investor, the IRS stated that it will require secondary market purchasers to capitalize premiums paid to prevent a term life insurance contract (without cash value) from lapsing. Therefore, the investor's adjusted basis in the life insurance contract was $29,000, which is equal to the $20,000 paid to acquire the life insurance contract and the $9,000 in aggregate monthly premiums paid to prevent the contract from lapsing.
The IRS concluded that the investor must recognize $1,000 of gain on the sale, which is the difference between the $30,000 amount realized on the sale of the life insurance contract and the adjusted basis of $29,000. Next, the IRS addressed the character of the income recognized by the investor upon the sale of the life insurance contract. The IRS stated that the term life insurance contract was not property described in Sections 1221(a)(1) through 1221(a)(8) and since it was held for more than one year, the $1,000 of gain recognized by the investor was long-term capital gain.
It is noteworthy that the IRS concluded that the investor was not required to reduce its adjusted basis in the life insurance contract by any cost-of-insurance charges that may have been imposed. The IRS noted that since the investor was wholly unrelated to the insured, he or she did not purchase the life insurance contract for protection against any economic loss upon the insured's death. The IRS stated that the investor acquired and held the contract solely with a view to profit, and paid additional premiums to prevent the lapse of the investor's purely financial investment in the contract. The IRS distinguished the investor in this Ruling from the taxpayer in other authorities 2 where it was held that the adjusted basis in a life insurance contract had to be reduced by the cost-of-insurance charges on the grounds that those charges represented the cost of insurance protection that was enjoyed by the policyholder as the beneficiary of the life insurance contract.
In Situation 3, the facts were the same as in Situation 1, except that the investor was a foreign corporation that was not engaged in a trade or business within the United States, including the trade or business of purchasing, or taking assignments of, life insurance contracts. The IRS stated that as in Situation 1, the investor must recognize $71,000 of income upon receipt of the death benefit. According to the IRS, this income was “fixed or determinable annual or periodical” income within the meaning of Section 881(a)(1). Consequently, the IRS stated, the investor is subject to tax under Section 881(a) with respect to this income, if the income is from sources within the United States.
The IRS acknowledged that the Code does not specify the source of income resulting from the payment of death benefits pursuant to a term life insurance contract. The IRS stated that when the source of an item of income is not specified by statute or Regulation, courts have determined the source of the item by comparison and analogy to classes of income specified within the statute. 3 The IRS concluded that the investor's income is from sources within the United States since the insured is a U.S. citizen residing in the U.S. and the insurance company is a domestic corporation.
Rev. Rul. 2009-14 addresses some of the tax issues that arise in the secondary market for life insurance policies. Until the issuance of this Ruling, there has been no clear guidance by the IRS regarding its views as to the income tax consequences of sales of life insurance policies or of the receipt of the death benefit by the purchaser. The three fact patterns presented are relatively straightforward. Many transactions in the secondary market are more complex. It would be helpful for the IRS to issue further guidance in this growing area.
1 2009-21 IRB 1031.
2 Rev. Rul. 2009-13, 2009-21 IRB 1029; Century Wood Preserving Co., 13 AFTR 910, 69 F2d 967 (CA-3, 1934); London Shoe Co., 16 AFTR 1398, 80 F2d 230, 35-2 USTC 9664, 1936-1 CB 205 (CA-2, 1935); and Keystone Consolidated Publishing Co., 26 BTA 1210 (1932).
3 See Bank of America, 50 AFTR 2d 82-5043, 230 Ct Cl 679, 680 F2d 142, 82-1 USTC 9415 (Ct. Cl., 1982); Howkins, 49 TC 689 (1968); Clayton, 76 AFTR 2d 95-5197, 33 Fed Cl 628, 19 EBC 1673, 95-2 USTC 50391 (1995); aff'd without published opinion, 77 AFTR 2d 96-2484, 91 F3d 170, 20 EBC 2390, 96-1 USTC 50314 (CA-F.C., 1996), cert. den. See also Rev. Rul. 79-388, 1979-2 CB 270.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.