The industry’s premier estates, gifts, and trusts resource that features research, planning, and implementation tools on one platform — backed by the nation's leading...
by Steven B. Gorin, Esq.
Thompson Coburn LLP
St. Louis, Missouri
Rev. Rul. 2009-13 represents the Internal Revenue Service's position on the amount and character of the insured's income recognized upon the surrender or sale of the life insurance contracts described in the three situations.
Rev. Rul. 2009-14 represents the Internal Revenue Service's position on the tax consequences to the buyer in three situations, upon the receipt of death benefits, or upon the receipt of sale proceeds, with regard to a term life insurance contract that the buyer purchased for profit.
Each ruling is described below, followed by a review of certain commentary and this author's preliminary views.
Rev. Rul. 2009-13
In Situation 1, A, an individual, 1 entered into a cash value “life insurance contract.” 2 Under the contract, A was the insured, and the named beneficiary was a member of A's family. A had the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value. 3
1 The ruling specified that A uses the cash method of accounting.
2 As defined in §7702 of the Internal Revenue Code of 1986, as amended (the “Code”).
3 The IRS included as a fact that the contract in A's hands was not property described in §1221(a)(1)-(8). Thus, A must not be a “dealer” in life insurance and must not have acquired the policy in any hedging transaction.
In Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract. Through that date, A had paid premiums totaling $64,000 with regard to the life insurance contract. A had neither received any distributions under the contract nor borrowed against the contract's cash surrender value. At the time of the sale, A was not a terminally ill individual, nor a chronically ill individual. 4
4 Within the meaning of §101(g)(4).
Because A received the $78,000 on the complete surrender of a life insurance contract, the amount A received is included in gross income to the extent it exceeds the investment in the contract. 5 Because A paid aggregate premiums of $64,000 with regard to the contract and neither received any distributions under the contract nor borrowed against the contract's cash surrender value before surrender, A's “investment in the contract” was $64,000. 6 Consequently, A recognized $14,000 of income on surrender of the contract, which is the excess of $78,000 received over $64,000. 7
However, the IRS ruled that the surrender of a life insurance contract does not produce a capital gain. 8 Accordingly, the IRS ruled that the $14,000 of income that A recognized on the surrender of the life insurance contract was ordinary income.
8 Citing Rev. Rul. 64-51, 1964-1 C.B. 322, which the IRS views as noting that, under §61(a)(10), the proceeds received by an insured upon the surrender of, or at maturity of, a life insurance policy constitutes ordinary income to the extent such proceeds exceed the cost of the policy. The IRS pointed out that §1234A, originally enacted in 1981, does not change this result.
In Situation 2, the facts were the same as in Situation 1, except that, instead of surrendering the contract to the issuer, A sold the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A's death.
Because the transaction was not a surrender to an insurer, the IRS looked to general tax law regarding the disposition of an asset. 9 A's amount realized from the sale of the life insurance contract was the $80,000 received from the sale. 10 A's adjusted basis generally would be A's investment in the contract, subject to proper adjustment for expenditures, receipts, losses, or other items properly chargeable to capital account. 11 The IRS then asserted that, to measure a taxpayer's gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale. The IRS did this first by pointing out that life insurance has investment and insurance components. 12 The IRS asserted that the part of the premiums which represents annual insurance protection has been earned and used. 13
9 §§61(a)(3) (gross income includes gains derived from dealings in property) and 1001(a) (gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in §1011 for determining gain).
11 §§263(a), 1011 and 1012; Regs. §§1.263(a)-4, 1.1016-2(a).
12 §7702; London Shoe Co. v. Comr., 80 F.2d 230, 231 (2d Cir. 1935); and Century Wood Preserving Co. v. Comr., 69 F.2d 967, 968 (3d Cir. 1934).
13 Century Wood Preserving Co., 69 F.2d at 968. The IRS also pointed to London Shoe Co., 80 F.2d at 233; Keystone Consolidated Publishing Co. v. Comr., 26 B.T.A. 1210, 1211 (1932); and Regs. §1.1016-2(a).
The IRS determined that A's adjusted basis in the contract as of the date of sale was $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance). Therefore, A must recognize $26,000 on the sale of the life insurance contract to B, which is the excess of the amount realized on the sale ($80,000) over A's adjusted basis of the contract ($54,000).
The IRS next turned to the nature of the recognized income. It stated that the Supreme Court has applied a “substitute for ordinary income” doctrine to recharacterize gain as ordinary income to the extent that a property's value includes claims or rights to ordinary income. 14 It pointed to a case that it said recharacterized as ordinary income gain from sale of an annuity contract. 15 In Situation 2, the inside build-up under A's life insurance contract immediately before the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). Thus, the IRS ruled that $14,000 of the income that A recognized on the sale of the contract was ordinary income and the remaining $12,000 of income was long-term capital gain. 16
14 U.S. v. Midland-Ross Corp., 381 U.S. 54, 57 (1965); see also Comr. v. P.G. Lake, Inc., 356 U.S. 260 (1958); Arkansas Best Corp. v. Comr., 485 U.S. 212, 217, n. 5 (1988); Prebola v. Comr., 482 F.3d 610 (2d Cir. 2007); U.S. v. Maginnis, 356 F.3d 1179 (9th Cir. 2004); Davis v. Comr., 119 T.C. 1 (2002).
15 Gallun, 327 F.2d 809, 811 (7th Cir. 1964).
16 Within the meaning of §1222(3).
In Situation 3, the facts were the same as in Situation 1, except that the contract was a level premium 15-year term life insurance contract without cash surrender value. The monthly premium for the contract was $500. Through the date of sale, A paid premiums totaling $45,000 with regard to the contract. On June 15 of Year 8, A sold the life insurance contract for $20,000 to B, a person unrelated to A and who would suffer no economic loss upon A's death.
The amount realized from the sale of the term life insurance contract is the $20,000 received from the sale. The IRS held that A's adjusted basis in the contract on the date of the sale to B was $250 (the pro-rated unexpired monthly premium). The IRS ruled that A must recognize $19,750 on the sale, which is the excess of the amount realized on the sale ($20,000) over the adjusted basis of the contract ($250).
Because the term life insurance contract had no cash surrender value, there was no inside buildup under the contract to which the substitute for ordinary income doctrine could apply. Therefore, the IRS ruled that all of the income recognized on the sale was long-term capital gain.
Effective Dates. The IRS stated that the holdings of this ruling with respect to Situations 2 and 3 will not be applied adversely to sales occurring before August 26, 2009. This implies that the IRS reserved the right to apply the ruling to Situation 1 retroactively.
Rev. Rul. 2009-14
In Situation 1, A was issued a policy 17 on A's life on January 1, 2001. 18 The contract was a level premium fifteen-year term life insurance contract without cash surrender value. On June 15, 2008, B 19 purchased the policy from A for $20,000. At the time of purchase, the remaining term of the contract was 7 years, 6 months, and 15 days. The monthly premium for the contract was $500, due and payable on the first day of each month. As owner of the contract, B had the right to change the beneficiary and, pursuant to that right, named itself beneficiary under the contract immediately after acquiring the contract.
17 A “life insurance contract” (as defined in §7702).
18 A was a United States citizen residing in the United States. A domestic corporation issued the policy.
19 B was a United States person as defined in §7701(a)(30), uses the cash method of accounting, and files its income tax returns on a calendar year basis.
B had no insurable interest in A's life and, except for the purchase of the contract, B had no relationship to A and would suffer no economic loss upon A's death. B purchased the contract with a view to profit. 20 The likelihood that B would allow the contract to lapse by failing to pay any of the remaining premiums was remote.
20 The IRS included as a fact that the contract in B's hands was not property described in §1221(a)(1)-(8). Thus, B must not be a “dealer” in life insurance and must not have acquired the policy in any hedging transaction.
On December 31, 2009, A died, and the life insurance company paid the $100,000 death benefit to B. Through that date, B had paid monthly premiums totaling $9,000 to keep the contract in force.
The IRS ruled that B must recognize $71,000 of ordinary income on the receipt of death benefits, based the excess of the $100,000 death benefit over the sum of (a) the $20,000 consideration B paid to acquire the contract and (b) the $9,000 premiums that B paid. The IRS applied the general rule taxing gross income, 21 held that making a transfer for value prevented the death benefit from excluded from income, but limited the amount of income recognized according to the transfer for value rule. 22
21 §61(a)(10), which expressly applies to life insurance contracts.
22 §101(a)(2), which overrides §61 under the general principles of Regs. §1.61-1(b).
In Situation 2, the facts are the same as in Situation 1, except that A did not die and, on December 31, 2009, B sold the contract to C (a person unrelated to A or B) for $30,000.
In this Revenue Ruling, IRS exercised its regulatory authority to authorize B to capitalize the premiums that B paid. 23 The IRS said that B paid the premiums not to protect against risk of loss due to A's death but rather to preserve B's investment in the contract. Accordingly, the IRS ruled that the premiums constituted an investment rather than insurance expense.
23 Regs. §1.263(a)-4(b)(1)(iv). The IRS reasoned that premiums paid by a secondary market purchaser of a term life insurance contract serve to create or enhance a future benefit for which capitalization is appropriate. Thus, a secondary market purchaser is now required to capitalize premiums paid to prevent a term life insurance contract (without cash value) from lapsing. The IRS promised that it would not challenge the capitalization of such premiums paid or incurred before the issuance of this ruling.
Thus, B recognized a $1,000 gain to the extent B's $30,000 sale proceeds exceeded B's $29,000 ($20,000 purchase price plus $9,000 premiums) investment in the contract. The IRS held that this gain was a long-term capital gain, because none of the gain was based on built-up cash value. 24
24 Therefore, the IRS reasoned, the substitute for ordinary income doctrine under U.S. v. Midland Ross, 381 U.S. 54 (1965), and its progeny did not apply.
In Situation 3, the facts are the same as in Situation 1, except that B is a foreign corporation that is 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).
As in Situation 1, B must recognize $71,000 of ordinary income upon the receipt of death benefits. The IRS rules that this income is “fixed or determinable annual or periodical” income 25 and is subject to tax with respect to this income. 26
25 Within the meaning of §881(a)(1). The IRS cited Regs. §1.1441-2(b) and Rev. Ruls. 64-51 and 2004-75.
26 The IRS reasoned that, when the source of an item of income is not specified by statute or by regulation, courts have determined the source of the item by comparison and analogy to classes of income specified within the statute. It cited Bank of America v. U.S., 680 F.2d 142, 147 (Ct. Cl. 1982); Howkins v. Comr., 49 T.C. 689 (1968); Clayton v. U.S., 33 Fed. Cl. 628 (1995), aff'd without published opinion, 91 F.3d 170 (Fed. Cir. 1996), cert. denied, 519 U.S. 1040 (1996). It also referenced Rev. Ruls. 79-388 and 2004-75. Because A is a U.S. citizen residing in the United States and IC is a domestic corporation, B's income is from sources within the United States.
Effective Dates. The IRS implicitly reserved the right to apply the ruling to Situations 1, 2 and 3 retroactively. Notwithstanding that the IRS viewed this ruling as necessary to permit B in Situation 2 to receive basis for premiums B paid, the IRS agreed not to disturb a taxpayer's prior capitalization of premiums paid in that situation.
In Steve Leimberg's Estate Planning Email Newsletter — Archive Message #1459, Larry Brody and Mary Ann Mancini state:
On the good news side, the Service agrees that the sale of a life insurance policy will produce, in part, capital gains, and they seem to agree that the reduction basis required in a sale of a policy for the insurance protection provided is based on actual cost of insurance charges. The bad news is that we now have a revenue ruling that requires a reduction in basis for that cost of insurance in a policy sale, at least if the sale is by the insured. Again, the issue in these rulings is to determine that cost.
They mention that the IRS's reduction in basis for the cost of insurance has been criticized:
Numerous tax commentators and practitioners have disagreed with the IRS's position in PLR 9443020 and will disagree with the IRS's position in Rev. Rul. 2009-13. Among other reasons, they argue the IRS's position is improper because:
1. Century Wood and London Shoe, cited by the IRS as support for its position, are distinguishable,
2. Other more recent and well-cited cases do not reduce basis for the cost of insurance protection,
3. Section 72(e), although applicable to surrenders of policies to the insurer, is often used by analogy by courts and does not support reducing basis for the cost of insurance, and
4. There is otherwise no direct support for decreasing the adjusted basis of personal assets, including life insurance contracts, by the value of economic benefit earned by the asset holders.
They tend to agree with that view:
Revenue Ruling 2009-13 (and Priv. Ltr. Rul. 9443020) ignores prior court decisions determining that the policyholder's adjusted basis in connection with the sale of a life insurance contract equals the aggregate of premiums paid for the policies less the amounts received, such as dividends, under the contract which were not included in gross income. See Gallun v. Commissioner, above, (“Gallun”); Commissioner v. Phillips, 275 F.2d 33 (4th Cir. 1960) rev'd 30 T.C. 866 (“Phillips”); and Estate of Gertrude H. Crocker v. Commissioner, 37 T.C. 605 (1962) (“Estate of Crocker”). [footnote omitted]
Although Gallun, Phillips, and Estate of Crocker conflict with Revenue Ruling 2009-13 (as well as Ltr. Rul. 9443020), they are not discussed in either ruling. In these cases, the courts found that the adjusted cost basis of a life insurance contract equaled the total premiums paid for the life insurance policy, less only amounts actually received and properly excluded from gross income, thus including in adjusted basis the cost (generally not deductible) of insurance protection.
However, they conclude:
However, a taxpayer (and a tax return preparer) ignores the IRS’ position in Revenue Ruling 2009-13 at his peril. Penalties can only be avoided under Sections 6662 and 6694 if the taxpayer (and return preparer) has substantial authority or adequately disclosed the position. In light of the Revenue Ruling, it is not clear that substantial authority can be established and therefore adequate disclosure of the position would have to be made on the return in order to avoid penalties.
In Steve Leimberg's Estate Planning Email Newsletter — Archive Message #1462, Jonathan Blattmachr, Mitchell Gans, and Diana Zeydel provided additional comment on this topic. They, too, question reducing the basis for the cost of the term portion ofinsurance when the insured sells the policy. They mention that “Rev. Rul. 2009-13 seems to be contradicted by Rev. Rul. 70-38, which the latter ruling does not even mention, much less distinguish, modify or overrule.” They quote from Rev. Rul. 70-38 (emphasis added by these commentators):
The taxpayer, a domestic corporation, purchased ordinary life insurance policies on the lives of its officers naming itself as the beneficiary. The premiums paid by the taxpayer were not allowed as a deduction pursuant to the provisions of section 264 of the Internal Revenue Code of 1954. In a later taxable year the taxpayer sold the insurance policies to the officers based on the cash surrender value at the date of sale. This was less than the total premiums paid. Held, the taxpayer, in the instant case, is not required to include in its gross income the amount received from the sale of the insurance policies to its officers. O.D. 724, C.B. 3, 244 (1920), is hereby superseded, since the position stated therein is set forth under the current statute and regulations in the Revenue Ruling.
They further argue that, on the surrender of the policy, the income might be capital gain under §1234A. They criticize the rulings for not having explained why §1234A does not apply:
Section 1234A was enacted to provide that gain or loss attributable to the cancellation, lapse, expiration of a right or obligation (subject to an exception not applicable to a policy of insurance) with respect to a capital asset would be treated as gain or loss from the sale of a capital asset. Rev. Rul. 2009-13 merely says it does not apply but fails to explain why.
Likewise, Rev. Rul. 2009-14 indicates that payment of the proceeds at death constitutes ordinary income. Although the revenue rulings are entitled to some deference in the courts, how much deference depends upon a number of factors.
In a situation like this, where the IRS has not only been inconsistent but has also been conclusory, courts may not be inclined to grant the ruling much, if indeed any, deference.
Other articles include:
• Leeds, “Providing Certainty On Death and Taxes: IRS Gives Guidance for Sellers and Purchasers of Life Insurance Policies,” Derivatives: Financial Products Report (WG&L) (May 2009 preview report) and TM Weekly Report (BNA) May 18, 2009, Vol. 28, No. 20.
• “Understanding the Tax Costs of Life Settlements,” Federal Taxes Weekly Alert Newsletter, Preview Documents for the week of 05/28/2009 — Volume 55, No. 22.
• “IRS explains the tax treatment of policyholder surrenders and sales of life insurance contracts,” RIA Federal Taxes Weekly Alert Newsletter 05/07/2009 — Volume 55, No. 19 (discussing Rev. Rul. 2009-13).
• “New guidance for investors who purchase life insurance contracts,” RIA Federal Taxes Weekly Alert Newsletter 05/07/2009 — Volume 55, No. 19 (discussing Rev. Rul. 2009-14).
• “Industry Representatives Say Insurance Rulings Consistent With Previous Treatment,” TM Weekly Report (BNA) May 18, 2009, Vol. 28, No. 19.
This Author's Preliminary View
For planning transactions, one should assume that Rev. Ruls. 2009-13 and 2009-14 are correct. However, in reporting transactions, one might take issue with certain portions, using some of the arguments the commentators set forth above; one might consider filing IRS Form 8275 when doing so to avoid penalties.
In Situation 2 of Rev. Rul. 2009-14, B should have engaged in a Situation 1 transaction. For example, suppose B acquires the term policy in violation of the transfer for value rules, then sells to C, an unrelated third party investor, 12 months and one day later. B receives long term capital gain treatment, and C's basis is now the policy's fair market value at the time of the purchase from B. Then, 12 months and one day later, C sells to another third party investor, D. C receives long-term capital gain treatment, and now D has a high basis. Thus, third party investors can largely avoid the ordinary income treatment, so long as transaction costs do not provide enough of a disincentive to engage in this frequent trading of contracts.
It remains to be seen how these rules will evolve as markets for life insurance contracts evolve. Furthermore, the Obama Administration's proposals suggest some additional changes to the transfer for value rules. 27 Keep on the lookout!
27 Page 112 of http://www.ustreas.gov/offices/tax-policy/library/grnbk09.pdf.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)