The Internal Revenue Service (the Service) has issued two revenue rulings on the tax consequences of life insurance contracts sold in secondary market transactions or surrendered. Revenue Ruling 2009-13 considers certain tax consequences to an individual who sells or surrenders a policy insuring his or her own life. Revenue Ruling 2009-14 addresses certain tax consequences to the purchaser of a policy in a secondary market who does not have an insurable interest in and is otherwise unrelated to the insured (sometimes referred to as life settlement transactions or Investor Owned Life Insurance). In summary, the Service ruled on the following situations.
The rulings reflect the following, important analytical points, some of which are controversial:
- It appears the Service addressed the surrender scenario (the only aspect of the rulings that does not arise in the secondary market context) at least in part to articulate the position that the enactment of Internal Revenue Code (IRC) § 1234A in 1981, providing capital gain treatment upon the termination of a right with respect to “property which is … a capital asset,” did not cause the gain recognized on policy surrender to be other than ordinary income.
- In contrast to the surrender scenario, which is governed by specific rules in IRC § 72(e), the Service applied the general tax rules for the sale or disposition of property in IRC § 1001 et seq. to determine the tax consequences to the seller of the policy in a secondary market transaction, generally treating the life insurance policy as a capital asset in the hands of both the seller and the purchaser.
- The Service relied on that difference to justify a cost basis concept that, in the case of a seller of a cash value or term insurance policy who is the insured, treats the amounts paid for life insurance protection prior to the sale as “consumed” and thus reducing cost basis—a different outcome than § 72 provides through its “investment in the contract” concept. The Service defended this conclusion, in part, as following from the Keystone Consolidated Publishing, Century Wood Preserving and London Shoe decisions of the Board of Tax Appeals, Second Circuit and Third Circuit, respectively, in the 1930s. The Service went on to say that the amount of gain that the seller would have recognized if the policy had been surrendered rather than sold is ordinary income (under the “substitute for ordinary income” doctrine), and any remaining gain is capital. Where the contract has no cash surrender value, gain recognized on the sale is entirely capital income.
- These holdings (Situations 2 and 3 of Rev. Rul. 2009-13) will not be applied adversely to sales occurring before August 26, 2009.
- In making the basis adjustment for the hypothesized term policy, the Service presumed that the entire monthly term premium was for the cost of insurance, absent other proof.
- The Service also concluded that a secondary market purchaser is not allowed a current deduction for premiums paid, subsequent to purchase, to prevent a term life insurance policy (without cash value) from lapsing. Because the purchaser becomes the beneficiary under the policy, the ruling observes that premiums are not deductible by reason of IRC § 264. The Service announced, however, pursuant to its authority under the IRC § 263 INDOPCO regulations, that the purchaser may capitalize and include in its cost basis for the policy such premiums paid after purchase to prevent lapsation.
- The existing § 263 regulations provide for capitalization with respect to cash value insurance, annuity and endowment contracts, but say nothing about term insurance. Treas. Reg. §1263(a)-4(d)(2)(i)(D).
- The ruling provides that the Service will not dispute the capitalization of premiums paid or incurred prior to the issuance of the ruling; i.e., secondary market purchasers are allowed a cost basis for such premium payments predating the ruling.
- The ruling does not take on the question of whether the amount paid by the purchaser to the seller to acquire the policy is amortizable.
- That is, the secondary market purchaser is allowed a cost basis in the policy, rather than a deduction, in the amount of the premiums paid to prevent the term policy from lapsing. (The ruling implicitly determines that this outcome is consistent with § 264.) Further, if that purchaser subsequently sells the policy in another secondary market transaction, the Service ruled that a basis adjustment for the cost of insurance is not required, reasoning that the purchaser acquired the policy to make a profit rather than to obtain protection against economic loss on the death of the insured.
- Finally, where (on the facts assumed in the ruling) the insured is a U.S. citizen residing in the United States, the insurer is a domestic corporation, and the unrelated purchaser of the policy in the secondary market is a foreign corporation, the Service ruled that gain on the insured’s death to the foreign purchaser is treated as U.S. source “fixed or determinable annual or periodical” income subject to IRC § 881 withholding tax.