A large market has developed for the purchase and sale of life insurance policies. An individual who has a life insurance policy he believes he no longer needs may be able to sell the policy to investors that are interested in holding the policy as an investment and ultimately collecting the death benefit. The investors pay all premiums due on the policy after their purchase. Depending upon the age of the insured at the time of the sale, he may receive a significant percentage of the death benefit amount as the sales price. You generally have to be over 65 years of age for a financial buyer to be interested and of course, the older you are, the more the buyer will pay because they will expect to collect the death benefit sooner. Until recently, there was uncertainty as to how the tax law applied to these sales transactions. The major issue was whether any gain recognized by the seller was capital gain or ordinary income.
The IRS recently issued guidance on these issues. In Revenue Ruling 2009-13, the IRS addressed the income tax consequences of both surrendering a policy back to the insurer and selling it to an investor group. Where the policy is surrendered to the insurer, any payment received that is in excess of the insured’s tax basis in the policy is treated as ordinary income. For these transactions, the insured’s tax basis is the full amount of the premiums he has paid on the policy up to the time of the surrender, reduced by any untaxed amounts that he had withdrawn from the policy.
The treatment of sale transactions is different. First, the IRS said that the insured’s basis in the policy must also be reduced by the portion of the premiums paid that is attributable to the “cost of insurance” under the policy. Many tax experts believe this position on the part of the IRS is not correct. The portion of the insured’s gain that does not exceed the cash surrender value of the policy at the time of sale is taxed as ordinary income. Any gain above that amount is treated as long term capital gain. The ruling illustrates these principles with an example. The insured had paid total premiums of $64,000 on the policy, out of which the cost of insurance was $10,000. He had not received any distributions. The cash surrender value was $78,000 and he sold the policy for $80,000. The IRS said his tax basis was the premiums paid of $64,000 reduced by the cost of insurance of $10,000 leaving a tax basis of $54,000. This resulted in tax gain of $26,000. Of this amount, $14,000 was ordinary income, determined as the difference between the cash surrender value of $78,000 and the total premiums paid of $64,000. The remaining gain of $12,000 was capital gain. On the facts of the ruling it was long term capital gain because the insured had held the policy for more than one year.
The conclusion by the IRS that the gain in excess of the cash surrender value amount is capital gain is of course what everyone connected with this industry, as well as those who have sold policies or may be contemplating such sales, had been hoping would be the result. The certainty that capital gain is available to the sellers may make these transactions even more attractive for those who have life insurance policies they no longer need.