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Income Tax Consequences Of The Sales And Surrenders Of Life Insurance Policies
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Income Tax Consequences Of The Sales And Surrenders Of Life Insurance Policies

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A presentation on the income tax consequences of the sales and surrenders of life insurance policies

A presentation on the income tax consequences of the sales and surrenders of life insurance policies

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  • 1. Income Tax Consequences of Sales and Surrenders of Life Insurance Policies A Presentation By: J. Scot Kirkpatrick, Esq. and Rose K. Drupiewski, Esq. June 16, 2010
  • 2. Tax Code Provisions The following Code provisions may affect income taxation of life insurance policies. § IRC §61(a)(10) states that gross income includes income from life insurance. § IRC §101(a)(1) generally excludes from gross income all amounts paid by reason of the death of the insured. § IRC §101(g) treats certain accelerated benefits received by terminally or chronically ill insureds or amounts received on sale to a viatical settlement provider as death benefits. § IRC §101(a)(2) contains an exception for a transfer for valuable consideration: amount excluded equals the amount of the consideration plus premiums subsequently paid.
  • 3. Tax Code Provisions § IRC §72 contains rules for amounts received under an insurance policy other than death proceeds. § Generally, such amounts are gross income only to the extent they exceed the investment in the policy. § Proceeds from a policy loan are not treated as amounts received. § For Modified Endowment Contracts (“MECs”), income tax consequences for all amounts received other than death proceeds are the same as for annuities.
  • 4. Tax Code Provisions § IRC §1035 provides for non-recognition of gain or loss on exchange of life insurance policies for other policies or for endowment or annuity contracts (on the same insured). § Starting in 2010, this also applies to exchanges for qualified long-term care insurance. § Nonrecognition does not apply if endowment or annuity contracts are exchanged for life insurance. § IRC §264 disallows a deduction for premiums paid if the payor owns the policy or the payor or his beneficiaries can benefit from the policy. § Also limits deduction of interest paid on a policy loan or on debt incurred to purchase or carry a policy.
  • 5. Tax Code Provisions § IRC §165 governs whether a loss realized on sale, exchange or other disposition of property can be deducted. § IRC §§ 1001 and 1011-1016 provide rules for determining the amount of gain or loss on the sale, exchange or disposal of property, and for determining adjusted basis of property. § IRC §§ 1221-1223 provide rules for determining if property is a capital asset. § IRC §§1222 defines a capital gain or loss as being realized from the sale or exchange of a capital asset. § IRC §1234A is a special rule that characterizes gain or loss arising from cancellation or termination of a right with respect to a capital asset as a capital gain or loss.
  • 6. Sales and Surrenders of Policies at a Gain In May 2009, the IRS issued two Revenue Rulings dealing with income tax consequences when life insurance policies are surrendered or sold at a gain. § Rev. Rul. 2009-13: Deals with the income tax consequences to the insured on sale or surrender of a policy at a gain. § Only applies to sales made after August 25, 2009. § Rev. Rul. 2009-14: Deals with the tax consequences to the investor and purchaser on sale of a policy at a gain. § Both Rulings mention cash-value contracts and term contracts.
  • 7. Revenue Ruling 2009-13 Surrender of Policy by the Insured § Tax treatment governed by IRC §72(e). § Gross income = excess of the amount received over investment in the policy. § Investment in the policy = total premiums paid. § Gross income is ordinary income. § IRC §1234A does not apply. § Surrender by a non-insured original owner or owner who is donee of a policy from the insured will generally receive the same treatment.
  • 8. Revenue Ruling 2009-13 Surrender of Policy: Facts and Holding § Facts: § Insured was not terminally or chronically ill for purposes of §101(g). § Insured owned the policy for 15 years. § Policy was not a MEC. § Total paid premiums of $64,000, cash surrender value $78,000 (after subtracting $10,000 cost of insurance charges). § Holding: § Gross income = $14,000. § All ordinary income.
  • 9. Revenue Ruling 2009-13 Sale of Policy by the Insured § Tax treatment governed by IRC §1001. § Gross income = amount realized - adjusted basis. § Adjusted basis = premiums paid - cost of insurance. § No explanation as to how cost of insurance is determined. § Under the “substitute for ordinary income doctrine”, gain is ordinary income to the extent ordinary income would have resulted on surrender. § Balance of the gain is capital gain.
  • 10. Revenue Ruling 2009-13 Sale of Permanent Policy: Facts and Holding § Facts: § Insured was not terminally or chronically ill for purposes of §101(g). § Insured owned the policy for 15 years. § Policy was not a MEC. § Insured paid premiums of $64,000, the cost of insurance was $10,000, cash surrender value was $78,000, and upon sale insured received $80,000. § Holding: § Adjusted basis = $54,000. § Gain realized = $26,000. § Ordinary income of $14,000; long-term capital gain of $12,000.
  • 11. Revenue Ruling 2009-13 Sale of Term Policy: Facts and Holding § Facts: § Insured held a $500/month 15-year level premium term policy. § Insured paid premiums of $45,000. § Insured sold the policy on June 15 of Year 8, and upon sale of the policy received $20,000. § Holding: § Cost of insurance is assumed to equal premiums. § Adjusted basis = $250 ($45,000 - $44,750). § Gain realized = $19,750. § Gain is long-term capital gain.
  • 12. Revenue Ruling 2009-14 Death of the Insured Following Sale § Tax treatment governed by IRC §101. § Gross income = proceeds - investment in the policy. § Investment = purchase price + additional premiums paid. § Gross income is ordinary income.
  • 13. Revenue Ruling 2009-14 Insured’s Death: Facts and Holding § Facts: § Investor purchased a 15-year level premium ($500 monthly) term policy with 7 years, 6 months, and 15 days remaining for $20,000. § Investor had no relationship to insured and would suffer no economic loss upon insured’s death. § Insured died and investor received $100,000 under the contract. § Investor had paid premiums totaling $9,000. § Holding: § Investment in the policy = $20,000 + $9,000. § Gain realized = $71,000, all ordinary income.
  • 14. Revenue Ruling 2009-14 Resale of Policy from Investor to Investor § Tax treatment governed by IRC §1001. § Seller’s gross income = gain on the sale § Gain = sale price – adjusted basis of the policy § Adjusted basis = purchase price + additional premiums paid § Gain is capital gain if the policy is a capital asset § Unlike the insured seller, no basis reduction for cost of insurance charges. § Rationale: an investor purchases a policy solely with a view to profit, thus all payments to keep the policy relate to an investment. § The Service will not challenge premiums capitalized prior to issuance of the Ruling.
  • 15. Revenue Ruling 2009-14 Resale of Policy: Facts and Holding § Facts: § Investor purchased a 15-year level premium ($500 monthly) term policy with 7 years, 6 months, and 15 days remaining for $20,000. § Investor had no relationship to insured and would suffer no economic loss upon insured’s death. § Investor sold the policy for $30,000. § Investor had paid premiums totaling $9,000. § Holding: § Adjusted basis = $20,000 + $9,000. § Gain realized = $1,000, long-term capital gain.
  • 16. Sales and Surrenders of Policies at a Loss Surrender of Policy at a Loss § A number of cases have held that even if the policy is held in a trade or business or as an investment, the loss upon surrender is not deductible. § Loss upon surrender represents unrecovered premium payments, which are not deductible under IRC §264. § However, if the insurance company is insolvent so recovery of cash value is impossible, a loss should be deductible to the extent of cash surrender value over amount received. § This loss should be an ordinary loss because a surrender is not a sale or exchange of a capital asset.
  • 17. Sales and Surrenders of Policies at a Loss Sale of Policy at a Loss by Business or Investor § If a policy is held in a trade or business or for investment, loss deduction should be allowed upon sale. § PLR 200945032: Loss = surrender proceeds – adjusted basis § Adjusted basis must be reduced for cost of insurance charges and mortality charges. § Therefore, loss may be disallowed to the extent it results from a failure to recover additional premiums paid that do not increase the policy’s cash value. § Deductible losses are capital losses if the policy is a capital asset.
  • 18. Sales and Surrenders of Policies at a Loss Sale of Policy at a Loss by Insured § Losses on personal use property are not deductible. § An IRC §1035 exchange may be a better solution. § Loss on the exchange is not deductible, but investment in the new policy should include premiums paid on the old policy if the new policy is later surrendered.
  • 19. Policy Loans Upon Sales and Surrenders Policy Loans in General § If a policy owner takes a loan against a policy (which is not a MEC), there are no income tax consequences. § Loan proceeds are not income. § The loan does not reduce the policy owner’s investment in the policy.
  • 20. Policy Loans Upon Sales and Surrenders Surrender of Policy Where Loan is Paid Off on Surrender § Amount realized = cash received by the policy owner + loan amount § Gross income = amount realized – investment in the policy § Barr v. Commissioner, T.C. Memo 2009-250 § Policy owner borrowed $350,000 against a policy having cash value of $361,000 and premiums paid of $225,000. § Insurance company terminated the policy when owner declined to pay premiums or reduce the loan. § Owner received a check for $11,000. § Owner’s gross income on surrender was ($350,000 + $11,000) - $225,000 = $136,000.
  • 21. Policy Loans Upon Sales and Surrenders Sale of Policy Where Loan is Relieved on Sale § Under the “substitute for ordinary income doctrine”, gain is ordinary income to the extent ordinary income would have resulted on surrender. § Balance of the gain is capital gain. § Gross income = amount realized – adjusted basis in the policy § Amount realized = cash received by the policy owner + loan amount § Adjusted basis = premiums paid - cost of insurance
  • 22. Policy Loans Upon Sales and Surrenders Sale of Policy Where Loan is Relieved on Sale § Example: § A’s policy has cash value of $100,000 and an outstanding loan of $85,000. § A has paid total premiums of $60,000 and cost of insurance is $20,000. § A sells the policy to an investor for $30,000 subject to the loan. § Amount realized = $30,000 + $85,000 = $115,000 § Gain = $115,000 – ($60,000 - $20,000) = $75,000 § $40,000 is ordinary income and $30,000 is capital gain.
  • 23. Policy Loans Upon Gift of Policy Gift of Policy Where Loan is Paid by Donee or Donee Takes Subject to Loan § If a donee of a policy pays off a policy loan or takes a policy subject to a loan, there may be income tax consequences to the donor. § Example: § A’s policy has cash value of $100,000 and carries a loan of $85,000. § Total premiums paid is $60,000 and cost of insurance is $20,000. § A gives the policy to his son subject to the loan. § A has taxable gain because he is deemed to have sold the policy to his son for $85,000. § Gain is $85,000 less basis of $40,000 ($60,000 - $20,000) = $45,000. § A has ordinary income of $40,000 and capital gain of $5,000.
  • 24. Estate Planning Transfers of Life Insurance Gift of Policy to ILIT § In the previous example, if A had given the policy to an ILIT for the benefit of his son, the outcome would have been more favorable. § Example: § A’s policy has cash value of $100,000 and carries a loan of $85,000. § Total premiums paid is $60,000 and cost of insurance is $20,000. § A gives the policy to an ILIT to benefit his son. § An ILIT is a grantor trust for income tax purposes. § No gain is recognized by A on the transfer of the loan obligation to the ILIT.
  • 25. Estate Planning Transfers of Life Insurance Sale of Policy to ILIT § In a transfer for value, the purchaser may only exclude from gross income the price paid + additional premiums paid when death benefits are paid. § Solution: Sell the policy to an ILIT. § ILIT is a grantor trust so there is no tax on sale. § Grantor may make cash gifts to fund premium payments or pay off policy loan. § Sale removes IRC §2035 risk. § Avoids the transfer for value rule under the exception where the purchaser’s basis in the policy is determined with reference to the seller’s basis.