Tax News

CCH (cch.taxgroup.com) reports:

  The IRS has clarified the character and amount of income that must be recognized under Code Sec. 72 on the surrender of a life insurance policy in one situation and the sale of such a policy in two situations. In the first situation, the policy owner received income in the amount of the difference between the surrender value of the policy and the aggregate premiums paid on the contract. Since the surrender of a life insurance contract does not produce capital gain, the income was ordinary income.

  In the second situation, the taxpayer sold the life insurance contract to an unrelated party. Under Code Sec. 1001, the gain realized from selling property is the excess of the amount realized over the adjusted basis of the property. The taxpayer's basis in the contract was determined under Code Secs. 1011 and 1012, as adjusted under Code Sec. 1016. Thus, his basis was the amount of premiums paid minus the amount paid by the insurer for cost-of-insurance charges. The taxpayer was required recognize as income the sale amount minus the adjusted basis.

  To determine the character of the income, the IRS applied the "substitute for ordinary income" doctrine. Under that doctrine, "property" as used in Code Sec. 1221 does not include rights or claims to ordinary income. Application of the substitute for ordinary income doctrine is limited to the amount that would be recognized as ordinary income on surrender of the policy, and income received on sale of a life insurance policy may qualify as gain from the sale of a capital asset to the extent that it exceeds the cash surrender value minus the premiums paid (that is, the "inside build-up" under the contract). Thus, of the income received, the amount equalling the inside buildup on the contract was taxed as ordinary income. The excess was taxed as long-term capital gain.

  In the third situation, the taxpayer sold a 15-year term life insurance contract without cash surrender value to a third party. The taxpayer's adjusted basis in the contract was the total premiums paid minus charges for the provision of insurance before the sale. The monthly cost of the insurance is, absent other evidence, presumed to be the amount of the premium paid for that month. Because the policy had no cash value, there was no inside buildup, and the "substitute for ordinary income" doctrine did not apply. Because the contract was not excluded from the definition of capital asset under Code Sec. 1221, and was held by the taxpayer for more than a year, the sales proceeds minus the taxpayer's basis in the contract were taxed as long-term capital gain.

Rev. Rul. 2009-13, 2009FED ¶46,357

Other References:

 
Code Sec. 61

  CCH Reference - 2009FED ¶5504.2665

 
Code Sec. 72

  CCH Reference - 2009FED ¶6140.79

 
Code Sec. 1001

  CCH Reference - 2009FED ¶29,225.1027

 
Code Sec. 1011

  CCH Reference - 2009FED ¶29,313.26

 
Code Sec. 1012

  CCH Reference - 2009FED ¶29,335.01

 
Code Sec. 1016

  CCH Reference - 2009FED ¶29,412.023

 
Code Sec. 1221

  CCH Reference - 2009FED ¶30,422.184

 
Code Sec. 1222

  CCH Reference - 2009FED ¶30,442.23

  Tax Research Consultant

  CCH Reference - TRC INDIV: 30,100
CCH Reference - TRC IRS: 48,110.50