Income from sales or settlements of life insurance contracts.

• Author: Beatty, Dawn M.

Life insurance contracts have a plethora of tax complexities with varying tax implications. In Rev. Rul. 2009-13, the IRS has provided guidance on the amount and character of income that taxpayers recognize in the surrender or sale of life insurance contracts. In Rev. Rul. 200914, the IRS has provided guidance to purchasers of life insurance contracts for profit. Life insurance contracts have long been in existence, but the Code did not define them for tax purposes until Sec. 7702 was added in 1984 by the Deficit Reduction Act of 1984, P.L. 98-369, effective for contracts issued after December 31, 1984, in tax years ending after December 31, 1984.

Life Insurance Contract Defined

The term "life insurance contract" as defined in Sec. 7702 means any contract that is a life insurance contract under the applicable law, but only if the contract:

* Meets the cash value accumulation test of Sec. 7702(b); or

* Meets the guideline premium requirements of Sec. 7702(c) and falls within the cash value corridor of Sec. 7702(d).

Cash value accumulation test: A contract meets the cash value accumulation test if, by the terms of the contract, the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at that time to fund future benefits under the contract.

Guideline premium requirements: A contract meets the guideline premium requirements if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time.

Cash value corridor: A contract falls within the cash value corridor if the death benefit under the contract at any time is not less than the applicable percentage of the cash surrender value. Additional information regarding the cash valuation accumulation test, guideline premium requirements, and the cash value corridor can be found in Sec. 7702 and its regulations.

Taxation If Contract Meets Definition and Insured Dies

If the contract meets the life insurance contract definition, Sec. 101(a) provides that amounts received are generally excluded from gross income if paid by reason of the death of the insured. The exclusion under Sec. 101(a) applies regardless of whether the payment is made to the estate of the insured or to an individual, corporation, partnership, or other beneficiary and whether it is made directly or in trust.

Taxation If Contract Does Not Meet Definition

If a contract does not meet the life insurance contract definition, in general the income on the contract for any tax year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during that year (Sec. 7702(g)(1)). The term "income on the contract" means, with respect to any tax year of the policyholder, the excess of:

* The sum of the increase in the net surrender value of the contract during the tax year and the cost of life insurance protection provided under the contract during the tax year, over

* The premiums paid under the contract during the tax year.

Life Insurance Contracts Sold and Purchased in the Secondary Market

Life insurance contracts purchased by the insured are not always held until death. The IRS issued guidance in Rev. Rul. 2009-13 on the amount and character of income to be recognized involving the surrender or sale of a life insurance contract that meets the definitional requirements of Sec. 7702. The guidance is provided through...