IRS answers: new guidance on life insurance settlements.

• Author: Josephs, Stuart R.
• Position: FedTax

Rev. Rul. 2009-13 (IRB 2009-21, May 26, 2009) answers this question: What income is recognized upon the surrender or sale of the life insurance contracts described in the three situations below?

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Situation 1

Facts: On Jan. 1, Year 1, individual A entered in a life insurance contract with cash value. A was the insured and his relative the beneficiary. A had the right to change the beneficiary, take out a policy loan or surrender the contract for its cash surrender value (CSV). The contract in A's hands was not property excluded from the definition of a capital asset [under IRC Sec. 1221 (a)(1)-(8)].

On June 15, Year 8, A surrendered the contract for its $78,000 CSV which reflected the subtraction of $10,000 of "cost-of-insurance" charges collected by the issuer for periods ending on or before the contract's surrender. Through that date, A paid premiums totaling $64,000 and was not terminally or chronically ill [as defined by Sec. 101(g)(4)]. A neither received any distributions under the contract nor borrowed against its CSV.

Holding: A must recognize ordinary income of $14,000 ($78,000 less $64,000).

Situation 2

Facts: The same as Situation I, except that on June 15, Year 8, A sold the contract for $80,000 to B, a person unrelated to A and who would not suffer economic loss upon A's death.

Holding: A must recognize income upon the contract's sale, as follows:

Sales proceeds $80,000 Less contract's basis: Premiums paid $64,000 Less cost of insurance charges $10,000 Basis $54,000 Total income recognized $26,000 Of this amount, $14,000 is ordinary income and $12,000 is long-term capital gain.

Situation 3

Facts: The same as Situation I, except that the contract was a level premium 15-year term life insurance contract without CSV. The contract's monthly premium was $500. Through June 15, Year 8, A paid premiums totaling $45,000.

On June 15, Year 8, A sold the contract for $20,000 to B, a person unrelated to A and who would not suffer economic loss upon A's death.

Holding: A must recognize long-term capital gain upon the contract's sale, as follows:

Sales proceeds $20,000 Less contract's basis: Premium paid $45,000 Less cost of insurance charges (see below) $44,750 Basis $250 Long-term capital gain $19,750 Absent other proof, the cost of the insurance provided to A each month is presumed to equal the monthly $500 premium. Thus, the cost of A's insurance protection during the 89.5 months that A held the contract is $44,750...