Two recent revenue rulings clarify tax treatment of life settlements.

• Author: McGivney, Michael

On May 1, 2009, the IRS issued two revenue rulings discussing the taxation of life settlement transactions. Rev. Rul. 200913 clarifies the tax implications of the surrender or sale of a life insurance policy by the original policyholder, while Rev. Rul. 2009-14 discusses the tax ramifications of certain transactions to an investor who has purchased a life insurance contract through a life settlement transaction. As the life settlement industry continues to grow, financial advisers should be aware of the tax implications of the transactions laid out in each revenue ruling.

Rev. Rul. 2009-13

Rev. Rul. 2009-13 presents the tax treatment of three common life insurance transactions: a taxpayer surrendering a whole-life insurance policy to the insurer for its cash surrender value, a taxpayer selling a whole-life insurance policy to an unrelated third party, and a taxpayer selling a term insurance policy to an unrelated third party who seeks to hold the policy for investment.

In situation 1, taxpayer A surrenders a policy to the insurer for its cash surrender value of $78,000. The cash surrender value reflects the total internal buildup of premiums paid to keep the policy in force and is net of a $10,000 cost of insurance protection provided by the insurer that allows A to enjoy the benefits of being insured. At the date of surrender, A had paid premiums on the policy totaling $64,000. As a result, A must recognize gain in the amount of $14,000. The IRS holds that this amount must be recognized as ordinary income based on Rev. Rul. 64-51, which states that "the proceeds received by an insured upon the surrender of, or at maturity of, a life insurance policy constitutes ordinary income to the extent such proceeds exceed the cost of the policy." It is also important to note that Rev. Rul. 2009-13 specifically states that Sec. 1234A (which deals with the tax treatment of certain derivatives) does not apply.

Situation 2 has the same set of facts as situation 1, except that A sells the policy to an unrelated third party for $80,000 rather than surrendering it to the insurer. In this situation, the Service recognizes Congress's position in the Code and holdings of the courts that a single life insurance contract can have both insurance and investment characteristics. For example, Rev. Rul. 2009-13 cites the opinion in Century Wood Preserving Co., 69 F.2d 967 (3d Cir. 1934), which states, "The policies of insurance involved here have a double aspect...