Selling a Life Insurance Policy

IRS offers guidance on tax consequences

Do you own a life insurance policy? Are you considering selling it? A new ruling from the IRS offers their thinking on the tax consequences of such a transaction.

In all the situations below, it is assumed that you took out a policy on your own life and named a member of your family as the beneficiary, retaining the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. You've held the policy for just under 7½ years. You aren't terminally ill or "chronically ill" as that term is defined for tax purposes. It's also assumed that you haven't received any distributions or taken a loan against your policy.

Surrendering the policy

If you hold a whole life policy, one way to cash in is to surrender it to the insurance company for its cash surrender value. In the ruling, the IRS assumes you paid a total of $64,000 in premiums, and the contract has a cash surrender value of $78,000, which reflects subtraction of $10,000 for cost-of-insurance charges.

The ruling says your income is $14,000, the difference between the $78,000 you received and your $64,000 "investment in the contract." Although you're receiving money in exchange for a contract you've held more than a year, this amount must be reported as ordinary income, not capital gain.

Note that you aren't required to reduce your basis for the $10,000 in cost-of-insurance charges. This figure doesn't enter into the tax calculation when you surrender a policy, but it's relevant in the situation described next.

Selling a whole life policy

The ruling offers a second set of facts where instead of surrendering the policy you sell it for $80,000 to an unrelated person who would not suffer a loss on your death. In this situation, the IRS says you have to reduce your basis in the contract by the portion of the premium that was used to provide life insurance. This is the $10,000 cost-of-insurance charge mentioned earlier. You paid premiums of $64,000, so your basis is $54,000. Subtract that amount from the sale proceeds of $80,000 to arrive at the amount of income you have to report, $26,000.

Is this capital gain or ordinary income? The IRS says it is some of both. The first $14,000 of profit is treated as ordinary income because it "substitutes" for the $14,000 of ordinary income you would have reported if you surrendered the policy instead of selling it. The remaining $12,000 of profit is long-term capital gain.

Selling a term policy

Finally, the IRS presents an alternative where you own a level premium 15-year term life insurance policy without cash value. Your monthly premium is $500, and as of June 15, the date of the sale, you've paid a total of $45,000 in premiums. You sell the contract for $20,000 to an unrelated person who would not suffer a loss on your death.

Your basis in the contract is equal to the total amount of premiums paid ($45,000) reduced by the insurance charges for that period. Because this is a term policy, the IRS assumes the insurance charge for each month is equal to the monthly premium, "absent other proof." As a result, your only basis is $250 representing the unexpired one-half month covered by your most recent payment. You report a profit of $19,750, and because the policy has no surrender value, the entire amount is long-term capital gain.

The method of determining basis for this situation is somewhat unfavorable, in that the monthly charge blends the cost of the less expensive life insurance coverage for the earlier years of the contract with the cost of the more expensive coverage for later years when mortality is higher. Nevertheless, the ruling is favorable in clarifying that the profit is taxed as capital gain and offers a simple way to calculate a result the IRS will accept.

Prospective effective date

The ruling for the first situation is in line with previous guidance from the IRS, but the guidance on the second and third situations is new. Therefore the IRS says the ruling with respect to the last two situations will not be applied adversely to sales occurring before August 26, 2009.

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