Why is this Topic Important to Wealth Managers?  Provides general taxation of life insurance contracts owned by a third party transferee, including the payment of death benefits as well as sale or exchange gain treatment.     

Today’s blogticle will discuss taxation of life insurance contracts from the purchaser’s prospective. 

As discussed yesterday, an insurance contract that carries a built-up cash value can be loaned against, collected by the beneficiary, surrendered or sold to a third party.   This blogticle deals in particular with payment of the face value to the third party caused by the death of the insured as well as another sale or exchange of the contract by the third party.  

What are the tax implications if the third party collects the death benefits?

As a starting point, gross income includes all income from whatever source derived including (but not limited to) income from life insurance contracts (unless otherwise excluded by law).[1]

Gross income specifically excludes amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.[2] 

Nevertheless, “In the case of a transfer for valuable consideration…the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration paid and the premiums and other amounts subsequently paid by the transferee.” [3]  In other words, the third-party must include the death benefits as gross income over the amount of consideration and any additional premiums paid. 

Moreover, because the collection of death benefits is not a sale or exchange, the collection of death benefits does not qualify for long-term capital gain treatment. [4]   Therefore the amount received over basis is ordinary income. 

What are the tax implications if the policy is sold to a third party?

As a starting point, gross income includes gains derived from dealings in property. [5]

In determining the amount of the gain, the amount realized is taken over the adjusted basis. [6] Amount realized is generally the selling price.[7]  To determine basis, the taxpayer must capitalize the amount “paid to another party to acquire…a life insurance contract”. [8]  Furthermore, any additional premiums paid by a “secondary market purchaser…serve to create or enhance a future benefit for which capitalization is appropriate.” [9]  The basis then for determination of gain purposes is generally consideration paid plus additional premiums remitted. 

In determining the nature of the gain, unlike the ordinary income resulting from collection of the face value of insurance contract, this situation involves an actual sale of the contract. “Nevertheless some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.” [10]

The “substitute for ordinary income” doctrine is limited in application “to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract).”  Therefore, the amount up to cash value, is taxed at ordinary income and if any amount “exceeds the ‘inside build-up’ under the contract, the excess may qualify as gain from the sale or exchange of a capital asset.”  [11]  Additionally, if the contract is held for more than one year, it would qualify for a long-term capital gain treatment. [12]

Tomorrow’s blogticle will continue the discussion of the taxation of life settlement agreements. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 26 U.S.C. § 61(a); 26 U.S.C. § 61(a)(10).

[2] 26 U.S.C. § 101(a).

[3] 26 U.S.C. § 101(a)(2). 

[4] Revenue Ruling 2009-14. 

[5] 26 U.S.C. §  61(a)(3). 

[6] 26 U.S.C. §   1001(a). 

[7] 26 U.S.C. §§ 1001. 

[8] Revenue Ruling 2009-14, cting CFR 1.263(a)-4(c)(1)(iv)

[9] Revenue Ruling 2009-14.  

[10] Id. 

[11] Revenue Ruling 2009-13, citing e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n. 3 (4^th Cir. 1960).

[12] 26 U.S.C. §§ 1001.

Tags: Business, Capital gain, Financial services, Gross income, insurance, Internal Revenue Code, Tax, United States

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