11.20 Selling or Surrendering Life Insurance Policy

Surrendering or selling a life insurance policy results in ordinary income, long-term gain, or a combination of both, depending on the type of policy and type of transaction. In Revenue Ruling 2009-13, the IRS presents three situations that illustrate the tax consequences of selling or surrendering a whole life or term insurance contract.

Situation 1 - surrender of whole life insurance contract.

On January 1 of Year 1, Tom Taxpayer bought a whole life insurance policy on his life, with the proceeds payable to a family member. Tom retained the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value.

After 89½ months, on June 15 of Year 8, Tom surrenders the contract for its cash surrender value of $78,000. As of the surrender date, Tom had paid total premiums of $64,000, $10,000 of which was the cost of the insurance protection received as of that date. The $78,000 cash surrender value reflected the subtraction of the $10,000 insurance cost.

On the surrender, Tom recognizes income of $14,000, the $78,000 received minus the total premiums paid of $64,000.

The Tax Code does not specify whether income recognized upon the surrender of a life insurance contract, as opposed to a sale, is treated as ordinary income or as capital gain. However, relying on a 1964 ruling (Revenue Ruling 64-51), the IRS holds that the proceeds received by an insured upon the surrender of a life insurance policy constitute ordinary income to the extent such proceeds exceed the cost of the policy. Thus here the $14,000 of income recognized on the surrender of the insurance contract is ordinary income and not capital gain.

Situation 2 - sale of whole life insurance contract.

Same facts as in Situation 1 except that Tom sold the contract for $80,000 to an unrelated person. To figure gain on the sale, the $80,000 amount realized must be reduced by the insured’s adjusted basis in the insurance contract. To figure basis, the $64,000 of total premiums paid must be reduced by the $10,000 cost of insurance provided before the sale. Therefore, adjusted basis is $54,000, and the gain on the sale is $26,000 ($80,000 proceeds minus $54,000 basis).

Part of the $26,000 gain is ordinary income and part is capital gain. The Supreme Court has held that under the “substitute for ordinary income” doctrine, income that has been earned but not yet recognized by a taxpayer cannot be converted into capital gain by a sale or exchange. In the case of a sale of a life insurance policy, the portion of the gain that would have been ordinary income if the policy had been surrendered (i.e., the inside buildup under the contract) is ordinary income. However, any income over that amount can qualify for capital gain treatment.

Here, $14,000 of the $26,000 gain is ordinary income representing the inside buildup under the contract ($78,000 cash surrender value minus $64,000 total premiums paid). The remaining $12,000 of income is long-term capital gain.

Situation 3 - sale of term life insurance contract.

Assume that Tom had entered into a 15-year level premium term contract with no cash surrender value, rather than the whole life contract in Situation 2. Monthly premiums were $500 and total premiums paid were $45,000 when the policy was sold after 89.5 months to an unrelated party for $20,000.

In this case, as in Situation 2, the adjusted basis of the contract for purposes of determining gain or loss is the total premiums paid minus charges for the provision of insurance before the sale. The cost of insurance protection in this case amounted to $44,750 ($500 × 89.5 months), so Tom’s adjusted basis is $250 ($45,000 total premiums minus $44,750).

Tom’s gain on the sale is $19,750 ($20,000 sale proceeds minus $250 basis). Because the term insurance contract had no cash surrender value, and thus no inside buildup to which ordinary income treatment could apply, the entire $19,750 is long-term capital gain.