D—Gain Or Loss On Surrender Or Sale

The surrender or sale of a life insurance policy, can result in a gain or loss to the policyowner. Generally, any gain is taxable as ordinary income. Rarely is there a deductible loss.

Gain Is Taxable

When a life insurance or endowment policy is surrendered for its cash value, amounts received in excess of "aggregate premiums or other consideration paid" are taxable income [I.R.C. §72(e)].

Cost Basis

To determine cost basis, find the sum of premiums paid, and subtract all non-taxable distributions actually received (i.e., dividends, tax-free withdrawals and any policy loans not repaid). [Reg. §1.72-6(a)(1)].

If premiums have been pre-paid on a discounted basis, the interest increment applied by the company for each credited premium payment is added to the cost basis of the policy (since that amount has been included in the taxpayer`s gross income). [Rev. Rul. 65-199, 1965-2 C.B. 20].

Investment in the contract (basis) also includes the economic benefit reportable imputed income (P.S. 58 cost) from the insurance benefit received under a qualified retirement plan and the economic benefit reportable income under a split-dollar plan.

The investment in the contract (basis) does not, include: premiums for disability income, premiums for accidental death benefits, premiums for waiver of premiums and interest paid on policy loans.

Dividends used to purchase paid-up additions do not decrease basis (because under this dividend option the dividends are in effect reinvested in the policy and thus become the cost basis of the purchased paid up additions).

In the case of a gift of a life insurance policy, the donor`s cost basis is carried over to the donee [Reg. §1.72-10(b)].

An employee`s cost basis includes premiums his employer paid, provided such premiums were includable in the employee`s gross income [Reg. §1.72-8(a)(1)]. However, cost basis does not include premiums paid by an employer where they do not constitute income to the insured [Reg. §1.72-8(a)(2); Card v. Comm`r, 216 F.2d 93 (1954)].

Double Indemnity And Waiver Of Premium

Amounts paid for double indemnity protection cannot be included in premium cost [Est. of Wong Wing Non, 18 T.C. 205 (1952)]. Moreover, amounts paid for a waiver-of-premium disability rider do not constitute a part of the premium cost for the life insurance [Est. of Wong Wing Non, supra; Rev. Rul. 55-349, 1955-1 C.B. 232]. Such additional coverage is in the nature of disability income coverage rather than life insurance.

Withdrawals And Partial Surrenders

Partial surrenders (also referred to as withdrawals) are normally considered a tax-free return of capital unless the amount withdrawn exceeds the investment in the contract [I.R.C. §72(e)(5)(c)]. This is sometimes referred to as the FIFO (first in, first out) rule. The first money put into the contract (i.e., the investment in the contract) is considered to be the first money taken out. For example, if the investment in the contract is $1,000, up to $1,000 can be withdrawn tax-free.

Certain Withdrawals During First 15 Years

As noted above, withdrawals up to the total amount of premiums paid (i.e., cost basis) are normally tax-free. However, there is an exception to this general rule in certain cases where there is a cash distribution within the first fifteen (15) years after the policy has been issued accompanied by a reduction in the death benefit. This is sometimes referred to as the "force out of gain provision." Code §7702(f)(7)(B).

If a policy change reduces the death benefit and there is a cash distribution to the policyholder as a result of the change, and but for that cash distribution the policy would fail to meet the statutory definition of life insurance under Code §7702, then a LIFO (last in, first out) rule applies to a portion of the distribution. Under the LIFO rule, the last money put into the contract (i.e., interest income) is considered to be the first money taken out.

Only the portion of a distribution that does not exceed the "recapture ceiling is subject to the LIFO rule." For a withdrawal during the first five years, the recapture ceiling is the amount required to be paid out of the policy to meet the cash value accumulation test or the guideline premium/cash value corridor test, whichever is applicable. For a withdrawal during the sixth through 15th years, the recapture ceiling is the amount by which the cash value immediately before the distribution exceeds the maximum permissible under the cash value corridor test, regardless of whether that test is otherwise applicable to the policy. These tests are discussed in Section 19.1, Subdivision A.

Gain On Sale Or Surrender Taxed As Ordinary Income

The gain realized upon the sale or surrender of a life insurance or endowment policy for its cash surrender value is taxable as ordinary income. It cannot be treated as gain derived from the sale or exchange of a capital asset [Avery v. Comm`r 111 F.2d 19 (1940); Blum v. Higgins, 150 F.2d 471; Ralph Perkins, 41 B.T.A. 1225].

Employer`s Sale To Employee

Sometimes an employee can realize a gain with the purchase of a policy from his or her employer. This gain is considered additional compensation and taxed as ordinary income. Thus, where an employer owned a policy on an employee`s life, and sold the employee this policy at its cash value, the employee realized income to the extent the policy`s value exceeded the sale price. The policy`s value equaled its interpolated terminal reserve at the sale date, plus any unearned premium [Rev. Rul. 59-195, 1959-1 C.B. 18].

Cash Surrender Value Paid Under Options

If a person surrenders a life insurance policy and leaves the cash value at interest with right to withdraw, he constructively receives such value in the year of surrender [Reg. §1.451-2(a)]. Any gain is taxable in that year [Reg. §1.72-11(d)]. Subsequent interest payments are fully taxable [I.R.C. §72(j); Reg. §1.72-14(a)].

If the surrender value is received under a fixed-amount or fixed-period option elected before, or within 60 days after, the surrender date, there is no constructive receipt of surrender values [I.R.C. §72(h); Reg. §1.72-12]. A portion of each payment is excludable from gross income under the applicable annuity rule. The excludable portion equals the investment in the contract divided by the expected return.

If the surrender value is settled under a life income option elected prior to, or within 60 days after, the surrender date, the cash value will not be deemed constructively received [I.R.C. §72(h); Reg. §1.72-12]. Any amount received thereafter as an annuity will be taxed under the applicable annuity rule. (See discussion on taxing of annuities, Subdivision D, of this Section). If the policyholder delays until the expiration of 60 days after the surrender date to elect a policy option, he or she will be taxed then on any excess of the surrender value over the net cost, and the surrender value will be used instead of the net cost in computing the exclusion ratio under the applicable annuity rule of taxation.

Gain on Government Life Insurance Is Exempt

Gain realized upon the surrender or maturity of United States Government or National Service Life Insurance is exempt from income tax [38 U.S.C. §3101; I.T. 3294, 1939-2 C.B. 151; see Section 24.]

Loss on Surrender or Sale

When a life insurance policy is sold or surrendered by a taxpayer, a deductible loss seldom arises. To be able to deduct a loss, a taxpayer must show that the loss was incurred in a trade or business, or in a transaction entered into for profit [I.R.C. §165(c)].

Cost Basis For Loss Purposes

Although the Code explicitly provides that "aggregate premiums paid" is the cost basis to be used to compute gain, there is no mention regarding how cost basis is to be determined to compute loss. However several courts have held that the portion of the net premiums credited toward the policy reserve constitutes the policy`s cost basis for loss purposes; the balance of the net premiums represents the cost of insurance protection, a nondeductible expense [Keystone Consolidated Publishing Co., 26 B.T.A. 1210; Century Wood Preserving Co., v. Comm`r, 69 F.2d 967; London Shoe Co. v. Comm`r, 80 F.2d 230]. As a result, there will be no loss if the cash surrender value equals the policy reserve.

Proving A Loss

When a policy is sold or surrendered for its cash surrender value, a loss is incurred if the taxpayer`s premiums paid toward the policy`s reserve exceed the cash surrender value. Therefore, to prove a loss, the taxpayer must submit an actuarial breakdown of net premiums paid. Furthermore, such a breakdown would not be expected to show a loss except in the very early years of a policy. This is because the portions of premiums paid toward the reserve would simply be totaled to obtain cost; whereas, such portions in the hands of the insurance company, subject to certain surrender charges in the early years, would be improved at compound interest to make up the cash surrender value. Without any surrender charge, obviously there could be no loss. If there is a surrender charge, it should soon be offset by the interest element in the cash surrender value. Thus, the occurrence of a loss is rare and insubstantial where the taxpayer receives the full cash surrender value. When a loss does occur, the difficulties of proving it by complicated actuarial computations would hardly make the effort worthwhile.

Loss Where Less Than Cash Surrender Received

If the policyowner receives less than the cash surrender value, there should be no difficulty in proving a loss. In the absence of an actuarial breakdown of premiums the courts have used the cash surrender value as equivalent to the taxpayer`s cost. In two cases where liens were placed against cash surrender values because of the insurance company`s insolvency, the taxpayer was allowed an ordinary loss upon surrendering his policy for its cash surrender value less the amount of the lien [Moses Cohen v. Comm., 44 B.T.A. 709; William R. Fleming v. Comm., 4 T.C.M. 316].

Individual Taxpayer`s Problem Under Code §165(c)

Even if an individual taxpayer proves a loss on sale or surrender of the policy, the loss cannot be taken unless the taxpayer also shows that the loss was incurred as a result of the taxpayer`s trade or business, or in a transaction entered into for profit. The courts disagree, however, on whether the acquisition of personal life insurance is a transaction entered into for profit. In Moses Cohen, supra, the taxpayer had purchased two participating 20-payment life policies as personal insurance. The Board, stressing the cash surrender values and the policy dividends, held that these features qualified the transaction "in respect to its investment features, as one entered into for profit within the meaning of the statute." One judge dissented. The Tax Court followed this case in William R. Fleming, supra which involved a $25,000 participating policy of undisclosed type, but with a substantial cash surrender value.

A federal district court, on the other hand, found that the purchase of retirement life income policies, bought at attained ages 51 and 55 to mature at age 65, was not a transaction entered into for profit. This finding was unnecessary because the court held that the taxpayer had sustained no loss since he still had an interest in the policies. (Three years after their maturity, he had taken the commuted value of the remaining seven years of guaranteed payments, but he would resume receive life income payments on surviving the seven years [Arnold v. U.S., 180 F. Supp. 746].)

Loss on Bad Debt Covered with Insurance

A creditor may deduct the amount of a bad debt charged off as worthless even though the debt is secured by a life insurance policy on the debtor`s life, and even though the creditor continues to hold this policy and keep it in force [Ross v. Comm`r, 72 F.2d 122 (1934); Dominion National Bank., 26 B.T.A.421; Citizens Trust Co. of Utica, 2 B.T.A. 1239].

On ascertaining the debt to be worthless, the creditor may charge off the difference between the amount of the debt and the cash value of the policy held as collateral. A creditor need not liquidate the collateral security to establish that the debt is worthless. In one case a bank carried a policy securing a loan owed to it by the insured. When the loan was charged off as a bad debt, the policy had a larger face value than the loan, but the cash value at the time was less than the debt charged off. The United States Board of Tax Appeals held that the bank was entitled to deduct as a loss the difference between the amount of the debt and the cash value of the policy, even though the bank maintained the policy. The Board proceeded on the theory that the bank was under no obligation to continue the policy until it became worth more at some future date [Dominion National Bank, supra].

Where the policy is a term contract with no cash value, the entire debt may be deducted as worthless [Northern National Bank, 16 B.T.A. 608].

Recovery Of Bad Debt

Recovery by the creditor of any part of the debt in a later year may result in taxable income if the prior year`s bad debt deduction resulted in a tax benefit [I.R.C. §111(b)(4)].

Income Tax Effect Of Lapse, Surrender And Assignment When Policy Is Subject To An Outstanding Loan

When a policy subject to a loan lapses, is surrendered or assigned, the policyowner`s indebtedness is discharged. The policyowner is therefore treated for income tax purposes as having received an amount equal to the discharged debt.

Gift Of Policy Subject To An Outstanding Loan—Transfer For Value Rule Implications

If the policy value is more than the amount of the outstanding loan, the transfer is considered in part a gift and in part a sale. The transfer for value rule will come into play. (The valuable consideration deemed received by the donor/transferor is the discharge of his or her legal obligation to ever repay the policy loan.) To avoid the taint of the transfer for value rule the transferee must be one of the "proper party transferees" or, in the alternative, if the transferee is not one of the proper parties; if the transferee`s basis in the policy is determined, in whole or in part, by reference to the transferor`s basis it will come within the transferors basis exception to the transfer for value rule. [I.R.C. §101(a)(2)(A)]. Qualification for the transferors basis exception will be automatic unless the loan assumed exceeds the transferor`s basis in the policy [Reg. §1.1015-4(a)]. To avoid any problem with the transfer for value rule, in a case where the transferee is not a "proper party" a transfer should therefore be designed so that the loan assumed is less than aggregate premiums paid by the transferor (i.e. the transferors basis in the contract). If the loan balance exceeds the transferor`s basis in the policy the transferor should pay back enough of the loan such that the loan balance will be less then the transferors basis.

Cancellation Or Lapse Of A Policy Subject To An Outstanding Loan Can Generate Taxable Income

Not only may cash values accumulate within a life insurance policy without current income taxation, but this untaxed income may even be utilized by the policy owner, still without income recognition for tax purposes, in the form of a policy loan.

The non-recognition of this income will become permanent when the insured dies, and the death benefit (net of any policy loan balance) is paid. Under the general rule of I.R.C. §101, the death benefit under a life insurance contract is excluded from gross income.

However, this avoidance of income recognition will not be permanent when a policy loan is effectively retired by offset against the cash value in connection with cancellation of the contract. In such event the income recognition will have only been deferred, and it must be recognized at the time of cancellation (or lapse) of the policy. This, of course, makes complete sense; to the extent that the policy owner has withdrawn from the policy an aggregate amount in excess of his or her cash input (cost basis in the policy), and no longer has any obligation to repay such funds, there has been a net benefit which would ordinarily be taxable income. Such transactions are governed by rules confusingly contained within I.R.C. §72, which deals primarily with annuities. Section 72(e), one of the most technically garbled sections of the Internal Revenue Code, deals with payments received with respect to insurance contracts, which are not received as an annuity. This includes amounts received upon a cancellation of the contract. In general, such amounts are treated first as recovery of the policy owner’s investment in the contract, and amounts received in excess of the amount invested are treated as ordinary income [I.R.C. §72(e)(1)(A), 5(A) and 5(C)].

Example: The Atwood Case

The recent Atwood case (Atwood v. Comm’r., T.C. Memo 1999-61) is a basic illustration of these principles. The taxpayers, husband and wife, had each purchased single-premium life insurance policies, one for $25,000 and one for $50,000. These policies allowed for loans up to the amount of the cash value. The taxpayers eventually borrowed the maximum amount on each policy, using the funds for personal living and other personal expenses. Interest on these loans was accrued and periodically added to the outstanding loan balance. Eventually, when required payments on the loans were not made, the respective insurance companies cancelled the policies. As of the date of cancellation, the husband’s policy had only a nominal cash value of $439.48, net of the outstanding loan balance, and the wife’s policy had none. The husband was sent a check for the remaining net value of $439.48.

The taxpayers reported nothing in their income tax return with respect to the policy cancellations, despite the fact that the insurance companies had issued Forms 1099-R reporting substantial amounts of taxable gain. With respect to the husband’s policy, the Form 1099-R reflected a cash value of $39,843.11 (of which $39,403.63 had been borrowed), an investment in the contract of $25,000, and a net taxable gain of $14,843.11. The wife’s insurance company issued a 1099-R showing a gain of $23,274.49, based upon an outstanding loan balance of $73,274.49 and an investment of $50,000. The insurance companies were, in effect, applying the rule discussed above when they issued the required 1099 forms to the taxpayers.

In representing themselves pro se in the Tax Court the taxpayers took the position that the cancellations did not give rise to income, but rather, were merely “paper transactions” on the books of the insurance companies. This, of course, conveniently ignores the fact that at some point prior to the time of these “paper transactions” the taxpayers had received and spent funds from the insurance companies far in excess of the amounts originally invested in the policies. The Court quite correctly points out that “when the petitioners’ policies terminated, their policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to the petitioners [which they then, in effect, repaid to the companies], and constituted income to them at that time.”

The Court also sustained a 20 percent accuracy-related penalty which the IRS had imposed for substantial understatement of tax. Such a penalty may be imposed when the tax liability is understated by at least the greater of 10% of the reported tax or $5,000, unless the understatement was attributable to an item that was adequately disclosed and has a reasonable basis, or which was based upon a position for which there was substantial authority. The Court pointed out that the taxpayers had not met this test for avoidance of the penalty, having failed to make any disclosure of this issue in their tax return, despite having received 1099 forms reporting material amounts of income.

While the surrender of a life insurance policy for its cash value will give rise to taxable income when the surrender proceeds exceed the investment in the contract, policy owners who voluntarily surrender their contracts are generally aware of the potential tax consequences, and when there are no policy loans involved, the cash proceeds will be available to pay the resulting tax. On the other hand, as the Atwood case reminds us, the surrender or cancellation of a life insurance policy subject to an outstanding policy loan can trigger a material amount of taxable income---often with little or no cash received.

In this case the painful tax consequences may have been brought on involuntarily, the facts indicating that the policies were cancelled by action of the insurance companies, rather than at the request of the policy owners, although it is not clear exactly what triggered the company’s actions. In any event, financial services professionals should be sure that clients understand the potential consequences when loan-encumbered policies are allowed to go into default and involuntary cancellation. When apprised of the tax consequences, clients may well conclude that the cash input required to maintain such a policy in force would be considerably less than the income tax that would be triggered by a cancellation.

Discounts For Pre-Payment Of Insurance Premiums

Any (interest) increment in the value of pre-paid life insurance or annuity premiums or premium deposit funds is includable in gross income for the year it is applied to premium payment or made available for withdrawal [Rev. Rul. 66-120, 1966-1 C.B. 14].

Amount Taxable

The amount that must be included in gross income by the policyholder each taxable year depends on whether the increments on the discounted prepaid premiums can or cannot be withdrawn.

When Increments Considered Withdrawable

Rev. Rul. 66-120, supra, stated that increments are considered to be withdrawable if not subject to substantial limitations or restrictions within the meaning of the regulations pertaining to constructive receipt. The fact that increments could be withdrawn only if all the unapplied advance premiums were also taken does not constitute a substantial limitation. But there is a substantial limitation where increments may be withdrawn only upon surrender of the policy or the insured`s death.

Where Increments Not Withdrawable

Since the insurance company discounts each premium separately where several are being prepaid, the smallest portion of the total "discount" occurs in the first policy year and the largest in the last policy year. If none of the increments on the discounted premium fund can be withdrawn, then they are taxable income in successively larger amounts when applied to premiums due.

For example, assume that a policyholder discounts five annual premiums of $1,000 each at the company`s 4 percent discount rate. Here, the discounted amount he pays for the first policy year is $962; it is $925 for the second year; $889 for the third; $855 for the fourth; and $822 for the fifth. Subsequently, as each discounted premium is applied to the respective premium when due, the policyholder will realize taxable income in the amount of the difference between the full premium of $1,000 and the discounted amount paid for such premium.

Where the insured dies before all of the advance premiums are earned by the insurance company, the unearned premiums plus any increments earned to the date of decedent`s death will be paid according to the terms of the advance premium agreement. The recipient of the unearned premiums plus interest would be taxable for such interest. Such interest income probably would be considered income in respect of a decedent.

Where Increments Withdrawable

If there is no substantial limitation on interest withdrawal, then the reverse is true as to the taxable portion; the largest portion of the total "discount" is taxable in the first policy year and the smallest in the last policy year. This is because interest income is considered earned ratably over the time involved, and under the constructive receipt rule is taxable when earned.

Using the facts in the preceding example, here the Revenue Service would consider $178 (4 percent of the total amount prepaid, $4,452) as the earned increment for the first policy year; $145 for the second; $111 for the third; $75 for the fourth; and $38 for the fifth. However, since the "policy" and "taxable" year are seldom ever the same period, an adjustment would be necessary. In this instance, if the policy year began July 1 and the taxable year was a calendar year, one-half of $178 ($89) would be the amount taxable in the first calendar year. Then the other half plus one-half of the $145 would be taxable in the second taxable year. The amount for subsequent taxable years would be similarly obtained.

Taxable Increments Increase Cost Basis

Where the insured during his lifetime receives amounts under a surrendered or matured policy, increments which have been included in gross income under the preceding rules are added to the cost basis of the contract. Such addition has the effect of reducing the taxable gain upon surrender or maturity.

Insurance Dividends Nontaxable

Dividends received before maturity under a life insurance contract are not subject to income tax and are considered a return of investment [I.R.C. §72(e); Reg. §1.72-11(b)(1)]. In addition, it is immaterial whether the dividends are paid in cash, credited against the current premium, used to buy paid-up additions or left with the insurance company to accumulate. However, tax liability arises when the amount of dividends received exceeds the aggregate premiums or other consideration paid or deemed to have been paid by the recipient for the policy. In this situation, the excess is considered taxable income.

Interest On Accumulated Dividends

Interest credited annually on dividends left on deposit with the insurance company is considered income to the policyholder. It must be included in gross income in the year it can be withdrawn. If there are substantial limitations on the policyholder`s ability to withdraw dividend interest, such interest will be taxable in the first year that the withdrawal rights become available [Reg. §§1.61-7(d); 1.451-2(b)]. In this regard, the regulations state that the following are not "substantial" limitations or restrictions:

1. A requirement that interest be withdrawn in even amounts:

2. A requirement that interest may be withdrawn only upon withdrawal of all or part of the dividend account:

3. A requirement that a notice of intention to withdraw be given in advance of the withdrawal; and

4. The fact that a higher rate of interest would be paid in the year subsequent to the current taxable year [Reg. §1.451-2].

Regardless of when dividend interest is taxed, it is added to the policyowner`s cost basis for computing gain or loss upon the subsequent surrender, sale or exchange of the policy.

The Tax Court held that interest paid on dividend accumulations was constructively received by the insured in the years credited since it "was subject to his unfettered right to withdraw it." [Theodore H. Cohen,. 39 T.C. 1055 (1963)]. The court noted that under the terms of the dividend option, the accumulation of dividends and interest were "withdrawable in cash on demand" by the insured.

Government Policies

Dividends paid on government life insurance policies are exempt from income tax (Rev. Rul. 71-306, 1971-2 CB 76). In addition, interest on accumulated dividends is not taxable (Rev. Rul. 91-14, 1991-1 CB 18).

Tax Levy On Insurance Policies

When an individual fails to pay his taxes the IRS can come after his assets including the cash value of any permanent life insurance policies.

To collect delinquent income taxes, the IRS can reach the cash value of a taxpayer`s life insurance policies. Using a summary levy procedure, the IRS can reach the loan value of a policy that is subject to a tax lien. An insurance company must pay the present loan value of the policy to satisfy the debt or the balance of the tax liability, if less.

The insured cannot surrender the policy for its cash value, execute a policy loan, or obtain any other advance on the policy after the notice of levy is served [I.R.C. §6332(b)(2)].

If the insured dies before paying the full amount of the delinquent income taxes, the IRS can enforce a tax lien against the beneficiary only to the extent of the cash value immediately preceding death. However, if the beneficiary is a surviving spouse whose has filed joint returns with the insured, the surviving spouse is generally liable for the unpaid taxes. In this case the entire amount of the insurance proceeds can be subject to a lien for the delinquent taxes.