Disposition Sale Or Purchase Of A Contract

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> The 2017 tax reform legislation reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the &ldquo;cost of insurance&rdquo;) in the case of a policy sale. Therefore, on sale of a term life insurance policy, the insured&rsquo;s basis is no longer reduced by the cost of insurance.<a href="#_ftn1" name="_ftnref1">¹</a> This new rule for determining basis is effective retroactively, to transactions entered into after August&nbsp;25, 2009.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Revenue Ruling 2009-13 explained how to calculate the amount and character of gain upon the surrender or sale of a life insurance policy by the insured.<a href="#_ftn3" name="_ftnref3">³</a> The example below illustrates the results upon the sale of a term life insurance policy (Situation 3), as previously enforced by the IRS. However, as noted in the editor&rsquo;s note above, the IRS position has explicitly been superseded by statute. For examples illustrating the results upon surrender of a cash value policy or the sale of a cash value policy, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="37">37</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="38">38</a>.<br /> <p style="text-align: center;"><strong>Revenue Ruling 2009-13: Situation 3</strong></p><br /> In Situation 3, the IRS took the position that the cost of insurance protection must be <em>subtracted</em> from the premiums paid. This position is no longer valid, and the cost of insurance may <em>not</em> be subtracted.<br /> <br /> <em>Facts</em>: On January&nbsp;1, 2001, John Smith bought a 15-year level premium term life insurance policy on his life. The policy had a $500 monthly premium. The named beneficiary was a member of John&rsquo;s family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John paid $45,000 total premiums through June&nbsp;15, 2008, at which point he sold the policy for $20,000 to a B, a person unrelated to John and who would suffer no economic loss upon John&rsquo;s death. John was not terminally or chronically ill on the sale date.<br /> <br /> <em>Amount and character of income recognized</em>: The IRS stated that absent other proof, the cost of the insurance provided to John each month was presumed to equal the monthly premium under the policy ($500). Consequently, the cost of insurance protection provided to John during the 89.5-month period was $44,750 ($500 monthly premium times 89.5 months). Thus, John&rsquo;s adjusted basis in the policy on the date of sale to B was $250 ($45,000 total premiums paid&nbsp;&ndash;&nbsp;$44,750 cost of insurance protection). The IRS concluded that John was required to recognize $19,750 long-term capital gain upon the sale of the term life policy ($20,000 amount realized &ndash; $250 adjusted basis).<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <em>Effective date</em>: Pre-reform, the IRS has declared that the holding in Situation 3 will not be applied adversely to sales occurring before August&nbsp;26, 2009.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Under the 2017 tax reform legislation, the otherwise available exceptions to the transfer for value rule generally do not apply if the sale was a reportable policy sale (i.e., most commercial transfers) for tax years beginning after 2017.<br /> <br /> <hr><br /> <br /> <em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for the new reporting requirements that apply when a life insurance contract is sold in a life settlement transaction.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702(c)(3)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1016(a)(1)(A).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No.&nbsp;115-97 (the 2017 tax reform legislation).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1222(3).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No.&nbsp;115-97 (the 2017 tax reform legislation).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Normally there will be no loss when a life insurance policy is sold for its cash surrender value ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="62">62</a>).<br /> <br /> For the treatment of amounts received from a viatical settlement provider, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="57">57</a>.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> The 2017 tax reform legislation reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the &ldquo;cost of insurance&rdquo;) in the case of a policy sale. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="36">36</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="39">39</a>.<br /> <br /> If a purchaser receives lifetime proceeds under a life insurance or endowment contract, the purchaser is generally taxed in the same way as an original owner would be taxed, but with the following differences. The purchaser&rsquo;s cost basis is the consideration the purchaser paid for the contract, plus any premiums the purchaser paid after the purchase, less any excludable dividends and unrepaid excludable loans received by the purchaser after the purchase.<a href="#_ftn1" name="_ftnref1">¹</a> It also should be noted that the purchase of a life insurance policy will, under some circumstances, result in loss of the income tax exemption for the death proceeds, under IRC Section&nbsp;101(a)(2), the so-called &ldquo;transfer-for-value&rdquo; rule (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="290">290</a>).<br /> <p style="text-align: center;"><strong>Revenue Ruling 2009-14</strong></p><br /> In 2009, the IRS released guidance regarding the different tax consequences for an investor (B) upon the receipt of either (1) death benefits or (2) sale proceeds with regard to a term life insurance policy that the investor purchased for profit.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em>Situation 1 &ndash; Receipt of Death Benefits by Third Party Who Purchases Term Life Policy from Insured</em>: John Smith is a U.S. citizen residing in the United States. B (a U.S. &ldquo;person&rdquo; within the meaning of Section&nbsp;7701(a)(30)) purchased a 15-year level premium term life insurance policy on John&rsquo;s life for $20,000 on June&nbsp;15, 2008, when the remaining term of the policy was seven years, six months, and 15 days. B named himself beneficiary of John&rsquo;s policy immediately after acquiring it. B purchased the policy with a view to profit, and the likelihood that B would allow the policy to lapse was remote. B was unrelated to John, had no insurable interest in John&rsquo;s life, and would not suffer economic loss upon John&rsquo;s death. B paid monthly premiums totaling $9,000. Upon John&rsquo;s death (December&nbsp;31, 2009), the insurance company paid $100,000 to B.<br /> <br /> The IRS determined that the purchase of the policy by B was a transfer for value that did not qualify for any of the potential exceptions to the rule. Accordingly, the amount received because of John&rsquo;s death was excludable from gross income under IRC Section&nbsp;101(a)(1), although under IRC Section&nbsp;101(a)(2) the exclusion would be limited to the sum of the actual value of the consideration paid for the transfer ($20,000) and other amounts paid by B ($9,000), or $29,000. Therefore, the IRS ruled that B was required to recognize $71,000 of gross income, which is the difference between the total death benefit received ($100,000) and the amount excluded under IRC Section&nbsp;101 ($29,000). With respect to the character of the gain, the IRS determined that neither the surrender of a life insurance or annuity contract, nor the receipt of a death benefit from the issuer under the terms of the contract, produces a capital gain. Accordingly, the IRS ruled that the $71,000 of income recognized by B upon the receipt of the death benefits under the contract was ordinary income.<br /> <br /> <em>Situation 2 &ndash; Resale of Policy by Third Party Who Bought Term Life Policy from Insured</em>: The facts here are the same as immediately stated above, except that: (a) John did not die; and (b) on December&nbsp;31, 2009, B sold the policy to C (unrelated to John or B) for $30,000. The IRS found that in this situation, unlike Situation 2 of Revenue Ruling 2009-13 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="38">38</a>), no reduction to basis for the cost of insurance charges was necessary because unlike John, B did not purchase the policy for protection against economic loss. The IRS therefore distinguished this situation from Revenue Ruling 2009-13 (which has now been overruled in part by the 2017 tax reform legislation) because B acquired and held the policy solely with a view to profit. Accordingly, the IRS required B to recognize only $1,000 on the sale of the life insurance policy ($30,000 &ndash; [$20,000 + $9,000]). Because the term life insurance policy was not property excluded from capital gain treatment under IRC Sections 1221(a)(1) through 1221(a)(8), and because it had been held for more than one year, the IRS characterized the $1,000 of gain recognized by B under IRC Section&nbsp;1001 as long-term capital gain (citing Revenue Ruling 2009-13). In addition, because the policy was a term policy without any cash value, the substitute for ordinary income doctrine (under <em>United States v. Midland-Ross Corp.</em><a href="#_ftn3" name="_ftnref3">³</a>) did not apply.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.72-10(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2009-14, 2009-21 IRB 1031.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; 381 U.S. 54, 57 (1965).<br /> <br /> </div></div><br />

<p> Gain up to the amount of the contract's cash surrender value should be taxed to the seller as ordinary income. According to the decided cases, the amount of taxable gain is determined in the same way as upon surrender of a contract ( Q <a href="javascript:void(0)">51</a>). In other words, gain is determined by subtracting the net premium cost (i.e., gross premiums less dividends to the extent excludable from income) from the sale price.<a href="#_ftn1">¹</a> Therefore, under applicable case law, the cost of insurance protection is <em>not</em> deducted from the premiums paid. While later guidance indicated that on a sale of a life insurance policy, the IRS considered the basis of the contract to be the premiums paid <em>minus</em> the cost of insurance protection, the 2017 tax reform legislation superseded this position by statute in providing that the cost of insurance protection cannot be subtracted from basis (effective with respect to transfers entered into after August 25, 2009).<a href="#_ftn2">²</a></p><p> Before Revenue Ruling 2009-13 (<em>see</em> Q <a href="javascript:void(0)">37</a> to Q <a href="javascript:void(0)">39</a>), the issue of whether gain in excess of the contract's cash surrender value (such as in a life settlement) is ordinary income or capital gain was unsettled. Some argued that the entire gain should be ordinary income. But others contended that gain in excess of the contract's cash surrender value should receive capital gain treatment. In support of the argument that a portion of a life settlement should be treated as a capital gain, proponents pointed to a footnote in the <em>Phillips</em> case in which the IRS conceded that in certain situations the sale of a life insurance contract might result in capital gain treatment.<a href="#_ftn3">³</a> However, in a technical advice memorandum, the IRS pointed out that even if a life insurance contract is treated as a capital asset, the entire gain from the sale of a contract should be treated as ordinary income.<a href="#_ftn4">⁴</a></p><p> In another case, the Tax Court held that settlement proceeds ($500,000) received by the taxpayer (a former corporate executive) with respect to a life insurance policy represented an extinguishment of the taxpayer's claim to ownership of the policy, as opposed to a sale or exchange of a capital asset. Accordingly, the proceeds were taxable as ordinary income.<a href="#_ftn5">⁵</a></p><p><hr align="left" size="1" width="33%"></p><p> <a href="#_ftnref1">1</a>. <em>Gallun v. Commissioner</em>, 327 F.2d 809 (7th Cir. 1964); <em>Commissioner v. Phillips</em>, 275 F.2d 33 (4th Cir. 1960); <em>Estate of Crocker v. Commissioner</em>, 37 TC 605 (1962); <em>Neese v. Commissioner</em>, 23 TCM 1748, TC Memo 1964-288 (1964); <em>see also Cohen v. Commissioner</em>, 39 TC 1055 (1963), <em>acq.</em> 1964-1 CB 4. </p><p> <a href="#_ftnref2">2</a>. ILM 200504001, Pub. Law No. 115-97 (the 2017 tax reform legislation), amending IRC § 1016(a)(1)(A). </p><p> <a href="#_ftnref3">3</a>. <em>Commissioner v. Phillips</em>, 275 F.2d 33, n.3 (4th Cir. 1960). </p><p> <a href="#_ftnref4">4</a>. TAM 200452033. </p><p> <a href="#_ftnref5">5</a>. <em>Eckersley v. Commissioner</em>, TC Memo 2007-282 (2007). </p>

<div class="Section1"><br /> <br /> If a contract sold is subject to a nonrecourse loan, the transferor&rsquo;s obligation under the loan is discharged and the amount of the loan is considered an amount received on the transfer.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> For the treatment of amounts received from a viatical settlement provider, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="57">57</a>.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> A life insurance policy may be exchanged for an annuity tax-free under IRC Section&nbsp;1035, after which the resulting annuity must have the same basis as the original life insurance policy. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="44">44</a>. The rules for recognizing a loss on the surrender of an annuity in a loss position are more liberal than those governing life insurance. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="566">566</a>.<br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2009-13, 2009-21 IRB 1029.<br /> <br /> </div></div><br />

<p> <em>Editor's Note:</em> The 2017 tax reform legislation reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the "cost of insurance") in the case of a policy sale. Therefore, on sale of a cash value insurance policy, the insured's basis is no longer reduced by the cost of insurance.<a href="#_ftn1">¹</a> This new rule for determining basis is effective retroactively, to transactions entered into after August 25, 2009.<a href="#_ftn2">²</a></p><p> Revenue Ruling 2009-13 explains how to calculate the amount and character of gain upon the surrender or sale of a life insurance policy by the insured.<a href="#_ftn3">³</a> The example below illustrates the results upon surrender of a cash value policy (Situation 1). For examples illustrating the treatment of the sale of a cash value life insurance policy and the sale of a term life insurance policy, <em><em>see</em></em> Q <a href="javascript:void(0)">38</a> and Q <a href="javascript:void(0)">39</a>. <br/><strong>Revenue Ruling 2009-13: Situation 1</strong></p><p> <em>Facts</em>: On January 1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John's family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John surrendered the policy on June 15, 2008, for its $78,000 cash surrender value, including a $10,000 reduction for the cost of insurance protection provided by the insurer (for the period ending on or before June 15, 2008). Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy's cash surrender value. John was not terminally or chronically ill on the surrender date. </p><p> <em>Amount of income recognized</em>. The IRS determined that the "cost recovery" exception (to the "income first" rule) applied to the non-annuity amount received by John.<a href="#_ftn4">⁴</a> Under that exception, a non-annuity amount received under a life insurance contract (other than a modified endowment contract) is includable in gross income to the extent it exceeds the "investment in the contract." For this purpose, "investment in the contract" means the aggregate premiums (or other consideration paid for the contract before that date) <em>minus</em> the aggregate amount received under the contract before that date that was excludable from gross income. The IRS ruled that John must recognize $14,000 of income: $78,000 (which included a $10,000 reduction for cost of insurance) <em>minus</em> $64,000 (premiums paid). </p><p> <em>Character of income recognized</em>: The IRS concluded that the $14,000 was ordinary income, not capital gain. The IRS determined that the life insurance contract was a "capital asset" described in IRC Section 1221(a). However, relying on earlier guidance, the IRS reiterated that the surrender of a life insurance contract does <em>not</em> produce a capital gain,<a href="#_ftn5">⁵</a> and further determined that IRC Section 1234A (which applies to gains from certain terminations of capital assets) does not change this result. </p><p> <em><em>See</em></em> Q 60 for the new reporting requirements that apply when a life insurance contract is sold in a life settlement transaction. </p><p><hr align="left" size="1" width="33%"></hr></p><p> <a href="#_ftnref1">1</a>. IRC § 7702(c)(3)(B) </p><p> <a href="#_ftnref2">2</a>. IRC § 1016(a)(1)(A). </p><p> <a href="#_ftnref3">3</a>. Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No. 115-97 (the 2017 tax reform legislation). </p><p> <a href="#_ftnref4">4</a>. IRC § 72(e)(5). </p><p> <a href="#_ftnref5">5</a>. Rev. Rul. 64-51, 1964-1 CB 322. </p>

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> The 2017 tax reform legislation reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the &ldquo;cost of insurance&rdquo;) in the case of a policy sale. Therefore, on sale of a cash value insurance policy, the insured&rsquo;s basis is no longer reduced by the cost of insurance.<a href="#_ftn1" name="_ftnref1">¹</a> This new rule for determining basis is effective retroactively, to transactions entered into after August&nbsp;25, 2009.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Revenue Ruling 2009-13 explained how to calculate the amount and character of gain upon the surrender or sale of a life insurance policy by the insured.<a href="#_ftn3" name="_ftnref3">³</a> The example below illustrates the results upon the sale of a cash value life insurance policy (Situation 2) prior to the clarification that reversed this position in the 2017 tax reform legislation. For examples illustrating the results upon the surrender of a cash value policy (Situation 1) and the sale of a term life insurance policy (Situation 3), <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="37">37</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="39">39</a>.<br /> <p style="text-align: center;"><strong>Revenue Ruling 2009-13: Situation 2</strong></p><br /> In Situation 2, the IRS took the position that the cost of insurance protection must be <em>subtracted</em> from the premiums paid when determining the adjusted basis in the contract. The 2017 tax reform legislation reversed this IRS position retroactively, for transactions entered into after August&nbsp;25, 2009.<br /> <br /> <em>Facts</em>: On January&nbsp;1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John&rsquo;s family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John sold the policy on June&nbsp;15, 2008, for $80,000 to a B, a person unrelated to John and who would suffer no economic loss upon John&rsquo;s death. Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy&rsquo;s cash surrender value, which, at the time, was $78,000, including a $10,000 reduction for the cost of insurance protection provided by the insurer (for the period ending on or before June&nbsp;15, 2008). John was not terminally or chronically ill on the sale date.<br /> <br /> <em>Amount of income recognized</em>. The IRS first stated the general rule that gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis for determining gain.<a href="#_ftn4" name="_ftnref4">⁴</a> The IRS determined that the amount John realized from the sale of the life insurance policy was $80,000.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The adjusted basis for determining gain or loss is generally the cost of the property minus expenditures, receipts, losses, or other items properly chargeable to the capital account.<a href="#_ftn6" name="_ftnref6">⁶</a> The IRS specifically pointed out that Section&nbsp;72, which involves the taxation of certain proceeds of life insurance contracts, has no bearing on the determination of the basis of a life insurance policy that is sold because that section applies only to amounts received <em>under</em> the policy, which was not the case in this situation.<br /> <br /> Next, the IRS noted that both the IRC and the courts acknowledge that a life insurance policy &ndash; while only a single asset &ndash; may have both investment and insurance characteristics.<a href="#_ftn7" name="_ftnref7">⁷</a> The IRS then stated that to measure a taxpayer&rsquo;s gain on the sale of a life insurance policy, the basis must be <em>reduced</em> by the portion of the premium paid for the policy that has been expended for the provision of insurance before the sale.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> Against that backdrop, the IRS determined that John had paid premiums totaling $64,000 through the date of sale, and that $10,000 would have to be subtracted from the policy&rsquo;s cash surrender value as cost of insurance charges. Thus, John&rsquo;s adjusted basis in the policy as of the date of sale was $54,000 ($64,000 premiums paid - $10,000 expended as the cost of insurance). Accordingly, the IRS ruled that John would have to recognize $26,000 of income upon the sale of the life insurance policy, which is the excess of the amount realized on the sale ($80,000) over John&rsquo;s adjusted basis in the contract ($54,000).<br /> <br /> <em>Character of income recognized</em>. The &ldquo;substitute for ordinary income&rdquo; doctrine (which essentially holds that ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange) was held by the IRS to be applicable in this situation. The IRS stated, however, that the doctrine is limited to the amount of income that would be recognized if a policy were <em>surrendered</em> (i.e., to the inside build-up under the policy). Thus, if the income recognized on a<em> sale</em> (or exchange) of a policy exceeds the &ldquo;inside build-up&rdquo; under the policy, the excess may qualify as gain from the sale or exchange of a capital asset.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> In Situation 2, because the &ldquo;inside build-up&rdquo; in John&rsquo;s life insurance policy was $14,000 ($78,000 cash surrender value - $64,000 aggregate premiums paid), the IRS concluded that that amount would constitute ordinary income under the doctrine. Because the policy was a capital asset (under Section&nbsp;1221) and had been held by John for more than one year, the remaining $12,000 of income represented long-term capital gain.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> <em>Effective date</em>: The IRS has declared that the holding in Situation 2 will not be applied adversely to sales occurring before August&nbsp;26, 2009.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Prior to the 2017 tax changes, a life settlement, or seemingly any transfer for value to a party lacking insurable interest, constituted a transaction possibly subject to income taxation. Revenue Ruling 2009-13 concluded that the policy basis is first reduced by the &ldquo;cost of insurance&rdquo; (COI) charges (a proposition which is no longer valid). The amount received in excess of basis is ordinary income up to the policy cash surrender value. Amounts in excess of cash surrender value are capital gain.<br /> <br /> <hr><br /> <br /> <em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for the new reporting requirements that apply when a life insurance contract is sold in a life settlement transaction.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702(c)(3)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1016(a)(1)(A).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No.&nbsp;115-97 (the 2017 tax reform legislation).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect;&nbsp;1001(a), 1011.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1001(b).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect;&nbsp;1011, 1012, 1016.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702; <em>London Shoe Co. v. Commissioner</em>, 80 F.2d 230 (2d Cir. 1935); <em>Century Wood Preserving Co. v. Commissioner</em>, 69 F.2d 967 (3d Cir. 1934).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; <em>London Shoe Co. v. Commissioner</em>, 80 F.2d 230 (2d Cir. 1935); <em>Century Wood Preserving Co. v. Commissioner</em>, 69 F.2d 967 (3d Cir. 1934); <em>Keystone Consolidated Publishing Co. v. Commissioner</em>, 26 BTA 1210, 12 (1932). <em>See also</em> Treas. Reg. &sect;&nbsp;1.1016-2(a). <em>But compare</em> Rev. Rul. 2009-14, 2009-21 IRB 1031, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="512">512</a>.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>&nbsp;Commissioner v. Phillips</em>, 275 F.2d 33, 36, n.3 (4th Cir 1960).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1222(3).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; &nbsp; &nbsp;Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No. 115-97 (the 2017 tax reform legislation).<br /> <br /> </div></div><br />

<p> <em>Editor's Note:</em> The 2017 tax reform law reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the "cost of insurance") in the case of a policy sale. Therefore, on sale of a cash value insurance policy, the insured's basis is no longer reduced by the cost of insurance.<a href="#_ftn1">¹</a> This new rule for determining basis is effective retroactively, to transactions entered into after August 25, 2009.<a href="#_ftn2">²</a></p><p> Prior to 2009, the question of whether the cost of insurance protection should be subtracted or not from the premiums paid was unsettled. A commonly held view was that the cost of insurance protection should <em>not</em> be subtracted from the premiums paid (thus decreasing the amount of taxable gain). Conversely, in 2005 guidance, the IRS had indicated that on a sale of a life insurance policy, it would consider the basis of the contract to be the premiums paid <em>minus</em> the cost of insurance protection – thus, increasing the amount of taxable gain.<a href="#_ftn3">³</a></p><p> In 2009, the IRS issued Revenue Ruling 2009-13 (discussed in Q <a href="javascript:void(0)">37</a>, Q <a href="javascript:void(0)">38</a> and Q <a href="javascript:void(0)">39</a>), which aimed to provide definitive guidance to policyholders who surrender or sell their life insurance contracts in life settlement transactions.<a href="#_ftn4">⁴</a> According to the revenue ruling, the basis is <em>not</em> adjusted for the cost of insurance protection when a policy is surrendered (Situation 1), but the cost of insurance protection<em> is</em> subtracted from the premiums paid when the policy is sold (Situations 2 and 3). The 2017 tax reform legislation reversed this IRS position retroactively, for transactions entered into after August 25, 2009, and provides that basis will not be adjusted in the case of a policy sale. </p><p> <em><em>See</em></em> Q 60 for the new reporting requirements that apply when a life insurance contract is sold in a life settlement transaction. </p><p><hr align="left" size="1" width="33%"></hr></p><p> <a href="#_ftnref1">1</a>. IRC § 7702(c)(3)(B) </p><p> <a href="#_ftnref2">2</a>. IRC § 1016(a)(1)(A). </p><p> <a href="#_ftnref3">3</a>. ILM 200504001. </p><p> <a href="#_ftnref4">4</a>. Rev. Rul. 2009-13, 2009-21 IRB 1029, as superseded in part by Pub. Law No. 115-97 (the 2017 tax reform legislation). </p>

<p>Prior to its enactment, one of the more widespread criticisms of the 2017 tax legislation bill was the potential impact that the sweeping changes would have on charities who rely heavily upon taxpayer donations to fulfill their mission. Although the federal tax deduction for charitable contributions was not changed dramatically under the final tax reform bill—post-reform, taxpayers are entitled to a deduction for cash gifts subject to a 60 percent AGI limit, while prior to reform, a 50 percent limit applied—other changes were expected to impact the deduction. For example, the substantial expansion of the standard deduction and limitations on itemized deductions themselves should mean that fewer taxpayers will itemize their deductions, and since the deduction for charitable contributions is an itemized deduction, it was argued that fewer taxpayers would give to charity.</p><p>We asked two professors and authors of ALM's Tax Facts with opposing political viewpoints to share their opinions on how the changes made by tax reform have impacted charitable giving, as well as any potential impact going forward. </p><p><strong>Their Votes:</strong></p><p><strong><img class="alignnone size-thumbnail wp-image-33388" src="https://search.taxfactsonline.com/wp-content/uploads/sites/3/2019/02/Thumbs_Up_Icon_200x200-150x150.jpg" alt="" width="150" height="150">Byrnes</strong></p><p><strong><img class="alignnone size-thumbnail wp-image-33387" src="https://search.taxfactsonline.com/wp-content/uploads/sites/3/2019/02/Thumbs_Down_Icon_200x200-150x150.jpg" alt="" width="150" height="150">Bloink</strong></p><p><strong>Their Reasons:</strong></p><p>Below is a summary of the debate that ensued between the two professors.</p><p><strong>Byrnes:</strong> First of all, under reform, the deduction for charitable donations was actually expanded so that taxpayers who itemize can now deduct larger cash gifts. Secondly, the panic over the impact on charitable donations has been completely unfounded—really, just another attempt by the democrats to incite panic and find a way to kill a tax reform package that has provided such widespread benefits. Taxpayers who give to charity continue to give to charity because they believe in a cause, not because they might get a tax break.</p><p><strong>Bloink:</strong> While it's nice to believe that taxpayers are motivated to "do good" on a widespread basis just for the sake of supporting a good cause, the reality is that many middle class taxpayers who previously gave to charity are no longer financially able to do so because they no longer itemize their deductions because of the larger standard deduction and the fact that post-reform, it's more difficult for taxpayers to claim basic itemized deductions such as the deduction for state and local taxes—so they're unable to reach the "threshold" of the standard deduction.</p><p><strong>____</strong></p><p><strong>Byrnes:</strong> Tax reform has provided substantial tax breaks and benefits to middle class taxpayers that have nothing to do with itemized deductions. Look at the enlarged tax credit and the changes made to the tax brackets and rates themselves. Although the financial incentive may not be as direct, it's still there because tax reform benefits everyone—even if only in the form of a strengthened economy and widespread job security. Regardless, taxpayers can still give to charity using tax-preferred strategies designed to get them the deduction if they need it.</p><p><strong>Bloink:</strong> Realistically, only the wealthiest taxpayers are able to take advantage of the remaining tax breaks that can be realized through charitable giving. Wealthy taxpayers who can make large annual contributions that exceed the $24,000 standard deduction (for joint returns) are able to take the deduction every year. Wealthy taxpayers who are able to form their own foundations and "bunch" their donations to the foundation into a single year…those high net worth taxpayers are still getting the deduction. It's the ordinary taxpayers who want to make smaller donations who lose out under the new law.</p><p><strong>____</strong></p><p><strong>Byrnes:</strong> Charities haven't suffered because taxpayers are giving regardless of the new rules. The fact of the matter is that many middle-income taxpayers aren't financially motivated to give to charity—they're motivated to give for more personal reasons, and have continued to support the charities that are important to them. These taxpayers have the option of saving (not giving) in some years in order to give enough to benefit from the deduction in year two or even in year three—that's not a strategy reserved exclusively for the wealthy. </p><p><strong>Bloink:</strong> Unfortunately, I don't think the system is working in the way that Professor Byrnes thinks it is. The changes to the basic mechanisms for calculating tax are just another way that tax reform has benefitted the one percent in this country—and the ability of middle-income taxpayers to provide steady support to charities has dwindled as a result. Ordinary Americans often need that tax break in order to be able to afford to give, and so refrain from giving post-reform, while the one percent can manipulate the system to ensure they still get the same tax benefit that existed pre-reform.</p>