Section 101(a)(1) excludes from gross income “amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of death.” This provision has always been a part of the Code, and the desire to avoid taxing heirs has made repeal difficult. Many people purchase life insurance so that family members will receive money at a time when they no longer have the income of the deceased insured. It could be unseemly to tax a grieving family under such circumstances.
- ”If any amount excluded from gross income ... is held under an agreement to pay interest thereon, the interest payments shall be included in gross income.” § 101(c).
- In the event that life insurance proceeds are paid otherwise than as a lump sum, a portion of each payment is allocated pro rata to the amount excluded and the remaining return on investment is subject to income tax. § 101(d)(1).
Consider: H purchased a life insurance policy on his life with a face amount of $200,000 and named W as the beneficiary. H died. W and the insurance company entered an agreement whereby the insurance company would hold $200,000 and pay her $250,000 in five years; W would have no claim of right to the funds during that time. At that time, instead of paying W $250,000, the insurance company will pay W $28,000 per year at a time when her life expectancy will be ten years.
- How would the payments to W be taxed during the first five years after H’s death?
- How would the payments to W during the succeeding ten years be taxed?
See §§ 101(c and d); Reg. § 1.101-3(a); Reg. § 1.101-4(a)(1)(i); Reg. § 1.101-4(g) (Examples 1 and 5 (first two sentences only)).
- The last provision might not be in your edition of the Regulations. Go to Westlaw or Lexis to find it.
- See §§ 101(c and d); Reg. § 1.101-3(a); Reg. § 1.101-4(a)(1)(i); Reg. § 1.101-4(g) (Examples 1 and 5 (first two sentences only)).
Section 101(a)(2) provides that in the case of a transfer of a life insurance contract for valuable consideration, the exclusion is lost. The beneficiary in such a case may exclude only the amount paid for the policy (i.e., premiums) plus any subsequent payments, i.e., premiums.
- An exception to this exception is made when the transferee takes for his/her basis the basis of the transferor. § 101(a)(2)(A).
- When might a transferee take for his/her basis the basis of the transferee?
- Another exception to the exception is made when the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. § 101(a)(2)(B).
- When (why) would transfers such as those described in § 101(a)(2)(B) occur?
A note about life insurance
Life insurance comes in various forms, and tax benefits can extend well beyond excluding death benefits from gross income. “Life insurance contract” is defined in § 7702 so as to preclude an investment from being a “life insurance contract.” To be insurance, there must be a shifting of risk from the insured to the insurer.
- Term insurance is insurance that promises only for the term for which it is purchased to pay upon the occurrence of death. Upon expiration of the term, the policyholder has nothing.
- Permanent life insurance is life insurance that the insured maintains by paying a premium annually. Premiums for permanent life insurance are higher than they are for term insurance; the insurance company invests the excess on behalf of the insured. The policy builds up cash value (“inside buildup”) – tax-free. Inside buildup can reduce premiums in future years, notably as premiums would otherwise increase because the insured is older and the risk of his/her death higher.
- Non-taxation of inside buildup permits permanent life insurance to function as a tax shelter.
H purchased a permanent life insurance policy on his life with a face amount of $300,000. He named W as the beneficiary. When H was 63 years old and the children were grown, W died. H saw no need to continue making premium payments so he sold the policy to his employer for $100,000.
- How would you compute H’s gross income from this sale?
- How would you compute H’s gross income if instead H surrendered the policy to the insurance company for its cash value of $100,000?
- Are there additional facts that you would need to know?
- Read on.
Rev. Rul. 2009-13, 2009-21 I.R.B. 1029
What is the amount and character of A’s income recognized upon the surrender or sale of the life insurance contracts described in the situations below?
On January 1 of Year 1, A, an individual, entered into a “life insurance contract” (as defined in § 7702 ...) with cash value. Under the contract, A was the insured, and the named beneficiary was a member of A’s family. A had the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value. The contract in A’s hands was ... [a capital asset].
On June 15 of Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract. Through that date, A had paid premiums totaling $64,000 with regard to the life insurance contract. A had neither received any distributions under the contract nor borrowed against the contract’s cash surrender value.
The facts are the same as in Situation 1, except that on June 15 of Year 8, A sold the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death.
LAW AND ANALYSIS
Amount of income recognized upon surrender of the life insurance contract
If a non-annuity amount is received ... on the complete surrender, redemption, or maturity of the contract, § 72(e)(5)(A) requires that the amount be included in gross income but only to the extent it exceeds investment in the contract. For this purpose, § 72(e)(6) defines “investment in the contract” as of any date as the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income.
In Situation 1, A received $78,000 on the complete surrender of a life insurance contract. A’s income upon surrender of the contract is determined under § 72(e)(5). Under § 72(e)(5)(A), the amount received is included in gross income to the extent it exceeds the investment in the contract. As A paid aggregate premiums of $64,000 with regard to the contract, and neither received any distributions under the contract nor borrowed against the contract’s cash surrender value prior to surrender, A’s “investment in the contract” as required by § 72(e)(6) was $64,000. Consequently, pursuant to § 72(e)(5)(A), A recognized $14,000 of income on surrender of the contract, which is the excess of $78,000 received over $64,000.
[A’s gain is ordinary income.] ...
Section 61(a)(3) provides that gross income includes gains derived from dealings in property.
Section 1001(a) provides that the gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in § 1011 for determining gain. Thus, to determine the amount of A’s income from the sale of the life insurance contract in Situation 2, it is necessary to determine A’s amount realized from the sale, and A’s adjusted basis in the contract.
Pursuant to § 1001(b), A’s amount realized from the sale of the life insurance contract is the sum of money received from the sale, or $80,000.
Under §§ 1011 and 1012, the adjusted basis for determining gain or loss is generally the cost of the property adjusted as provided in § 1016 ... Under § 1016(a)(1), proper adjustment must be made for expenditures, receipts, losses, or other items properly chargeable to capital account. See also Reg. § 1.1016-2(a). Section 72 has no bearing on the determination of the basis of a life insurance contract that is sold, because § 72 applies only to amounts received under the contract.
Both the Code and the courts acknowledge that a life insurance contract, although a single asset, may have both investment characteristics and insurance characteristics. See, e.g., § 7702 (defining life insurance contract for federal income tax purposes by reference, in part, to both the cash surrender value and death benefits under the contract); [citations omitted]. To measure a taxpayer’s gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.
In Situation 2, A paid total premiums of $64,000 under the life insurance contract through the date of sale, and $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. Accordingly, A’s adjusted basis in the contract as of the date of sale under §§ 1011 and 1012 and the authorities cited above was $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance).
Accordingly, A must recognize $26,000 on the sale of the life insurance contract to B, which is the excess of the amount realized on the sale ($80,000) over A’s adjusted basis of the contract ($54,000).
Unlike Situation 1, which involves the surrender of the life insurance contract to the issuer of the contract, Situation 2 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.
Application of the “substitute for ordinary income” doctrine is limited 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). Hence, if the income recognized on the sale or exchange of a life insurance contract exceeds the “inside build-up” under the contract, the excess may qualify as gain from the sale or exchange of a capital asset. See, e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n.3 (4th Cir. 1960).
In Situation 2, the inside build-up under A’s life insurance contract immediately prior to the sale to B was $ 14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). Hence, $14,000 of the $26,000 of income that A must recognize on the sale of the contract is ordinary income under the “substitute for ordinary income” doctrine. Because the life insurance contract in A’s hands was ... [a capital asset] and was held by A for more than one year, the remaining $12,000 of income is long-term capital gain within the meaning of § 1222(3).
1. In Situation 1, A must recognize $14,000 of ordinary income upon surrender of the life insurance contract.
2. In Situation 2, A must recognize $26,000 of income upon sale of the life insurance contract. Of this $26,000 of income, $14,000 is ordinary income, and $12,000 is long-term capital gain.
Notes and Questions:
1. In the case of surrender of a life insurance policy, inside buildup that (helps to) pay future premiums is not subject to tax. In the case of a sale of an insurance policy, inside buildup that (helps to) pay future premiums is subject to tax.
2. In Situation 2, assume that the face amount of the policy was $400,000. B paid $80,000 for the policy plus another $500 per month in premiums for another six years. A died. B received $400,000 from the life insurance company. How much must B include in his/her gross income?
3. Section 72 governs the tax treatment of payouts from an annuity contract. Section 72(a)(1) provides that gross income includes “any amount received as an annuity ... under an annuity, endowment, or life insurance contract.”
- Thus, annuity treatment can only apply to payments made under the named type of contracts.
- A taxpayer may invest after-tax dollars in an annuity contract. As with life insurance contracts, the inside buildup of an annuity contract is not subject to income tax. At a certain point in time, the taxpayer begins to receive a stream of payments from the investment and the income that the annuity has accumulated. [You should see immediately that taxpayer will be receiving some of his/her own after-tax money and some not-yet-taxed investment income.] There may be a fixed number of payments or the stream of payments may terminate only on the death of the taxpayer. Section 72 allocates a portion of each payment to taxpayer’s recovery of basis and a portion to not-yet-taxed inside buildup.
- Section 72(c)(1) defines taxpayer’s “investment in the contract.”
- Section 72(c)(4) defines “annuity starting date” as “the first day of the first period for which an amount is received as an annuity under the contract.”
- Section 72(a)(1) provides that taxpayer must include in gross income “any amount received as an annuity.”
- Section 72(b)(1) excepts from “amounts received as an annuity” a pro-rated amount of taxpayer’s basis in the contract. This requires a determination of taxpayer’s “expected return under the contract.”
- If the “expected return” depends on the life expectancy of one or more individuals, taxpayer determines the “expected return” in accordance with actuarial tables that the Secretary of the
Treasury has prescribed. These tables are in the regulations, see Reg. § 1.72-9.
- Simply multiply the number of payments taxpayer can expect based on these actuarial tables by the amount of each payment. This product is the “expected return.”
- Divide the taxpayer’s investment in the contract by the “expected return.” Taxpayer multiplies this product by “any amount received as an annuity” to determine the amount that s/he excludes from gross income.
- If taxpayer outlives what the actuaries predicted ...: Once taxpayer has excluded his/her investment in the annuity contract from his/her gross income, taxpayer may no longer exclude any “amount received as an annuity” from his/her gross income. § 72(b)(2).
- If taxpayer dies before the actuaries predicted s/he would ...: On the other hand, should payments cease because taxpayer died prior to recovery of taxpayer’s investment in the contract, taxpayer may deduct the amount of the unrecovered investment for his/her last taxable year. § 72(b)(3)(A).
4. Section 72(e) states rules applicable to amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity – if no other provision of this subtitle is applicable. § 72(e)(1).
- Section 1001 is a provision of “this subtitle.”
- In Situation 2, no payments were made under the contract. Instead, a third party bought the contract. For that reason, § 72(e)(1) did not apply. Instead, the ruling requires treatment of the sale as any other sale of property with adjustments to basis for prior expenditures on life insurance.
- Section 72(e)(5)(C) provides that § 72(e)(1) applies to amounts not received as an annuity under a life insurance or endowment contract.
- This describes the payment from the insurance company to the taxpayer in Situation 1.
- Section 72(e)(1) provides that the amount taxpayer must include in his/her gross income is the amount of the payment “to the extent it exceeds the investment in the contract.” Section 72(e)(6) defines “investment in the contract” to include the aggregate of premiums or other consideration paid for the contract minus any amounts previously received that taxpayer excluded from his/her gross income.
- It is because of § 72(e)(5) that Situations 1 and 2 are resolved differently.
5. Section 101(g): Amounts that a “terminally ill” or “chronically ill” person receives under a life insurance contract may qualify for exclusion under § 101(a)(1). The same is true of the “amount realized” on the sale of a life insurance policy to a “viatical settlement provider.” § 101(g)(2).
- A “terminally ill” taxpayer is one who is certified by a physician as having “an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification.” § 101(g)(4)(A).
- A “chronically ill” taxpayer is one who is not “terminally ill” and is unable to perform at least two activities of daily living (i.e., eating, toileting, transferring, bathing, dressing, and continence) or requires substantial supervision to protect himself/herself “from threats to health and safety due to severe cognitive impairment.” § 101(g)(4)(B), referencing § 7702B(c)(2).
- A “chronically ill” taxpayer must use the payment for unreimbursed costs of long-term care. § 101(g)(3)(A).
Section 101(g) enables an insured taxpayer to get money out of a life insurance policy at a time when s/he has a substantial need for cash and the risk of death has nearly materialized.
6. In the movie, Capitalism: A Love Story (2009), Michael Moore recounts how Wal-Mart purchased life insurance policies on the lives of low-paid persons. Wal-Mart of course liked the fact that inside buildup was free of income tax. If one of the employees died, Wal-Mart would collect the proceeds of the policy without tax. A number of businesses engaged in this practice of purchasing “corporate-owned life insurance” (COLI) and did not inform the affected employees that it had done this. [Michael Moore lamented that Wal-Mart did not hand the money over to the family of a deceased employee.]
- In 2006 – before release of the movie – Congress enacted § 101(j) which limited the exclusion in the case of employer-owned contracts to the amounts paid for the policy. § 101(j)(1).
- There is an exception to the exception if the employee is a key employee and is notified that the employer intends to procure such insurance and the employee gives his/her consent. § 101(g)(2 and 4)
Do the CALI Lesson, Basic Federal Income Taxation: Gross Income: Annuities and Life Insurance Proceeds. You may have to read some portions of the Code to answer all of the questions. That would be a good thing. However, do not worry about the consequences of a tax-deferred corporate reorganization.