1. Revenue Ruling 2009-13, issued April 1, 2009, effective August 26, 2009 AND Revenue Ruling 2009-14, Issued May 1, 2009. NEW RULES ON TAXATION OF THE SALE AND REDEMPTION OF LIFE INSURANCE POLICIES Copyright 2009 Minto Law Group, LLC 1

2. The IRS has clarified the character and amount of income that must be realized and recognized with the surrender and sale of life insurance policies. Copyright 2009 Minto Law Group, LLC 2

3. Example #1 Facts:  January 1 of year #1. Ralph purchases a universal life insurance policy, with the right to:  Change beneficiaries,  Borrow against the plan, and  Surrender the policy.  June 15 th of year #8. Ralph surrenders the life insurance contract for its cash surrender value of $78,000.  The aggregate premiums Ralph paid on the policy were $64,000.  The cash surrender is net of “cost of insurance” for period year #1 through year #8. The cost of insurance is determined to be $10,000.  During the 8 years Ralph did not receive any distributions or loan proceeds stemming from the policy.  Ralph is a cash basis taxpayer and not terminally ill. Copyright 2009 Minto Law Group, LLC 3

4. Example #1 (Cont.) Internal Revenue Code (IRC) §72(e)(5) states that amounts received are included in gross income to the extent they exceed investment in the contract. Income Recognized $78,000 ◊Ralph paid premiums of $64,000 Realized income of $14,000 ◊ Cost of policy was approximately reflected in cash surrender value, London Shoe Co., 80 F.2d at 233. Copyright 2009 Minto Law Group, LLC 4

5. Example #1 (Cont.) What is the Character of the Income? Capital Gain or Ordinary Income Insurance policy holdings do qualify as a capital asset under IRC § 1221. However, IRC § 61(a)(10) states “Proceeds received by an insured upon surrender of or at maturity of a life insurance policy constitutes ordinary income to the extent such proceeds are in excess of the cost of policy.” Result – Ralph has realized and recognized $14,000 in ordinary income from the surrender of his policy. Copyright 2009 Minto Law Group, LLC 5

6. Example #2 Facts: Same as Example #1 except Ralph sells his policy to Brian for $80,000 Brian is unrelated to Ralph and will not suffer economic loss upon Ralph’s demise. Copyright 2009 Minto Law Group, LLC 6

7. Example #2 (Cont.) Income Realized Sales price to Brian$80,000 Adjusted basis of the policy: Total premiums paid $64,000 Cost of insurance, year #1 through year #8 $10,000 $54,000 Gain on Sale$26,000 Copyright 2009 Minto Law Group, LLC 7

8. Example #2 (Cont.) What is the Character of the Income? Capital Gain or Ordinary Income “ Substitute for ordinary income” doctrine – U.S. Supreme Court, property within the meaning of IRC §1221 (capital asset) does not include claim on rights to ordinary income. U.S. v. Midland-Ross Corp., 381 US 260 (1958). Thus, ordinary income that has been earned but not recognized cannot be converted to capital gain by sale or exchange. Application of “substitute for ordinary income” doctrine is limited to amount that would be recognized as ordinary income if a contract was surrendered. Total gain on sale $26,000 Substitute for ordinary income (Cash Surrender Value – minus premiums paid)$14,000 Balance is long term capital gain, per IRC §1222$12,000 Copyright 2009 Minto Law Group, LLC 8

9. Example #3 Sale of Term Life Insurance Contract Facts:  January 1 of year #1, Ralph purchases level premium 15 year term life insurance contract.  No cash surrender value (CSV)  Monthly premium is $500  As of June 15 of year #8 Ralph has paid in aggregate premiums of $45,000.  On June 15 of year #8, Ralph sells the insurance contract to Brian for $20,000.  Brian is not related to Ralph, and  Brian will not suffer economic loss upon Ralph’s demise. Copyright 2009 Minto Law Group, LLC 9

10. Example #3 (Cont.) Income Realized Sales Price $20,000 Adjusted Basis: Total premiums paid$45,000 Cost of insurance, year #1 through year #8 ◊ 89.5 months X $500$44,750 Basis in Policy $250 Gain on sale $19,750 ◊ The cost of insurance provided to Ralph each month is presumed to equal the monthly premium. Copyright 2009 Minto Law Group, LLC 10

11. Example #3 (cont.) What is the character of the income? Capital gain or ordinary income Since there is not CSV in a term life policy, there is no inside basis that would qualify as “substitute for ordinary income” doctrine. Therefore, given that an insurance policy is a capital asset, the entire gain $19,750, is recognized as a long term capital gain. Copyright 2009 Minto Law Group, LLC 11

12. Example #4 Facts:  January 1 of year #1, Ralph purchases level premium 15 year term life insurance contract.  Ralph is the owner and the insured  No cash surrender value (CSV)  Monthly premium is $500.  June 15, year #8, Brian purchased the policy from Ralph for $20,000  At purchase there are 7 years, 6 months and 15 days remaining on the term of the policy.  Brian exercises his right as policy owner to change beneficiary to himself.  December 31, year #9 Ralph dies and the policy pays out $100,000 to Brian.  From the purchase date, June 15 th yr. #8, to the date of death, Brian has paid $9,000 in premiums to maintain the policy. Tax consequences to a taxpayer upon receipt of death benefits or sale of life insurance contracts purchased for profit. Copyright 2009 Minto Law Group, LLC 12

13. Example #4 (Cont.) Income Realized IRC § 101(a)(a) provides generally that gross income does not include amounts received under life insurance contracts if such amounts are paid by reason of death of insured. In case of transfer for value however, IRC § 101(a)(2) provides amounts excluded from income shall not exceed an amount equal to the sum of the actual value of consideration paid and premiums and other amounts subsequently paid by transferee. Cash receipt/death benefit$100,000 Adjusted basis: Original purchase price$20,000 Cost to maintain policy$ 9,000 $29,000 Gain$71,000 Copyright 2009 Minto Law Group, LLC 13

14. Example #4(Cont.) What is the Character of the Income? Capital Gain or Ordinary Income The $71,000 gain is taxed as ordinary income to Brian. Due to IRC § 61(a)(10) which states all income for insurance policies are ordinary income and IRC § 101 does not exempt insurance proceeds to transferees (Brian) for value. Copyright 2009 Minto Law Group, LLC 14

15. Example #5 Facts: Same as Example #4 except Ralph did not die but rather Brian sold the policy to Mary for $30,000. Income Realized Sales Price to Mary$30,000 Adjusted basis: Original purchase price$20,000 Cost to maintain policy$ 9,000 $29,000 Gain$ 1,000 NEW RULE – This revenue ruling requires a secondary market purchaser to capitalize premiums paid to prevent a term life insurance (with out CSV) contract from lapsing. The IRS will not challenge capitalization of such payments paid before the issuance of this policy. Copyright 2009 Minto Law Group, LLC 15

16. Example #5 (Cont.) What is the Character of the Income? Capital Gain or Ordinary Income Note example #2 required the taxpayer to recognize ordinary income to the extent of the cost of insurance. This was to account for the benefit the insured received for coverage on his life while he owned the policy. However, in this instance Brian is not at risk of economic loss should the insured die; therefore the benefit to the insured is irrelevant. Hence, the substitute for ordinary income doctrine under U.S. v. Midland-Ross Corp. and its progeny does not apply. Brian would realize and recognize $1,000 in long term capital gain. Copyright 2009 Minto Law Group, LLC 16