T3: TAXING TIMES Tidbits
Rev. Rul. 2020-5: IRS Updates Guidance on Basis in Life Insurance Contracts
By Mayowa Dauda and Mark Smith
TAXING TIMES, December 2021
Background
Early in 2020, the Internal Revenue Service (IRS) published Rev. Rul. 2020-5[1], which modifies two prior revenue rulings to take into account 2017 changes to the Internal Revenue Code that affect the gain reported on the sale of a life insurance contract.
Taxable gain or loss on the sale of an asset is equal to the amount received for the asset minus its adjusted basis. Under section 1016 of the Internal Revenue Code, the adjusted basis of an asset generally is the amount that was paid for it. The Tax Cuts and Jobs Act (TCJA)[2] amended section 1016(a) to provide that no adjustment shall be made to basis in determining gain or loss on the sale of a life insurance contract or annuity contract for mortality, expense, or other reasonable charges. In other words, a taxpayer that sells a life insurance contract may compute gain or loss based on the entire amounts paid for the contract, unadjusted by the value of any insurance coverage provided.
In Rev. Rul. 2009-13[3] and Rev. Rul. 2009-14[4], the IRS previously concluded that such an adjustment was required under section 1016(a), as in effect before the TCJA[5]. Rev. Rul. 2020-5 modifies the IRS's analysis in three situations: Situation 2 of Rev. Rul. 2009-13 (original policyholder's sale of cash value life insurance contract), Situation 3 of Rev. Rul. 2009-13 (original policyholder's sale of a level-term life insurance contract without cash value), and Situation 2 of Rev. Rul. 2009-14 (investor's sale of a level-term life insurance contract without cash value).
Both the amendment to section 1016(a) and Rev. Rul. 2020-5 are effective for transactions entered into on or after Aug. 26, 2009[6], which was the original publication date of Rev. Rul. 2009-13 and Rev. Rul. 2009-14.
Original Policyholder's Sale of a Cash Value Life Insurance Contract
In Rev. Rul. 2009-13, Situation 2, an individual entered into a life insurance contract with cash value and later sold the contract to an unrelated party. The individual had paid $64,000 in premiums, and sold the contract for $80,000. The cost-of-insurance charges collected by the issuer for periods before the sale was $10,000. The adjusted basis of the contract was $54,000, determined by subtracting the cost of insurance provided from the premiums paid ($64,000 less $10,000). The individual recognized a gain of $26,000 on the sale of the life insurance contract.
Rev. Rul. 2020-5 updates the analysis to be consistent with amended section 1016(a), under which the adjusted basis of a life insurance contract is not reduced by the cost of insurance. Rev. Rul. 2020-5 concludes that the individual is not required to reduce the basis in the contract by the cost of insurance charges ($10,000). The individual, therefore, recognized a gain of $16,000, rather than $26,000.
Original Policyholder's Sale of a Level-Term Life Insurance Contract without Cash Value
In Rev. Rul. 2009-13, Situation 3, an individual entered into a level-premium, fifteen-year term life insurance contract without cash surrender value and later sold the contract to an unrelated third party. The monthly premium was $500. After 89.5 months had passed and $45,000 of premiums were paid, the individual sold the contract for $20,000. Rev. Rul. 2009-13 concluded that the basis of the contract was equal to the premiums paid less cost of insurance charges collected by the issuer for periods before the sale. The cost of insurance provided under the contract was $44,750 (89.5 multiplied by the $500 monthly premium) and, therefore, the adjusted basis in the contract was $250 ($45,000 less $44,750). The individual recognized gain on the sale of the contract of $19,750 ($20,000 received, minus $250 adjusted basis).
Rev. Rul. 2020-5 modifies the analysis of Situation 3, consistent with its modification of the analysis of Situation 2. That is, the adjusted basis of the contract in Situation 3 is equal to the premiums paid—$45,000—unreduced by the cost of insurance. Rev. Rul. 2020-5 concludes that the individual recognizes a loss of $25,000 ($20,000 received minus $45,000 adjusted basis). According to the ruling, that loss is nondeductible unless it is incurred in a trade or business, or in a transaction entered into for profit.
Investor's Sale of a Level-Term Life Insurance Contract without Cash Value
In Rev. Rul. 2009-14, Situation 2, individual A sold a level premium, fifteen-year term life insurance contract without cash surrender value to B. B purchased the contract from A for $20,000 with the intention of making a profit, and later sold it to C for $30,000. While it owned the contract, B made $9,000 premium payments to prevent the policy from lapsing. Under Rev. Rul. 2009-14, B's basis in the contract includes both the $20,000 purchase cost and $9,000 additional premiums. Rev. Rul. 2009-14 does not require B to reduce its basis in the contract by any cost-of-insurance charges and, therefore, B recognizes a $1,000 gain ($30,000 received minus $29,000 adjusted basis).
Unlike Rev. Rul. 2009-13, which required an original owner to adjust the basis in a life insurance contract for the cost of insurance, Rev. Rul. 2009-14 did not require an investor to make the same adjustment. This reflected a difference in IRS's analysis based on the investor's motivation to profit. Rev. Rul. 2020-5 confirms the conclusion that the investor's basis should not be adjusted for the cost of insurance, and notes that the situations no longer are distinguishable.
Observations
The conclusions in Rev. Rul. 2020-05 are unsurprising. In fact, the analyses in Rev. Rul. 2009-13 and Rev. Rul. 2009-14 had become partially obsolete, in effect, as a result of the TCJA. Rev. Rul. 2020-5 nevertheless is helpful to taxpayers for at least three reasons:
- The publication of Rev. Rul. 2020-5 may make it easier for practitioners to identify the "modified" status of Rev. Rul. 2009-13 and Rev. Rul. 2009-14, and to update their approach to sales of life insurance contracts accordingly.
- The approach taken in Rev. Rul. 2020-5—to incorporate most of Rev. Rul. 2009-13 and Rev. Rul. 2009-14 by reference and modify the analysis only for parts of three situations—clarifies the extent to which the TCJA affects those rulings. The IRS has identified the analysis that is affected and left intact the rest.
- The publication of Rev. Rul. 2020-5 highlights for taxpayers that the relevant TCJA provision applies retroactively to transactions entered into on or after August 26, 2009, which in certain respects corresponded with the effective date of Rev. Rul. 2009-13. Taxpayers who sold a life insurance contract and reduced the basis in those contracts based on the 2009 guidance may wish to file a claim for refund, provided the statute of limitations for that year has not lapsed.
The publication of Rev. Rul. 2020-5 should bring closure to an issue that drew practitioner and Congressional attention for nearly a decade.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or PwC.
Mayowa Dauda is a director in PwC's New York office and can be reached at dauda.mayowa@pwc.com.
Mark Smith is a managing director in PwC's Washington National Tax Services office and may be reached at mark.s.smith@pwc.com.