A CPE course takes the following examples pretty much verbatim from Rev Ruling 2009-13:
"Surrender of policy – The Rev Ruling provides the following example: In Year-1, John enters into a “life insurance
contract” with cash value. John is the insured and a member of John’s family was the beneficiary. John had the right
to change beneficiaries or surrender the contract for its cash value. In Year-8 John surrenders the contract for its cash
value of $78,000 which reflects the subtraction of $10,000 for the “cost of insurance.” John paid total premiums on
the policy of $64,000. John was not terminally or chronically ill at the time of the surrender. John’s resulting gain
from the sale would be:
Surrender Cash Value: $78,000 (this figure is net of insurance costs)
Paid Premiums: <64,000>
Ordinary Income: $14,000
Since the surrender of a life insurance contract does not produce capital gain, the income was ordinary income.
Sale of policy with cash value - The facts are the same, except that John sells the insurance contract for $80,000 to
George who is unrelated to John and who would suffer no economic loss upon John’s death. Here, John’s resulting gain
from the sale would be determined as follows:
Contract Sales Price: $80,000
Paid Premiums: 64,000
Cost of Insurance <10,000>
Contract Basis <54,000>
Total Profit: $26,000
Ordinary Income $14,000 (Difference between cash value & paid premiums)
Capital Gains $12,000 (Balance of gain)
To determine the character of the income, the IRS applied the "substitute for ordinary income" doctrine. Application of
the substitute for ordinary income doctrine is limited to the amount that would be recognized as ordinary income on
surrender of the policy, and income received on sale of a life insurance policy may qualify as gain from the sale of a
capital asset to the extent that it exceeds the cash surrender value minus the premiums paid (that is, the "inside
build-up" under the contract). Thus, of the income received, the amount equaling the inside buildup on the contract
was taxed as ordinary income. The excess was taxed as long-term capital gain."
It seems to me that there is something wrong here. When John sells the policy, instead of just surrendering it, he grosses 2K more, but he pays capital gains tax on an additional 12K! Can that really be right? In particular, one might ask why his basis in the second instance should be 10K less than in the first.
"Surrender of policy – The Rev Ruling provides the following example: In Year-1, John enters into a “life insurance
contract” with cash value. John is the insured and a member of John’s family was the beneficiary. John had the right
to change beneficiaries or surrender the contract for its cash value. In Year-8 John surrenders the contract for its cash
value of $78,000 which reflects the subtraction of $10,000 for the “cost of insurance.” John paid total premiums on
the policy of $64,000. John was not terminally or chronically ill at the time of the surrender. John’s resulting gain
from the sale would be:
Surrender Cash Value: $78,000 (this figure is net of insurance costs)
Paid Premiums: <64,000>
Ordinary Income: $14,000
Since the surrender of a life insurance contract does not produce capital gain, the income was ordinary income.
Sale of policy with cash value - The facts are the same, except that John sells the insurance contract for $80,000 to
George who is unrelated to John and who would suffer no economic loss upon John’s death. Here, John’s resulting gain
from the sale would be determined as follows:
Contract Sales Price: $80,000
Paid Premiums: 64,000
Cost of Insurance <10,000>
Contract Basis <54,000>
Total Profit: $26,000
Ordinary Income $14,000 (Difference between cash value & paid premiums)
Capital Gains $12,000 (Balance of gain)
To determine the character of the income, the IRS applied the "substitute for ordinary income" doctrine. Application of
the substitute for ordinary income doctrine is limited to the amount that would be recognized as ordinary income on
surrender of the policy, and income received on sale of a life insurance policy may qualify as gain from the sale of a
capital asset to the extent that it exceeds the cash surrender value minus the premiums paid (that is, the "inside
build-up" under the contract). Thus, of the income received, the amount equaling the inside buildup on the contract
was taxed as ordinary income. The excess was taxed as long-term capital gain."
It seems to me that there is something wrong here. When John sells the policy, instead of just surrendering it, he grosses 2K more, but he pays capital gains tax on an additional 12K! Can that really be right? In particular, one might ask why his basis in the second instance should be 10K less than in the first.