In the past decade, viatical settlements and senior or life settlements have become more popular estate planning strategies. A viatical settlement is the sale of a life insurance policy by an insured with a short life expectancy (due to terminal or chronic illness). A life settlement (also known as a senior settlement) is a sale of a life insurance policy by an insured whose life expectancy is not severely impaired. On May 1, 2009, the IRS issued two Revenue Rulings that help clarify the taxation of the amount received by the seller (either the insured or the investor who does not have an insurable interest in the insured) of the insurance policy. Revenue Rulings 2009-13 and 2009-14 also answered the question of the tax treatment of the death benefit payable to an investor.

Revenue Ruling 2009-13 deals with the income tax consequences of the surrender or sale of a life insurance policy by an insured or other individual, such as a spouse, who purchased the policy to hold it as insurance. Revenue Ruling 2009-14 deals with the investor's income tax consequences when receiving the death benefits or selling a policy of life insurance purchased for profit. Of course, it has been long-established law that the death benefit paid from a life insurance policy will normally be income tax free to the beneficiary, as provided under Internal Revenue Code ("IRC") § 101(a)(1).

The ruling describes the effects of the owner-insured surrendering a cash value policy to the issuing company. It concludes that the amount received (equal to the policy's cash value) is ordinary income to the extent it exceeds the sum of all of the premiums paid for the life insurance coverage.

The ruling further provides that, if an owner-insured sells the life insurance policy to a third-party investor (as opposed to being surrendered to the insurance company), there will be ordinary income to the extent the cash value exceeds the sum of all premiums (adjusted as described below). If there is any additional gain, the excess gain is treated as a capital gain. The determination of the total gain on the sale of a cash value policy is determined by using as a basis the aggregate premiums paid less the cost of insurance. If the life insurance policy being sold is a term life insurance policy, all the sale proceeds are taxed as capital gain to the extent they exceed any unexpired premium.

The ruling gives three examples of the surrender or sale of a life insurance policy.

In the first example, when the insured surrenders the policy, it has a cash surrender value of $78,000 and the insured has paid aggregate premiums of $64,000. The ruling looks to IRC § 72(e) to determine the treatment of the surrender proceeds which applies to any amount (i) received under a life insurance contract, (ii) not received as an annuity, and (iii) to which no other special rule applies. The ruling concludes that IRC§ 72(e)(5)(A) applies in the case of a complete surrender of an insurance policy that is not a modified endowment contract, and the amount received is included in gross income to the extent it exceeds the investment in the contract. The insured's investment in the insurance policy includes the aggregate premiums paid. Assuming the insured never received any distributions nor borrowed against the policy's cash surrender value prior to the surrender of the policy, the insured recognizes ordinary income of $14,000 ($78,000 surrender proceeds less $64,000 of aggregate premiums paid).

In the second example, the insured sells the insurance policy for $80,000. In this case, the insured is engaged in a sale or other disposition of property within the meaning of IRC § 1001(a), and, therefore, it is necessary to determine the insured's amount realized over his adjusted basis in the policy. The ruling cites both London Shoe Co. v. Commissioner, 80 F.2d 230 (2nd Cir. 1935) and Century Wood Preserving Co. v. Commissioner, 69 F.2d 967 (3rd Cir. 1934) for the proposition that an insurance policy has both insurance and investment characteristics. To the extent that a portion of the premiums paid are used to provide insurance protection, that cost of insurance must be subtracted from the aggregate premiums paid to determine the insured's adjusted basis in the policy under  IRC § 1016(a)(1). Therefore, the insured's adjusted basis is $54,000 ($64,000 less cost of insurance of $10,000). Thus, the insured has a total realized gain of $26,000 (the purchase price of $80,000 less the adjusted basis of $54,000). As in the first example, $14,000 is ordinary income ($78,000 cash surrender value less $64,000 of aggregate premiums paid). The remaining gain of $12,000 (total gain of $26,000 less the ordinary gain of $14,000) is capital gain.

In the third example, the insured sells a term life insurance policy. The IRS concludes that the insured's adjusted basis in the contract for purposes of determining gain or loss is equal to total premiums paid less charges for the provision of insurance. The IRS concludes that cost of insurance protection is presumed to be equal to the premiums paid in the case of a term policy. Therefore, the insured's only basis in the contract is equal to any unexpired premium on the date of sale. If the insured sells the policy of $20,000, his adjusted basis is $250 ($45,000 of premiums paid less $44,750 of cost of insurance protection) for a net long-term capital gain of $19,750.

Revenue Ruling 2009-14 indicates that payment of the proceeds at death constitutes ordinary income to the extent the death benefit received exceeds the investor's income tax basis in the life insurance policy.