Many aspects of the sale of life insurance contracts have clearly defined tax treatment under the tax code, tax regulations, and case law. Some important aspects of the transaction, however, have not been settled or fully court tested. What is clear is the following:
1. For the nonterminally ill insured (who would otherwise have a
specific exemption from income tax addressing certain viatical settlements), the sales of these insurance contracts are taxable.
2. To the extent there is a gain (which is generally defined as the excess of funds received over the policy owner's premiums paid, less cash dividends received), the cash surrender value is taxed as ordinary income. Typically, the cash surrender value in these transactions is structured to be small and is a minor tax consideration.
What is not completely settled or court tested is the tax treatment of the gain in excess of the cash surrender value. Many sophisticated tax attorneys and accountants contend that this gain should receive capital gain treatment. These proponents find support for this position in a 1960 4th Circuit case (Comm v. Phillips) whereby the IRS conceded that, in certain situations, a life insurance contract might result in capital gain treatment. These situations have elements similar to the insurance contract sales now being transacted.
Nevertheless, the IRS has not agreed to capital gain treatment and asserts that gains from such sales are to be taxed as ordinary income. There have been no court challenges in many years by the IRS regarding capital gain positions taken by taxpayers.
Mark Balaban, CPA is the managing partner of Sigmund Balaban & Co. LLP, a full-service tax and business accounting firm established on Wall Street over 60 years ago. Mr. Balaban can be reached at 212-344-2100 or mark@balabanandco.com.
