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Life Insurance Premiums and Outside Basis: The Untold Story

Posted on Aug. 15, 2022
Matthew P. Wochok
Matthew P. Wochok

Matthew P. Wochok is a partner in the Washington office of Morris, Manning & Martin LLP.

In this article, Wochok examines whether a partner is required to reduce the basis in his interest in a partnership when the partnership, named as a beneficiary under the contract, makes premium payments on a life insurance contract.

Copyright 2022 Matthew P. Wochok.
All rights reserved.

This article addresses whether a partner is required to reduce the basis in his interest in a partnership when the partnership, named as a beneficiary under the contract, makes premium payments on a life insurance contract. If the premium payments are considered “expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account”1 then they reduce a partner’s basis. Because life insurance premiums paid by the partnership are clearly not deductible,2 the issue depends on whether the payments are “properly chargeable to capital account.” If so, then premium payments do not reduce a partner’s basis.

While there is little authority directly addressing this issue, there is a long history of court decisions and administrative rulings involving the disposition of life insurance contracts held by individual and corporate taxpayers. These authorities in conjunction with regulatory authority and passage of the Tax Cuts and Jobs Act create little doubt that a partner is not required to reduce his basis in a partnership on account of a life insurance premium payment made by a partnership.3 But, as discussed in more detail below, numerous treatises touching on the topic come to a different conclusion and do so with little actual analysis of the issue. The lack of analysis is surprising given the importance of properly calculating a partner’s basis.

The calculation of a partner’s basis in his partnership interest is important for a variety of reasons. Cash, to the extent of the partner’s basis, can generally be distributed tax-free to the partner. Losses, if meeting other requirements, can pass through and be used by a partner, but only to the extent of his partnership basis. Also, if a partner sells his partnership interest, his basis will offset his amount realized, thereby reducing his tax liability.

Life insurance plays an important role in many businesses. Should an integral person become incapacitated or die, life insurance proceeds can provide an economic cushion. Life insurance contracts also play an important role in many buy-sell and redemption agreements by providing the necessary cash to purchase or redeem a decedent’s equity interest. Given the ubiquity of life insurance and importance of a partner’s basis in a partnership, understanding the relationship between the two is critical.

This article is divided into five sections. The first provides a broad overview of insurance contracts and the applicable federal income tax rules. The second section summarizes historic court decisions and administrative rulings applicable to basis calculation in life insurance contracts. The third applies the concepts discussed in the second section to partnerships and analyzes the effect of premium payments on a partner’s basis in his interest in a partnership. The fourth section discusses potentially conflicting views. The final section offers concluding thoughts. For purposes of this article, (1) all life insurance contracts are assumed to satisfy the definition of a life insurance contract under section 7702;4 (2) it is assumed that any partnership mentioned is named as a beneficiary under the contract; and (3) a partner’s basis in his interest in a partnership is referred to as his outside basis.

I. Overview of Life Insurance Contracts and Related Rules of Taxation

This section provides a brief overview of life insurance contracts, definitions of some key terms, and the principal provisions governing their taxation. In its most basic form, life insurance is a contract between an insurer and a policyholder under which the insurer promises to pay a sum of money to a designated beneficiary upon the death of a specified person. In return for this benefit, a policyholder pays a premium to the insurer at regular intervals or in a lump sum. Though relatively simple in concept, this straightforward arrangement has become considerably more complex with modern life insurance contracts.

Modern life insurance has evolved from its most basic form and can generally be divided into two categories. The first is designed to only provide a lump sum payment upon the occurrence of a designated event, such as the death of a specified person. Term life insurance is the common name for this type of insurance. The second category, while like the first in providing a potential benefit upon the occurrence of a designated event, is also designed to facilitate growth of capital. Whole life, universal live, and variable life policies are examples of policies in this category.

Policies in the second category include a cash value or cash surrender value component.5 This component represents a savings element over what is necessary to pay death benefits under the contract. The cash surrender value reflects the amount a taxpayer would receive on cancellation of the contract. Depending on the policy, the cash surrender value may be available to the policyholder during the policyholder’s lifetime.

For purposes of this article, (1) life insurance contracts are categorized as either with cash surrender value or without it and (2) a life insurance contract entered into by the original owner is referred to as a beneficial-owned contract and a life insurance contract purchased by a secondary-market participant is referred to as an investor-owned contract.

The IRC of 1986, as amended, provides a quasi-conceptually comprehensive framework for the treatment of beneficial-owned life insurance contracts and the receipt of proceeds under these contracts. What follows is a brief summary of the relevant provisions.

Section 61(a)(9) sets forth the general rule that, except as otherwise provided, gross income includes income from a life insurance contract. Section 101(a)(1), however, provides an exception to the general rule that gross income does not include amounts received under a life insurance contract if they are paid by reason of the death of the insured.6 To prevent a taxpayer from benefiting beyond the tax-free receipt of death proceeds, section 264(a) denies a taxpayer a deduction for any premium paid on a life insurance contract if the taxpayer is directly or indirectly a beneficiary under the contract.7 Section 72(e) addresses non-annuity amounts received under the terms of a life insurance contract other than upon payment of death benefits and generally provides that these amounts are included in gross income to the extent they exceed the investment in the contract, which is generally defined as the excess of the premiums and other consideration paid in accordance with the contract over any amounts received under the contract that have been excluded from gross income.8

Given congressional intent to exempt only death proceeds from taxation, these provisions, though incomplete in scope, arguably create an equitable outcome. Taxpayers receiving exempt death benefits are denied a deduction for premium payments. Otherwise, the taxpayer would benefit twice from the payment of premiums — once in the form of a deduction and once in the form of exempt proceeds. For a taxpayer receiving proceeds other than exempt death benefit proceeds, for purposes of calculating gain, she can offset any amount received with her amount invested in the contract (which includes premium payments). Absent the inclusion of premium payments, the taxpayer would effectively be taxed on her return of basis, which would violate general norms of taxation.9

Although these provisions provide a general roadmap for the treatment of life insurance contracts, they fail to address numerous issues. Their shortcomings are particularly apparent when a contract is disposed of before maturity and when a contract is held by a passthrough entity such as a partnership.

II. Calculation of Basis in Life Insurance Contracts

The IRC does not specifically address how a policyholder should calculate gain or loss on the sale of a life insurance contract. In 1911, however, the Supreme Court established that a life insurance contract is transferable private property and, in doing so, suggested that the general rules relating to private property for calculating basis would apply to life insurance contract sales as well.10 Regarding the sale of property generally, a taxpayer recognizes gain or loss based on the difference between the amount realized and the taxpayer’s adjusted basis in the property.11 A property’s adjusted basis is generally its initial cost adjusted upward or downward to reflect items such as capital outlays and tax-free receipts generated by the property.12

Throughout the 1920s and 1930s, courts applied these principles to transactions involving life insurance contracts. These court decisions, though not always consistent, established a repository of authority for taxpayers to evaluate when reporting their life insurance contract dispositions. The principal issue of contention was whether a cost-of-insurance charge should be deducted from a taxpayer’s basis in the contract. The remainder of this section provides a brief history of important decisions and rulings relating to life insurance contract transactions. This history is essential in understanding the law’s evolution into where it is today.

The story begins in earnest with a 1927 Board of Tax Appeals (BTA) decision involving the Standard Brewing Co.13 The BTA denied a corporate taxpayer the ability to recognize a loss on its surrender of a life insurance contract taken out on its officers. The taxpayer had argued that it should be entitled to a loss equal to the difference between the premiums paid and the cash surrender value.14 The BTA held that to the extent any premiums paid exceeded the cash surrender value of the contract, this excess constituted payment for earned or used insurance and was consequently considered an expense. Therefore, the taxpayer had to reduce its basis in the contract by the cost of insurance.15

But in 1929, in Lucas v. Alexander,16 the Supreme Court suggested a different analysis might be proper. While the issue before the Court was determining the amount of accrued gain before the enactment of the income tax in 1913, the Court calculated gain as the excess of the proceeds of the policy over the amount of premiums paid. The implication was that a taxpayer was not required to take a cost-of-insurance deduction in calculating basis.

Shortly thereafter in Forbes Lithograph,17 a Massachusetts federal district court interpreted Lucas in precisely this manner. In Forbes Lithograph, the court ruled that all premiums paid should be allowed as an offset against the amount realized in any sale of a life insurance contract. The Forbes Lithograph decision, however, was quickly put to the test.

Over the course of the next several years, courts soundly rejected the holding in Forbes Lithograph that a taxpayer should be entitled to include all premiums paid in the basis of a life insurance contract when disposing of, or surrendering, the contract for less than the total amount of premiums paid. In Keystone Consolidated,18 the BTA held, as it did in Standard Brewing, that the amount of premiums paid over a policy’s cash surrender value represented the cost of insurance and denied the taxpayer the ability to recognize a loss on the sale of a life insurance policy for its cash surrender value.19 A few years later in Century Wood,20 the Third Circuit followed the reasoning in Keystone and denied a taxpayer a loss on the sale of a life insurance contract for less than the premiums paid. The next year, the BTA reiterated its position, this time in Summers and Moore,21 that a taxpayer should not be entitled to a loss on the sale of a life insurance contract for premiums paid over the cash surrender value.

While addressing the predecessor to section 72(e), in 1935 the Second Circuit, in London Shoe,22 discussed in more detail the dual nature of a life insurance contract with cash surrender value. According to the court, a taxpayer’s premium payment purchased two items, (1) an investment asset corresponding to the cash surrender value and (2) current insurance protection.23 The court held that the current insurance protection portion reflected a current expense or usage and, consequently, should be excluded from basis. The decision, however, hinted that a distinction could be drawn for calculating basis between a disposition of a life insurance contract for a gain and one for a loss. Many later court decisions supported this distinction by allowing a full offset for premiums paid against the amount realized in a gain transaction.24 Thus, it appeared until the 1970s that a taxpayer could take reasonable comfort in offsetting any gain on the disposition of a life insurance contract with the full amount of premiums paid; but for a disposition at a loss, the taxpayer would have to reduce basis by the cost-of-insurance portion of the premiums.25

In 1970 the IRS formally entered the basis foray and released Rev. Rul. 70-38,26 which involved the sale of life insurance contracts taken out by a corporation on its officers to the individual officers for less than the amount of premiums paid. The ruling held that the corporation was not required to include the proceeds in income. Although the ruling did not establish whether the corporation would be entitled to a loss, it was apparently meant to reestablish the view that a taxpayer should not be required to take a cost-of-insurance reduction when calculating basis for the purpose of determining gain on a policy sale.27

But the IRS appeared to change its position with the issuance of LTR 944302028 and CCA 200504001,29 finding in each that a taxpayer was required to deduct from basis the cost of insurance when calculating gain. In its analysis, the IRS relied on London Shoe and Century Wood. Though noting in the letter ruling that the cases involved losses, the IRS failed to treat this distinction as relevant. Consequently, the body of case law supporting the gain/loss distinction was thrown into flux.

In hopes of clearing up the confusion and inconsistencies in transactions involving life insurance contracts, Treasury released two revenue rulings on May 1, 2009.30 Rev. Rul. 2009-1331 addressed the tax consequences to a taxpayer of a beneficial-owned contract and Rev. Rul. 2009-1432 addressed the tax consequences of an investor-owned contract.

In Rev. Rul. 2009-13, the IRS described three factual situations involving the sale or surrender of a beneficial-owned contract. Situations 2 and 3 involved the sale of a contract to an unrelated third party and consequently directly addressed the calculation of the taxpayer’s basis in the contract. In situation 2, at the time of the sale the taxpayer had paid $64,000 in premiums, of which $10,000 represented cost-of-insurance charges, and the contract had a cash surrender value of $78,000. The taxpayer sold the contract for $80,000. The ruling held that the taxpayer recognized $26,000 of gain — the $80,000 received minus the taxpayer’s basis of $54,000 (reflecting the premiums paid minus the cost-of-insurance charges).33 In situation 3, at the time of the sale the taxpayer had paid $45,000 in premiums (reflecting a payment of $500 a month for 90 months) and the contract had no cash surrender value. The taxpayer sold the contract for $20,000. Absent other evidence to the contrary, the ruling held that the monthly premiums were equal to the cost of insurance. Because the taxpayer had held the contract for 89.5 months at the time of sale, the cost of insurance was equal to $44,750, giving the taxpayer a basis in the contract of $250. Accordingly, the taxpayer recognized a gain of $19,750 on the sale of the contract.

In Rev. Rul. 2009-14, the IRS described three factual situations involving the sale or surrender of an investor-owned contract, one of which is relevant to the calculation of basis. In situation 2, the investor sold a contract without cash surrender value for $30,000 after initially acquiring the contract for $20,000 and paying $9,000 in premiums after its acquisition. The ruling held that the taxpayer had a basis of $29,000 in the contract and accordingly recognized $1,000 of gain on disposition. In reaching its conclusion, the IRS relied on the regulations promulgated under section 263 to calculate basis.

Under the section 263 regulations, a taxpayer is required to capitalize an amount paid to another party to acquire an intangible.34 Significantly, a life insurance contract is included in the definition of an acquired intangible.35 Thus, the taxpayer was required to include the amount paid to acquire the contract of $20,000 in its basis. The ruling then relied on authority granted under the section 263 regulations allowing the IRS to publish guidance identifying a future benefit as an intangible for which capitalization is required.36 Using this authority, the ruling held that the $9,000 in premiums paid should be included in the taxpayer’s basis in the contract. Citing Century Wood, London Shoe, and Keystone, the ruling did not require the taxpayer to consider any cost-of-insurance charges, reasoning that the taxpayer acquired the contract purely for investment purposes and did not enjoy any actual insurance protection like the taxpayers in the noted cases.37

After the dust settled from the 2009 rulings, a taxpayer could think of life insurance contracts as falling into four categories: (1) beneficial-owned contracts with cash surrender value, (2) beneficial-owned contracts without cash surrender value, (3) investor-owned contracts with cash surrender value, and (4) investor-owned contracts without cash surrender value.

For an investor-owned contract, the analysis was relatively straightforward — basis included the amount paid plus any premiums paid and no cost-of-insurance charge was required.38 This conclusion applied regardless of whether the contract had cash surrender value. But for beneficial-owned contracts, the analysis was more complicated.

For a beneficial-owned contract without cash surrender value, it was the IRS’s view that a taxpayer had to take a cost-of-insurance charge into account when calculating basis.39 Absent other proof, the cost of insurance was presumed to be equal to the premiums paid (and any other amounts paid as consideration under the contract).40 The result was that a taxpayer would have no basis in the contract except to the extent of prepaid premiums or other consideration paid that had not yet been used.

For beneficial-owned contracts with cash surrender value, the IRS’s position was that basis included any initial outlay on entering into the contract and any premiums paid, but required a reduction for the cost of insurance.41 It appeared that the IRS did not view the distinction of whether a contract was disposed of at a gain or a loss to be relevant in whether a cost-of-insurance deduction was required.42 Curiously absent from the situation 2 analysis is any reference to reg. 1.263(a)-4(d)(2). This regulation unambiguously states that amounts paid to renew a beneficial-owned contract that “has or may have cash value” must be capitalized.43 In trying to reconcile the ruling and the regulation, perhaps a taxpayer was supposed to capitalize premiums into a contract’s basis but then periodically make a reduction for a cost-of-insurance charge. Though possible, this interpretation has no support under statutory law and creates the practical difficulty of calculating such charge and determining its timing. Further, if Treasury had intended this outcome, it presumably would have drafted the regulation to provide for this result — having been litigated for nearly a century, the cost-of-insurance issue was not new.44 As a result, and notwithstanding Rev. Rul. 2009-13’s holding, a taxpayer could reasonably take the position of capitalizing premium payments into basis for beneficial-owned contracts with cash surrender value (or simply the possibility of having cash surrender value) without taking a cost-of-insurance charge.45 Any remaining uncertainty over the issue was put to rest in 2017 — at least for contracts entered into after August 25, 2009.

In the TCJA, Congress provided that no cost-of-insurance charge would be required for any life insurance contract and made it retroactive to contracts entered into after August 25, 2009.46 As a result, no taxpayer that entered into a life insurance contract after such date, regardless of whether beneficial-owned or investor-owned or having cash surrender value, is required to take a cost-of-insurance charge into account when calculating basis for contracts. For contracts in existence before August 25, 2009, a taxpayer presumably must decipher the case law, regulations, and rulings discussed above to decide whether a cost-of-insurance charge is required.

In 2020 the IRS released Rev. Rul. 2020-5,47 modifying the results in the 2009 Rulings to be consistent with the TCJA. In particular, the taxpayer in situations 2 and 3 in Rev. Rul. 2009-13 was no longer required to reduce basis by the cost of insurance. Therefore, in situation 2 the taxpayer would only have to recognize $16,000 of gain and in situation 3 the taxpayer would recognize a loss of $25,000. The result in situation 2 of Rev. Rul. 2009-14 did not change; however, it was no longer distinguishable from situation 3 in Rev. Rul. 2009-13 — the factual difference between the two scenarios simply being that one contract was beneficial-owned and the other was investor-owned.

III. Application to Partnerships

Because partnerships often hold life insurance contracts, and partners may dispose of their partnership interests before the surrender, expiration, or payment of death benefits under a contract, an understanding of the impact of premium payments on a partner’s outside basis is crucial. While the authorities noted previously generally deal with corporations and individuals owning life insurance contracts, the logic and conclusions relating to the calculation of basis should flow naturally to life insurance contracts held by a partnership.48 In fact, the IRC provides that taxable income of a partnership is generally computed in the same manner as for an individual.49 Consequently, the basis in a life insurance contract held by a partnership should generally include premium payments to the same extent as if the contract was held by an individual or a corporation. Determining the impact of premium payments on a partner’s outside basis, however, is a more nuanced exercise.

The first step in analyzing the treatment of a premium payment made by a partnership on a partner’s outside basis is to evaluate the IRC provisions and regulations. Section 705 generally provides that outside basis is increased by the taxable income and tax-exempt income of the partnership and decreased by losses of the partnership and expenditures not deductible and not properly chargeable to capital account. Because insurance premiums are not deductible to a beneficiary under the contract,50 premium payments by the partnership will not be included in the calculation of taxable income or loss of the partnership. As a result, such premium payments will decrease outside basis unless the payments are considered to be properly chargeable to capital account. Unfortunately the meaning of “not properly chargeable to capital account” is not particularly intuitive.

But fortunately, regulations promulgated under sections 705 and 263 provide guidance. The section 705 regulations clarify that any capital expenditure is considered “chargeable to capital account.”51 Thus, if a premium payment is considered a capital expenditure, then outside basis is not reduced on account of such payment. Regulations promulgated under section 263 address premium payments regarding (1) beneficial-owned contracts that have or may have cash surrender value and (2) investor-owned contracts.52 In particular, a premium payment made on a beneficial-owned insurance contract that has or may have cash surrender value is considered a capital expenditure.53 Similarly, a premium payment made on an investor-owned contract, regardless of whether it has cash surrender value, is also treated as a capital expenditure.54 Though no specific regulatory guidance is offered regarding a beneficial-owned contract without cash surrender value, a premium payment made on this contract is presumably a capital expenditure as well based on the authorities discussed previously (though potentially fully offset by a cost-of-insurance charge).55 Thus, the regulations provide that because premium payments are considered capital expenditures, no reduction in outside basis is required based on the payment of premiums alone. The possibility remained, however, that a cost-of-insurance charge could be required, thereby reducing outside basis by this amount.

Given the absence of statutory and regulatory authority regarding whether a cost-of-insurance charge is required outside the partnership context, it is not surprising that there is a lack of explicit authority addressing the cost of insurance in the partnership context. As a result, before the enactment of the TCJA it was possible that, under principles previously discussed, a partnership would have been required to consider a cost-of-insurance charge. But given the language in the regulations, including the lack of any mention of a cost-of-insurance charge, the better conclusion was that no such charge was required — at least for any contract other than a beneficial-owned contract without cash surrender value. After the enactment of the TCJA, however, for any contract entered into after August 25, 2009, no reduction in outside basis is required for any life insurance premium paid by a partnership.

IV. A Different View?

Notwithstanding the compelling logic presented so far on this topic, consultation with several leading treatises would likely lead a taxpayer to a different conclusion. The consensus view of these scholars falls into two categories. The first is merely that insurance contract premiums are not deductible and therefore reduce outside basis.56 The second is that only a portion of the premium, for policies with cash surrender value, reduces outside basis.57

Regarding the first category, the scholars focus entirely on the nondeductibility of premiums without any apparent consideration as to whether a premium payment could be chargeable to capital account.58 Little can be deciphered as to why the authors do not consider the possibility of capitalizing the premium payment. No citations are offered other than to section 264(a). A proper conclusion would, at the very least, include some discussion of the regulations promulgated under sections 705 and 263 and why, notwithstanding the explicit language of the regulations, outside basis is still required to be reduced on account of premium payments.

The conclusion in the second camp of authorities, that bifurcation is appropriate, presumably is based on a cost-of-insurance concept — whereby the portion of a premium payment representing the cost of insurance (with such amount presumed to be the amount in excess of cash surrender value) reduces outside basis. Like the analysis by the scholars in the first camp, these scholars offer few citations in support of their conclusion. Accordingly, it is unclear how the authors reach the bifurcation conclusion.

One treatise with the bifurcation view, however, does reference a field service advice issued by the IRS.59 In FSA 1993-832, the IRS advised that an S corporation shareholder must reduce his basis in his shares of the S corporation for life insurance premium payments made by the corporation, but only to the extent the premiums fund the insurance feature of the contract. The FSA concluded that “bifurcation of the premium is the only approach consistent with economic reality,” but also noted that the bifurcation issue was one of first impression and not free from doubt.

Although not discussed directly in any of these treatises, concerns of equity may be driving the conclusion that premium payments should reduce outside basis.60 In particular, gross income does not generally include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured.61 If the entire amount of death benefit payments received is considered “income of the partnership exempt from tax,” a partner would be required to increase his outside basis in the partnership by this amount.62 The result is arguably a windfall to the partner — the partner’s outside basis would reflect all premiums paid plus the entire amount received under the contract (which to some degree reflects a return of premium payments made), effectively making the premium payments deductible by providing the taxpayer with a loss upon the sale or redemption of his interest.63 Making premiums deductible, in effect, would be inconsistent with congressional intent in drafting section 264(a).64 Though a thorough analysis of the issue is beyond the scope of this article, it is possible, however, that existing law under sections 705 or 265 is already sufficient to corral this concern.

Section 705(a)(1)(B) requires a partner to increase her outside basis by “income exempt from tax under this title.”65 Neither the regulations nor the legislative history offer significant guidance as to the meaning of “income of the partnership exempt from tax” other than providing that basis adjustments are meant to prevent inappropriate or unintended benefits or detriments to each partner.66 Theoretically, one could read “income . . . exempt from tax” as only exempting proceeds in excess of the taxpayer’s basis in the contract (that is, taxation of the return of basis was never intended). But this reading of the statute contradicts the position taken by the IRS67 and belies a plain reading of the statute.

Alternatively, section 265(a)(1) could prevent a taxpayer from recognizing a loss after death proceeds are paid. In theory, this section could apply at the time insurance proceeds are paid to the partnership by creating a nondeductible and non-capitalized expense at that time — presumably representing only the insurance portion of premiums paid. But this approach is inconsistent with regulatory authority that suggests that the timing of a nontaxable item is determined for the tax year in which the item would have been includable or deductible under the taxpayer’s method of accounting.68 Alternatively, section 265(a)(1) could deny a taxpayer a loss on sale or redemption of her interest — the excess basis being considered allocable to a class of income wholly exempt from tax. Section 265 applied in this manner reaches an equitable result and appears feasible under a plain reading of the statute.

Regardless of how the conclusions were reached in these treatises, the conclusions do not appear to be supported by existing law. At the very least, a discussion of the 2009 rulings, the 2020 ruling, the TCJA, the 263 regulations, and their relevance or lack thereof would be appropriate to satisfactorily reach a conclusion that outside basis is reduced, either in whole or in part, by a life insurance premium payment made by a partnership.

V. Concluding Thoughts

The exercise of calculating basis in a life insurance contract has had a long and, at times, inconsistent history. Fortunately, the TCJA resolved the issue of whether a cost-of-insurance charge is required for recently originated contracts. Thus, notwithstanding scholarly positions to the contrary, taxpayers should be comfortable in taking the position that premium payments made by a partnership do not reduce outside basis to any extent for any contract entered into after August 25, 2009. For contracts entered into before that date, taxpayers still need to review and apply historical authorities discussed in this article to their facts, though it seems perfectly reasonable that a taxpayer could reach the same conclusion for such contracts as well.

FOOTNOTES

1 See section 705(a)(2)(B).

2 Section 264(a).

3 The scope of this conclusion extends beyond partnerships. The same conclusion should apply for premiums paid by an S corporation. The S corporation basis rules were drafted after publication of the partnership basis rules and were intended to achieve the same result. The legislative history states that the basis adjustment rules under subchapter S should be analogous to those provided for partnerships under section 705. See S. Rep. 640, 97th Cong., 2d Sess. (1982), reprinted in 1982-2 C.B. 718, 726. Also, the conclusion is likely applicable in the consolidated return setting as well (see Treas. reg. section 1.1502-32(b)(2)(iii)).

4 Unless otherwise noted, all section references are to the IRC of 1986, as amended.

5 The terms “cash surrender value” and “cash value” are often used interchangeably. In the commercial setting, cash surrender value technically reflects the cash value of the contract minus any fees or expenses imposed upon surrender of the contract. Section 7702 uses the terms “cash surrender value” and “net surrender value” to represent what is typically referred to as cash value and cash surrender value, respectively. See section 7702(f)(2). For consistency in this article, “cash surrender value” is used when referencing a contract with a cash value component.

6 There are, however, several exceptions to this general rule, such as the transfer-for-value rule and carryover basis rule. These exceptions are not relevant to this article and are not discussed in detail.

7 The statutory predecessor to section 264(a) was enacted in 1918 in response to a concern that large stockholders of corporations were using the corporations to take over and handle insurance for them. Denying the corporation a deduction for premiums paid was meant to deter this practice. See 56 Cong. Rec. 10,419 (1918).

8 Section 72(e)(2), (3), (6).

9 Return of basis is generally not treated as an accession to wealth and therefore conceptually should not be subject to taxation. See Raytheon Products Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944); CCA 200504001 (Oct. 12, 2004).

10 Grigsby v. Russell, 222 U.S. 149 (1911).

11 Section 1001(a).

12 See sections 1011, 1012, 1016.

13 Standard Brewing Co. v. Commissioner, 6 B.T.A. 980 (1927).

14 Because section 72(e), and its precursor at the time, applies only to gains and not losses, it had no application in the decision.

15 The cost of insurance was calculated as the difference in premiums paid over the cash surrender value. Throughout the last century, many court decisions have calculated insurance cost in this manner.

16 279 U.S. 573 (1929).

17 Forbes Lithograph Manufacturing Co. v. White, 42 F.2d 287 (D. Mass. 1930).

18 Keystone Consolidated Publishing Co. v. Commissioner, 26 B.T.A. 1210 (1932).

19 Given the difficulty in calculating cost of insurance, various courts have held that cash surrender value is a rough approximation of basis.

20 Century Wood Preserving Co. v. Commissioner, 69 F.2d 967 (3d Cir. 1934).

21 Summers and Moore v. Commissioner, B.T.A.M. (RIA) 1935-100.

22 London Shoe Co. v. Commissioner, 80 F.2d 230 (2d Cir. 1935).

23 Some commentators have argued that an insurance contract with cash surrender value is indivisible and that the court’s analysis in London Shoe is questionable especially regarding modern insurance contracts. See Kenneth N. Orbach, “Premiums Paid on Key Person Cash Value Life Insurance Policy Should Not Affect Stock Basis,” J.S. Corp. Tax’n (Fall 1994); Orbach, “The Tax Consequences of Disposing of Cash Value Life Insurance,” Tax Notes, May 3, 2010, p. 567; Todd D. Keator, “Basis in a Life Insurance Contract: The Janus Face of Revenue Ruling 2009-13,” 27 J. Tax’n Inv. 5 (2010).

24 Commissioner v. Phillips, 275 F.2d 33 (4th Cir. 1960); Gallun v. Commissioner, 327 F.2d 809 (7th Cir. 1964); Nesbitt v. Commissioner, 43 T.C. 629 (1965); Estate of Crocker v. Commissioner, 37 T.C. 605 (1962); Neese v. Commissioner, T.C. Memo. 1964-288.

25 Given that courts often equated cash surrender value and basis, taxpayers were effectively denied any loss on the surrender of a contract; see Century Wood, 69 F.2d 967.

26 Rev. Rul. 70-38, 1970-1 C.B. 11. This holding is consistent with an IRS ruling finding that a corporation increased its earnings and profits by the difference between the amount of death proceeds received by the corporation over the amount of premiums paid. See Rev. Rul. 54-230, 1954-1 C.B. 114.

27 See New York State Bar Association Tax Section, “Report on Investor-Owned Life Insurance” (Dec. 5, 2008); Keator, supra note 23.

28 LTR 9443020 (July 22, 1994).

29 CCA (RIA) 200504001 (Oct. 12, 2004).

30 These rulings were released at least partly in response to a letter from Rep. Herb Kohl, then the chair of the House Special Committee on Aging, noting the confusion and lack of transparency regarding the taxation of life settlement transactions.

31 Rev. Rul. 2009-13, 2009-21 IRB 1029.

32 Rev. Rul. 2009-14, 2009-21 IRB 1031.

33 Sections 1011 and 1012. The ruling notes authority under section 263 and in particular reg. section 1.263(a)-4. Oddly, the ruling does not mention reg. section 1.263(a)-4(d)(2), which requires a taxpayer to capitalize amounts paid to another party “to create, originate, enter into, renew . . . any insurance contract that has or may have cash value.” As discussed below, this regulation is directly on point, requires capitalization, and does not mention any requirement for a cost-of-insurance charge.

34 Treas. reg. section 1.263(a)-4(c)(1).

35 Treas. reg. section 1.263(a)-4(c)(1)(iv).

36 Treas. reg. section 1.263(a)-4(b)(1)(iv).

37 This distinction is a dubious one. It seems perfectly reasonable that a secondary purchaser of an insurance contract could still enjoy the benefits of insurance beyond just the economic payout upon a triggering event.

38 Rev. Rul. 2009-14, situation 2.

39 Rev. Rul. 2009-13, situation 3.

40 Id.

41 Rev. Rul. 2009-13, situation 2.

42 Id.

43 An amount paid to renew a life insurance contract encapsulates a life insurance premium payment. Alternatively, a premium could be considered a cost to create the contract. Either way both are required to be capitalized under Treas. reg. section 1.263(a)-4(d)(2).

44 This regulation was published as part of 69 F.R. 436 (Jan. 5, 2004).

45 Treasury regulations are binding on the IRS and represent a higher level of authority than revenue rulings. See Rev. Proc. 89-14, 1989-1 C.B. 814, section 7.01(4). Depending on the circumstances, court decisions discussed previously would have potentially provided support for a taxpayer seeking to capitalize all premiums paid into basis.

46 Section 1016(a)(1)(B).

47 Rev. Rul. 2020-5, 2020-9 IRB 454.

48 The Summers and Moore case, supra note 21, involved partners in a partnership but did not address outside basis.

49 Section 703. Similarly, section 1363(b) provides for an analogous result in the S corporation context.

50 Section 264(a)(1).

51 Treas. reg. section 1.705-1(a)(3)(ii).

52 For investor-owned contracts, the authority technically comes from the use of authority granted under Treas. reg. section 1.263(a)-4(b)(1)(iv) by Rev. Rul. 2009-14. The regulations also provide that amounts paid on entering into (i) a beneficial-owned contract that has or may have cash surrender value or (ii) an investor-owned contract are also considered capital expenditures. Treas. reg. section 1.263(a)-4(b)(1)(i); Treas. reg. section 1.263(a)-4(d)(2)(i)(D).

53 Treas. reg. section 1.263(a)-4(d)(2)(i)(D). The regulation technically states that an amount paid to renew an insurance contract that has or may have cash value must be capitalized — a premium payment certainly should constitute a renewal payment.

54 Treas. reg. section 1.263(a)-4(b)(1)(iv); Rev. Rul. 2009-14.

55 The court decisions and administrative rulings generally suggest that an appropriate first step is to capitalize any premium paid and then make a determination, based on the situation, whether to take a cost-of-insurance charge.

56 William S. McKee, William F. Nelson, and Robert L. Whitmire, Federal Taxation of Partnerships and Partners section 6.02[3](c) (2007 and Supp. 2022-2) (finding that any life insurance premiums not deductible under section 264 (including premiums on insurance used to fund partnership liquidation agreements) should cause a decrease in a partner’s outside basis); Arthur B. Willis, Philip F. Postlewaite, and Jennifer H. Alexander, Partnership Taxation section 5.02 (2017 and Supp. 2022-2) (expenditures that are not deductible in computing partnership taxable income and are not properly chargeable to capital account include premiums on life insurance contracts, if not deductible), and section 5.05 (life insurance premiums are not deductible by the partnership if the partnership is directly or indirectly a beneficiary); Federal Tax Coordinator Analysis 2d para. B-1516 (2022) (nondeductible expenditures not chargeable to capital account include premiums on life insurance contracts that are not deductible under section 264); William R. Christian and Irving M. Grant, Subchapter S Taxation section 19.01 (1998 and Supp. 2022-2) (stating that some life insurance premiums are not deductible and suggesting a basis reduction is proper).

57 Howard M. Zaritsky and Stephan R. Leimberg, Tax Planning with Life Insurance: Analysis With Forms section 7.05 (1998 and Supp. 2022-1) (premiums paid on a corporate-owned life insurance policy, reduced by cash surrender value increases, will reduce the shareholders’ basis in their stock; when an S corporation pays premiums on a whole-life type policy, only the excess of each year’s premium outlay over that year’s increase in cash surrender value should reduce basis; with whole life insurance, the year-to-year cash surrender value increase should be charged to the capital account, because it is not an expense but rather a shift of funds from cash to cash values); Horacio Sobol and Samuel Star, S Corporations: Shareholder Tax Issues, No. 732 Tax Mgmt. (BNA) U.S. Income Section IV(D)(2)(b)(1) (noting that the issue in the context of S corporations is not settled but stating that a bifurcation approach is theoretically correct).

58 Conceptually, the concern is that a failure to reduce outside basis would effectively convert what otherwise would be a nondeductible expense into a tax loss on a disposition of a partnership interest by the partner.

59 Zaritsky and Leimberg, supra note 57. The authors refer to an unnumbered FSA. It appears they are referring to FSA 1993-832, 1999 TNT 45-71.

60 The position that outside basis should be reduced, however, arguably creates its own inequitable result. Specifically, if the basis in a life insurance contract reflects all premiums paid but outside basis does not, a sale by the partnership of the contract for an amount equal to the amount of premiums paid would create no gain, while a partner’s disposition of an interest in the partnership still holding that contract would create gain.

61 Section 101(a)(1). The exclusion of such proceeds from income does not apply in all circumstances — see section 101(a)(2).

62 Section 705(a)(1)(B). There is little authority interpreting what “income of the partnership exempt from tax” means. Given the language of section 101(a) and Treas. reg. section 1.1366-1(a)(2)(viii), it appears that the best reading of this language is that all proceeds (regardless of whether they represent a return of premiums) are considered “income of the partnership exempt from tax.”

63 It is worth noting, however, that even under the bifurcation approach the windfall would still exist for some contracts regarding the non-insurance portion of the premium and for which outside basis is not reduced. While the terms of life insurance contracts vary, some contracts provide that cash surrender value is, in effect, included as part of the death benefit proceeds. Thus, outside basis would be increased by both the non-insurance portion of the premium and the receipt of proceeds.

64 Absent a restriction on a partner’s ability to recognize a loss in such a case, failing to reduce outside basis for premium payments alone arguably circumvents the intent of section 264(a) by effectively providing a deduction to a partner on disposition of his interest even without receiving death benefit proceeds.

65 Section 705(a)(1)(B).

66 See S. Rep. No. 1622, 82d Cong., 2d Sess. (1952); Rev. Rul. 96-10, 1996-1 C.B. 138.

67 LTR 9309021 (Dec. 3, 1992); but see Rev. Rul. 54-230, supra note 26.

68 Treas. reg. section 1.1367-1(d)(2).

END FOOTNOTES

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