Revenue Ruling 65-53: Tax on Endowment Policy Sales
An analysis of the tax character for gains on an endowment policy sale, explaining why the profit is treated as ordinary income, not capital gain.
Revenue Ruling 65-53 is a pronouncement from the Internal Revenue Service (IRS) that clarifies the tax character of profit generated from the sale of an endowment insurance policy before its maturity date. Its primary conclusion is that any gain from such a sale is treated as ordinary income for tax purposes. This determination prevents the gain from being classified as a long-term capital gain, which often benefits from lower tax rates.
The Core Holding of the Ruling
An endowment policy combines a death benefit with a savings component, designed to pay a lump sum after a specific term. For example, a 20-year endowment policy pays the face amount to the beneficiary if the insured passes away within the 20 years, or it pays the face amount to the policyholder at the end of the 20-year period if they are still living. The policy accumulates a cash value over time, which is composed of the premiums paid and the interest earned.
Revenue Ruling 65-53 examines a scenario where a taxpayer sells an endowment policy to a third party just before it reaches its maturity date. The conclusion of the ruling is that the profit realized from this sale is taxed as ordinary income. The IRS determined that this transaction does not represent the sale of a capital asset in the traditional sense, as the amount received above the premiums paid is not considered appreciation in value.
Rationale for the Ordinary Income Treatment
The justification for treating the gain from an endowment policy sale as ordinary income rests on a legal concept known as the “substitute for ordinary income” doctrine. This doctrine posits that if a transaction is merely a substitute for what would have otherwise been received as ordinary income, the proceeds from that transaction should also be taxed as ordinary income. The IRS reasoned that the profit on the sale of an endowment policy fits this description, as the gain represents the future interest income the policy was set to earn and pay out upon maturity.
By selling the policy, the policyholder is receiving a payment in lieu of the future ordinary income that the contract would have generated. This is different from the sale of a typical capital asset, such as corporate stock, where value is due to market appreciation. The gain on an endowment policy is primarily attributable to the predictable accumulation of interest, and the sale simply accelerates its receipt. Allowing this gain to be treated as a capital gain would create a loophole, enabling taxpayers to convert interest income into a more favorably taxed form.
Calculating the Taxable Gain
The taxable gain from the sale of an endowment policy is the difference between the sale price received and the policyholder’s tax basis in the contract. The formula is: Taxable Gain = Sale Price – Tax Basis. The ‘Sale Price’ is the total amount of cash and any other property the policyholder receives. The ‘Tax Basis’ is defined as the total net premiums paid by the policyholder, less any dividends or other non-taxable distributions received from the insurance company.
For a clear example, consider a taxpayer who owns an endowment policy for which they have paid total premiums of $8,000. Shortly before the policy matures, they sell it to an investor for $9,500. In this case, the taxable ordinary income would be $1,500, which is calculated by subtracting the $8,000 tax basis from the $9,500 sale price. This $1,500 represents the accumulated interest income within the policy and must be reported as ordinary income on the seller’s tax return.
Broader Implications and Related Rulings
The principles established in Revenue Ruling 65-53 have had a lasting impact on the taxation of insurance products, extending well beyond endowment policies. The “substitute for ordinary income” doctrine has been applied to other types of financial instruments where a sale can be used to realize future income. The most significant extension of this logic came with the rise of the life settlement market, where individuals sell their cash value life insurance policies to third-party investors.
In the context of these life settlement transactions, the IRS has clarified that the portion of the gain representing accumulated interest is treated as ordinary income, while any excess gain may be treated as a capital gain.