What Is Revenue Ruling 87-12 for Life Insurance?
Explore the foundational IRS ruling on the tax treatment of accessing life insurance cash value and how later laws changed these rules for overfunded policies.
Revenue Ruling 87-12, issued by the Internal Revenue Service (IRS), provided clarification on the income tax consequences for single-premium cash value life insurance policies. The ruling established a framework for how transactions such as withdrawals and loans would be treated for tax purposes.
This guidance predated legislative changes, most notably the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). The rules outlined in Revenue Ruling 87-12 established a “cost recovery” system for distributions from these policies, providing the context for the rules that apply today.
Determining the Investment in the Contract
A concept in the taxation of life insurance is the “investment in the contract.” This figure represents the policyholder’s cost basis in the policy and is the benchmark against which distributions are measured. The calculation begins with the aggregate amount of premiums paid into the policy.
This total must then be adjusted downward for any amounts the policyholder has previously received from the contract that were not included in their gross income. Policy dividends are a common example, as they are considered a return of a portion of the premiums paid and therefore reduce the investment in the contract.
For instance, if a policyholder paid a single premium of $50,000 and received $5,000 in policy dividends, their investment in the contract would be reduced to $45,000. This adjusted figure is what the IRS uses to determine the taxability of future withdrawals or other distributions.
This calculation is specified under Internal Revenue Code Section 72, which defines the investment in the contract. Every non-taxable distribution effectively reduces the basis, and tracking this amount is necessary for proper tax reporting.
Tax Treatment of Withdrawals and Partial Surrenders
Revenue Ruling 87-12 affirmed the “First-In, First-Out” (FIFO) accounting method for distributions from cash value life insurance policies. Under this principle, withdrawals are first treated as a tax-free return of the policyholder’s investment in the contract. A policyholder can withdraw funds up to their basis without incurring immediate tax liability, and these withdrawn amounts reduce the remaining investment in the contract. Only after the entire basis has been recovered do any further distributions become subject to income tax as ordinary income.
Consider a policy with a cash surrender value of $75,000 and an investment in the contract of $50,000. If the policyholder takes a partial withdrawal of $55,000, the first $50,000 is a tax-free recovery of their investment. The remaining $5,000 is a gain and must be reported as taxable income. After this transaction, the policyholder’s investment in the contract is reduced to zero.
This approach is distinct from a full surrender of the policy. When a policy is completely surrendered, the transaction is finalized, and the entire gain is taxed at once. The taxable amount is the total cash surrender value received minus the policyholder’s remaining investment in the contract.
Tax Treatment of Policy Loans
Under the framework of Revenue Ruling 87-12, a loan taken against a life insurance policy is not considered a taxable distribution, provided the policy is not classified as a Modified Endowment Contract (MEC). The loan proceeds are received tax-free.
The policyholder is not required to make payments on the loan, but the outstanding balance and accrued interest will reduce the death benefit paid to beneficiaries or the cash value available upon surrender.
A tax event occurs if the policy lapses or is surrendered while a loan is outstanding. At that point, the outstanding loan balance is treated as a distribution. If this amount exceeds the policyholder’s investment in the contract, the excess is taxable as ordinary income.
The Impact of Subsequent Legislation
The tax rules were altered by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which addressed concerns that some policies were being used as tax shelters. TAMRA introduced a new classification for life insurance policies known as the Modified Endowment Contract (MEC).
A policy becomes a MEC if it fails the “7-pay test,” detailed in IRC Section 7702A. This test determines if the cumulative premiums paid into a policy during its first seven years exceed the total that would have been required to have the contract paid-up after seven level annual payments. If a policy is funded more rapidly than this standard, it is permanently classified as a MEC.
For any policy deemed a MEC, the FIFO tax treatment for distributions is reversed, and a “Last-In, First-Out” (LIFO) accounting method applies. Under LIFO, distributions, including policy loans, are treated first as a taxable distribution of the gain in the policy. Only after all the gain has been distributed are subsequent amounts treated as a tax-free return of the investment in the contract.
Furthermore, distributions from a MEC before the policyholder reaches age 59½ may also be subject to a 10% penalty tax on the taxable portion. This legislative shift created a two-tiered system where non-MEC policies follow the FIFO rules, while MECs are subject to the LIFO rules.