The cash value of a surrendered life insurance policy is includable in gross income to the extent it exceeds the taxpayer's investment in the insurance contract. This excess is taxable as ordinary income.
There are two elements to this computation. First, what is the cash value. Second, what is the “investment in the insurance contract.” A recent case (Brown v. Comm.) illustrates some elements that go into these two items.
Cash Value. In the case, the insured did not receive the cash value. Instead, it was applied by the insurance company to pay off a policy loan. The court nonetheless included the cash surrender value applied to the loan as being received by the insured.
Investment in the Insurance Contract. This generally is the total insurance premiums paid by the insured. However, the court recognized two reductions to the investment in the contract. First, the insured had surrendered some of his insurance coverage. This surrender was treated as a reduction in the investment in the contract. Second, during the term of the policy the insurance company had used some of the dividends earned on the policy to purchase additional coverage.
Oftentimes, the quick and dirty computation of the income arising from the surrender of a policy is the cash received by the insured, over the premiums previously paid. This case reminds us that adjustments to both these items may apply that can materially impact this computation.
Brown v. Comm., 110 AFTR 2d 2012-XXXX (CA7 09/11/2012)