Is the IRS Saying That Class Action Damages are Not Subject to IRC Section 72?

One of the significant tax benefits of a life insurance contract is that, for purposes of determining the taxable amount of proceeds received under the contract on distributions or surrender, the investment in the contract includes the aggregate amount of premiums, unreduced by the cost of insurance provided (IRC section 72(c)). In a recent Chief Counsel advice letter (CCA), the IRS seems to have ignored this basic tax rule and effectively treated a policyholder as taxable on the cost of insurance. However, the adverse result might have been avoided by a little tax planning.

In CCA 200504001 (Oct. 12, 2004), the IRS concludes that damages received from an insurance company in settlement of a class action lawsuit are includible in gross income to the extent that they exceed the policyholder’s basis in the life insurance policies. However, rather than use the investment in the contract under section 72 to determine the basis and apply section 1035, the IRS used a section 1001 analysis and determined the basis for this purpose as being the premiums paid, reduced by the cost of insurance provided, as well as by amounts previously received and not included in income. In the CCA, a woman policyholder held two life insurance policies
issued by the same insurance company. The first policy, which was on her former husband’s life, was converted to a policy with a lower face amount (the company encouraged her to do so by erroneously saying that she would not incur any additional premiums). The second policy, on her own life, was surrendered. A class action suit was brought against the insurance company with claims that the company induced the policyholder to surrender, borrow against or otherwise withdraw values from the policies by misrepresenting the financial effect of such transactions and failing to disclose that such switches were against the policyholder’s best interest. As part of the class action settlement, the policyholder was awarded damages, a portion of which was interest. The policyholder in the CCA filed a return, reporting the entire amount of damages as income and later amended her return seeking a refund, arguing that the portion of the damages in excess of interest represented the recovery of out-of-pocket expenses for premiums. The CCA concludes that the damages received by the policyholder with respect to the policy on her former husband’s life (the first policy) are not includible in her gross income to the extent they exceed her “basis” in the insurance policy, as defined above. With respect to damages attributed to the policy on her own life (the second policy), the CCA concludes that all amounts are included in the policyholder’s gross income because the policy was surrendered.