Subchapter L: Withholding and Reporting May Not Be Required for Income on Failed Life Insurance Contracts

A policyholder who owns a contract which is a life insurance contract under applicable law that fails the definition of a life insurance contract in I.R.C. § 7702 is required to treat the income on the contract as ordinary income received or accrued during the taxable year. In general, this income on the failed contract is the amount by which the increase in the net surrender value of the contract plus the cost of insurance exceeds the premiums paid for the year. In Rev. Rul. 91-17, the IRS ruled that the issuer of a failed contract is subject to the withholding and reporting requirements applicable to nonperiodic distributions from life insurance contracts. The ruling also noted that an insurer’s failure to comply with these withholding and reporting requirements could result in penalties. Is this ruling correct? Believe it or not, the ruling likely is wrong.

The exclusive support for the IRS’s legal conclusion in Rev. Rul. 91-17 is legislative history. The House Committee Report that explains the House bill’s version of what was enacted as I.R.C. § 7702 includes the following statement that assumes that withholding and reporting are required on failed contracts:

Because the income on the contract is treated as received by the policyholder, the income would be a distribution subject to the recordkeeping, reporting, and withholding rules under present law relating to commercial annuities (including life insurance). It is hoped this will provide the policyholder with adequate notice that disqualification has occurred, thus giving some protection against underpayment of estimated taxes.