IRS Revenue Ruling 2009-13, Explained in Plain English

Why the IRS Issued the Ruling in 2009

By the late 2000s, the life settlement market had grown from a niche into a multi-billion-dollar secondary market, yet the tax law had never squarely answered the basic question every seller asked: if I sell my policy instead of surrendering it, what do I owe? The Internal Revenue Code addressed death benefits (excluded under Section 101) and surrenders (taxed under the distribution rules of Section 72(e)), but the sale of a policy to an investor fell into a doctrinal gap. Practitioners improvised, positions varied, and audit outcomes were unpredictable.

In May 2009 the IRS answered with a matched pair of rulings. Revenue Ruling 2009-13 addressed the seller’s side — the policyholder disposing of the policy — while its companion, Revenue Ruling 2009-14, addressed the buyer’s side, governing how investors are taxed when the policy later matures or is resold. For policyholders, 2009-13 is the one that matters.

A revenue ruling is not a statute; it is the IRS’s published interpretation of existing law applied to stated facts, and taxpayers can generally rely on it. The 2009 timing was no accident — it arrived roughly one year before the Government Accountability Office’s comprehensive study of the settlement market, GAO-10-775, amid rising regulatory attention to a market where seniors were selling policies at 4 to 8 times surrender value with no clear tax roadmap. The ruling supplied that roadmap, and with one major statutory amendment in 2017, it remains the governing framework — the modern rules are summarized in our complete tax treatment guide.

The Cast of Characters: One Policy, Three Fates

The ruling’s genius is its concreteness. Rather than announcing abstract principles, the IRS posed three variations on a single fact pattern and taxed each one. In all three situations, an individual bought a life insurance policy on his own life for genuine protection, held it for years, and then — with no terminal or chronic illness — disposed of it in month 89 or so of ownership. The three fates:

• Situation 1: he surrenders a cash value policy back to the insurance company for its cash surrender value.
• Situation 2: he sells the same cash value policy to an unrelated investor for more than its cash surrender value.
• Situation 3: he sells a level-premium term policy — no cash value at all — to an unrelated investor.

The stipulated numbers in the ruling: total premiums paid on the cash value policy of $64,000; cash surrender value of $78,000; a surrender in Situation 1 at $78,000; a sale in Situation 2 at $80,000. In Situation 3, term premiums of $45,000 had been paid and the policy sold for $20,000.

The health stipulation matters: because the insured was neither terminally nor chronically ill, the Section 101(g) viatical exclusion never enters the analysis. Sellers who are terminally ill live under an entirely different — and far more generous — rule, covered in the viatical settlement tax exclusion guide.

Situation 1: Surrender — All Ordinary Income

Situation 1 confirmed what practitioners already understood about surrenders, and it supplies the baseline against which the sale scenarios are measured. When the policyholder surrenders for the $78,000 cash surrender value, having paid $64,000 in premiums, he recognizes $14,000 of income — and all of it is ordinary income.

The reasoning: a surrender is not a sale of property to anyone; it is the termination of a contract with the insurer, taxed under Section 72(e)’s rules for amounts received under an insurance contract. Those rules tax the excess of what is received over the “investment in the contract” (broadly, premiums paid less prior untaxed distributions), and the resulting income is ordinary because no sale or exchange of a capital asset ever occurs. No sale, no capital gain — the entire $14,000 lands at the taxpayer’s marginal rate.

Notice what did not reduce the calculation: the cost-of-insurance charges. In a surrender, the full $64,000 of premiums counted as investment in the contract, with no COI haircut. That asymmetry — full basis on surrender, reduced basis on sale — became the ruling’s most controversial feature, as the next section shows, and it is the piece the 2017 tax law repaired. Situation 1’s rule itself remains fully in force today: surrender gain is ordinary income, period. That permanent character difference is the heart of the settlement-versus-surrender tax comparison.

Situation 2: Sale of a Cash Value Policy — The Three Tiers Are Born

Situation 2 is the life settlement scenario, and it produced the framework the industry now takes for granted. The policyholder sells the policy for $80,000, having paid $64,000 in premiums, with a cash surrender value of $78,000. The IRS held that this is a sale of property, so capital gain treatment is available — but only partially.

First, basis. Here the original ruling took its infamous turn: it required the seller to reduce the $64,000 of premiums by the cumulative cost of insurance protection already consumed — stipulated at $10,000 — leaving an adjusted basis of $54,000 and a total gain of $26,000. (Hold that thought; the 2017 tax law erased this step.)

Second, character. The IRS invoked the “substitute for ordinary income” doctrine: the portion of the sale price representing the policy’s untaxed inside buildup — the amount that would have been ordinary income on surrender — cannot be laundered into capital gain by selling instead. In the ruling’s numbers, that inside buildup was $14,000 (CSV of $78,000 minus premiums of $64,000), taxed as ordinary income. The remaining $12,000 of gain was long-term capital gain.

The durable principle: sale proceeds split into tax-free basis, ordinary income up to the surrender-value gain, and capital gain above it. With TCJA’s basis fix applied, the modern arithmetic on those facts becomes even cleaner — $64,000 tax-free, $14,000 ordinary, $2,000 capital gain. The full modern mechanics are laid out in the three-tier treatment explainer.

Ruling Scenario	Transaction	Original 2009 Result	Result After TCJA Basis Fix
Situation 1	Surrender cash value policy ($78,000 CSV; $64,000 premiums)	$14,000 ordinary income	Unchanged: $14,000 ordinary income
Situation 2	Sell cash value policy for $80,000	Basis cut to $54,000 by COI; $14,000 ordinary + $12,000 capital gain	Full $64,000 basis; $14,000 ordinary + $2,000 capital gain
Situation 3	Sell term policy for $20,000 ($45,000 premiums)	Basis ≈ $250; $19,750 capital gain	Basis $45,000; no gain — entire $20,000 tax-free

Situation 3: Sale of a Term Policy — Nearly All Capital Gain

Situation 3 answered a question unique to the settlement market: how is the sale of a term policy taxed, when term insurance has no cash value at all? The stipulated facts: $45,000 of premiums paid on level-premium term coverage, and a sale to an investor for $20,000.

The original ruling reasoned that term premiums essentially purchase insurance protection that is consumed month by month, like rent. It therefore treated virtually the entire premium history as cost of insurance and assigned the policy a tiny basis — in the ruling’s numbers, just $250 of unearned premium — making $19,750 of the $20,000 price taxable. The good news was character: with no cash value, there is no inside buildup, no ordinary income tier, and the entire gain was long-term capital gain.

The Tax Cuts and Jobs Act transformed this situation more than any other. With no COI reduction allowed after TCJA, a term policy’s basis is simply premiums paid. On the ruling’s facts, $45,000 of basis against a $20,000 sale price produces no gain at all — the entire $20,000 is a tax-free recovery of capital. Many settled convertible term policies now generate little or no taxable income unless the sale price exceeds cumulative premiums, and when gain does exist it is capital gain. For the many seniors holding convertible term — a policy type that qualifies for settlement only while conversion rights last — this is among the most favorable corners of the entire tax framework, discussed further in capital gains tax on life settlements.

What TCJA Kept, Killed, and Added

The Tax Cuts and Jobs Act of 2017 performed surgery on Revenue Ruling 2009-13 without discarding it. Understanding the ruling today means knowing which parts survived.

Kept: the entire analytical skeleton. Surrenders still produce ordinary income (Situation 1). Sales still split into tax-free basis, an ordinary income tier capped at the surrender-value gain, and capital gain above it (Situation 2). Term sales still produce capital gain when gain exists (Situation 3). The substitute-for-ordinary-income doctrine still polices the boundary between the tiers.

Killed: the cost-of-insurance basis reduction. TCJA Section 13521 amended IRC Section 1016(a) to provide that no adjustment to basis is made for mortality, expense, or other reasonable charges under a life insurance or annuity contract — and made the fix retroactive to transactions entered into after August 25, 2009, the ruling’s original effective date. Sellers who had overpaid tax under the old computation could pursue refunds for open years.

Added: transparency. New Section 6050Y requires buyers to file Form 1099-LS (reporting the sale price) and carriers to file Form 1099-SB (reporting the seller’s investment in the contract), so both the seller and the IRS now receive the inputs for the tiered calculation. The full legislative story — motivation, mechanics, and planning consequences — is told in how the TCJA changed life settlement taxes.

What the Ruling Does Not Cover

Reading 2009-13 for more than it holds is a common error. Several boundaries deserve flags.

Viatical settlements. The ruling stipulates a healthy insured. Where the insured is terminally ill — certified life expectancy of 24 months or less — IRC Section 101(g) generally excludes settlement proceeds from income entirely when sold to a licensed viatical provider, and the three-tier machinery never engages. Chronically ill insureds have a narrower, use-limited version of the exclusion.

The buyer’s taxes. Investor-side treatment — how a purchased policy’s eventual death benefit or resale is taxed — belongs to companion Revenue Ruling 2009-14, which reached notably different conclusions, including that a purchased policy’s death benefit is not excludable under the transfer-for-value rules.

State income tax. Revenue rulings interpret federal law only. States are free to diverge, and New Jersey’s Gross Income Tax has its own conventions — a separate analysis covered in the NJ life settlement tax guide.

Regulatory protections. Nothing in the ruling addresses licensing, disclosure, or escrow — those live in state insurance law, framed nationally by the NAIC Life Settlements Model Act and enforced in New Jersey by the Department of Banking and Insurance. Tax treatment and consumer protection are parallel tracks, and a well-advised seller runs both.

Using the Ruling in Practice: A Seller’s Worked Example

Bring the ruling forward to a realistic modern transaction. A 79-year-old policyholder sells a $500,000 universal life policy for $135,000. Lifetime premiums total $88,000; she once took a $6,000 cash-value withdrawal; the cash surrender value at sale is $71,000; she is not terminally or chronically ill.

• Step 1 — basis: $88,000 of premiums minus the $6,000 previously received tax-free = $82,000. No cost-of-insurance reduction applies post-TCJA.
• Step 2 — total gain: $135,000 minus $82,000 = $53,000.
• Step 3 — ordinary income tier: CSV of $71,000 is below basis of $82,000, so there is no inside buildup above basis — the ordinary tier is $0.
• Step 4 — capital gain tier: the entire $53,000 is long-term capital gain, taxed at 0/15/20% rates.

Note how consequential the details are: because this policy’s surrender value sat below cumulative premiums — a common profile among settled universal life policies — Situation 2’s ordinary income tier vanished entirely, and the seller’s blended rate dropped accordingly. Her Forms 1099-LS and 1099-SB should tie to these numbers, and discrepancies in the carrier’s basis figure should be reconciled before filing.

The reliable takeaways: reconstruct premiums carefully (the methodology is in the cost basis guide), capture the CSV in writing at closing, and hand the whole file to a CPA — the ruling’s arithmetic is simple once the three inputs are documented, and expensive when they are not.

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Frequently Asked Questions

What does IRS Revenue Ruling 2009-13 actually say?

It establishes how policyholders are taxed when they dispose of a life insurance policy, using three scenarios. Surrendering a cash value policy produces ordinary income on the gain over premiums paid (Situation 1). Selling a cash value policy splits proceeds into tax-free basis recovery, ordinary income up to the cash-surrender-value gain, and capital gain above that (Situation 2). Selling a term policy produces capital gain (Situation 3). Its cost-of-insurance basis reduction was repealed retroactively by the 2017 Tax Cuts and Jobs Act.

Is Revenue Ruling 2009-13 still good law after the Tax Cuts and Jobs Act?

Yes, with one major amendment. The ruling’s analytical framework — ordinary income on surrenders, three-tier treatment on sales, capital gain character above cash surrender value — remains the governing guidance. What changed is basis: TCJA Section 13521 amended IRC Section 1016 so that basis is no longer reduced by cost-of-insurance or other charges, retroactive to transactions after August 25, 2009. TCJA also added Forms 1099-LS and 1099-SB reporting, so the ruling’s math now runs on documented numbers.

What is the difference between Revenue Ruling 2009-13 and 2009-14?

They are companion rulings covering opposite sides of the same transaction. Revenue Ruling 2009-13 governs the policy seller — the original policyholder — establishing the tiered tax treatment of settlement and surrender proceeds. Revenue Ruling 2009-14 governs the investor who buys the policy, addressing how the buyer is taxed when the insured dies or the policy is resold, including the transfer-for-value consequences that make a purchased policy’s death benefit taxable to the investor. Sellers only need to understand 2009-13.

Why is part of a life settlement taxed as ordinary income instead of capital gain?

Because of the substitute-for-ordinary-income doctrine the ruling applied. The policy’s inside buildup — the excess of cash surrender value over premiums paid — would have been ordinary income had the owner surrendered the policy under Section 72(e). The IRS held that selling the policy cannot convert that same accumulated, untaxed gain into capital gain. So the sale price is carved up: the inside-buildup slice keeps its ordinary character, and only the amount a buyer pays above cash surrender value earns capital gain treatment.

How is selling a term life insurance policy taxed under Revenue Ruling 2009-13?

Favorably, especially after the 2017 tax law. Term policies have no cash value, so there is no inside buildup and no ordinary income tier — any gain on sale is long-term capital gain. And since TCJA repealed the cost-of-insurance basis reduction, a term seller’s basis is simply total premiums paid. Because cumulative term premiums often exceed the sale price of a settled convertible term policy, many such sales now produce little or no taxable gain at all, making the entire payment a tax-free return of capital.

What numbers do I need to apply Revenue Ruling 2009-13 to my own policy sale?

Three inputs drive everything: your cost basis (total premiums paid, minus dividends received in cash and prior withdrawals — with no cost-of-insurance reduction under current law); the policy’s cash surrender value at the time of sale; and the gross sale price. Proceeds up to basis are tax-free, the slice from basis to cash surrender value is ordinary income, and the rest is long-term capital gain. Forms 1099-SB and 1099-LS now supply the carrier’s and buyer’s versions of these figures.

Does Revenue Ruling 2009-13 apply if the insured is terminally ill?

No — the ruling expressly assumes an insured with no terminal or chronic illness. When a physician certifies a life expectancy of 24 months or less, the sale is a viatical settlement, and IRC Section 101(g) generally excludes the entire proceeds from income when the buyer is a licensed viatical settlement provider, treating the payment like an advance death benefit. Chronically ill insureds have a narrower exclusion tied to long-term care use. The three-tier framework only governs sellers outside those categories.

Can I rely on a revenue ruling the way I would rely on the tax code?

For practical purposes, yes. A revenue ruling is the IRS’s official published position applying the law to stated facts, and taxpayers whose facts substantially match may rely on it; the IRS is bound to follow its own published rulings. It ranks below statutes and Treasury regulations, and Congress can override it — exactly what happened when TCJA reversed the ruling’s basis-reduction rule. Today the operative framework is the ruling as modified by statute, which is how any competent preparer will apply it.

Related Reading

• Life Settlement Tax Treatment Guide
• Tcja Impact Life Settlements
• Three Tier Tax Treatment Life Settlement
• 1099 Reporting Life Settlements

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Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.