Final answer:
The cost basis of a cash-value life insurance policy is exempt from taxation upon surrender. Any amount over the cost basis is taxable as income. The correct answer is that the policy's cost basis is exempt from taxation (D).
Step-by-step explanation:
When a cash-value life insurance policy is surrendered, the cost recovery rule dictates how the received funds are taxed. According to this rule, the policyholder's cost basis in the policy is exempt from taxation upon surrender. Any amount received over the cost basis, specifically the gains represented by the part of the cash value that exceeds the amount of premiums paid, is subject to income taxation. The correct answer to the question is D) The policy's cost basis is exempt from taxation.
To clarify, the cost basis is the total amount of premiums that have been paid into the policy. Therefore, during the surrender of a life insurance policy, one can receive their cost basis back without incurring taxes. However, if it turns out that the policy's accumulated cash value is higher than the cost basis, the excess is considered taxable income by the IRS.