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Taxation of Life Settlements

The life settlement market isn’t what it used to be but it’s not dead. We have negotiated a couple of life settlement transactions lately, so I have been reviewing IRS Revenue Rulings pertaining to gain. It’s been almost three years since the IRS provided guidance so I thought this would be a good time for a refresher.

Before these Rulings, the prevailing wisdom was that taxation on the proceeds from a sale of a policy would be non-taxable up to the basis, ordinary income from the basis to the cash value, and capital gains over and above cash value. In other words, if a policy owner with a $1,000,000 contract had paid a $10,000 premium for 20 years and the cash value was $300,000 and the settlement offer was $400,000, the spread between the $200,000 basis and the $300,000 cash value would be taxed at ordinary rates and the spread between the $300,000 cash value and the $400,000 offer would be taxed at capital gains rates. With term insurance, most advisors planned on capital gains taxes on the spread between the offer and cumulative premiums.

The bottom line is that anything considered ordinary income on the surrender of a policy would be ordinary income on the sale of a policy with any additional gain being taxed at capital gain rates.

A pair of Revenue Rulings was issued In May of 2009 and provides additional guidance for taxpayers. For individual policy owners, Revenue Ruling 2009-13 reiterates that life insurance is a capital asset for tax purposes but that the surrender of a policy results in ordinary income, not capital gain.

The example provided is a personal policy with a total of $64,000 paid in premiums and a current cash value of $78,000. $10,000 has been utilized for all costs of insurance coverage. Upon surrender, the amount of gain, which will be taxed at ordinary rates, is the spread between the cash value and the basis. $78,000 – $64,000 = $14,000.

When it comes to the sale of a policy, they provide the following example. Assuming the same policy is sold for $80,000, they now reduce basis by the cost of insurance to calculate the gain. $80,000 – $54,000 = $26,000. The IRS takes the position that a portion of premiums paid represents personal consumption of the insurance protection and only the remainder of premiums paid are considered basis.

One inherent problem is that the IRS position requires policy owners who sell to third parties to acquire the cumulative cost of insurance from the company to file tax returns. That may be difficult.

Regarding ordinary versus capital gain, the IRS indicates that the $14,000 ordinary gain under a surrender will still be $14,000 of ordinary gain in a sale and the additional $12,000 will be capital gain.

With term policies, the IRS indicates that the basis is limited to the amount of any unearned premiums, absent other proof. In other words, in most term transactions, almost all of the settlement proceeds will be deemed to be capital gain.

While some of this does not ring true to my notion of common sense, none-the-less, this is the prevailing guideline which does give us a more solid framework on which we can advise clients.

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This material is for informational purposes only and should not be considered tax or legal advice. Any person needed tax or legal assistance should contact their respective advisors.

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