Issue No. 127, February 16, 2023

A Refresher On The Taxation Of Life Settlements

It’s tax season and so we thought now would be a good time to review the tax consequences to the seller of a Policy in a life settlement transaction.

The Tax Cuts and Job Act of 2017 (TCJA) and Rev. Rul. 2020-05 confirmed rather favorable income tax treatment to the seller of a life insurance policy. The tax on a life settlement transaction is calculated using three tiers as follows:

1. Amounts received up to the tax basis are received free of income tax,
2. Amounts received in excess of the tax basis up to the amount of the cash surrender value are taxed at ordinary income rates, and
3. Amounts received in excess of the cash value get favorable capital gains treatment.

Here is an example of how the three-tiered approach works. A hypothetical policy with a Tax Basis of $50,000 and a cash surrender value of $60,000 is sold for $100,000.

1. The first $50,000 is received tax-free as return of basis.
2. The next $10,000, which is gain attributable to the cash value, is taxed at ordinary income rates
3. Finally, the next $40,000, which is gain attributable to the life settlement, is taxed at capital gain rates.

As a practical matter, given the extended period of low interest rates and that many policies sold in a life settlement have little or no cash surrender value and are near lapse, we rarely see policies that have cash surrender values that exceed Basis. So policies which are sold for an amount exceeding their basis are usually taxed, almost always, at capital gain rates. The proceeds from policies sold for less than their tax basis, which is also very common, are not taxed at all.

In order to calculate the tax using the three-tiered system, it is fundamentally important to know the policy’s tax basis. The way to determine the tax basis of a life insurance policy has been clarified. For most policies, the tax basis is cumulative premiums less any surrenders, withdrawals or dividends taken in cash. Term premiums paid on the policy are included in the computation of cumulative premiums as well. This is significant because term policies that are convertible to universal life represent some of the best life settlement prospects, and being able to included term premiums in the basis reduces any tax consequences.

Note, if a policy is sold, surrendered or lapsed at a loss, there is a long-standing tax principle that the loss is not deductible for tax purposes unless the policy was bought for profit rather than protection.

For each transaction, the policyholder usually gets two 1099s:

• 1099-LS, from the company that bought the policy which shows the amount of proceeds that the client received.
• 1099-SB, from the insurance company that shows the basis in the policy at the time of the ownership transfer. Note, however, it’s been our experience that the basis reported frequently fails to include the term premiums paid for policies which were previously converted from term or were converted as part of the life settlement transaction. Therefore, it’s up to the policyholder to make an adjustment when reporting their basis to the IRS.

Some situations are more complex than the basic example given here, so it is recommended that clients should always be advised to consult their own tax advisor.

Finally, to make estimating the tax implications easier for all parties involved, we have prepared a worksheet which shows how to do the calculations. Click here to request a copy.

Understanding the tax ramifications of a life settlement transaction, as well as being able to explain them, enhances your value as a trusted advisor and builds loyalty with your clients and their advisors.

Robin S. Weinberger, CLU, ChFC, CLTC

(617) 451-3343

Peter N. Katz, JD, CLU, ChFC, RICP^®

 (860) 937-2936

Ria J. Johnson, CFP^®

(619) 920-4000

Rob Haynie

(954) 599-4433

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