The Internal Revenue Service has come out with two batches of advice discussing how buyers and sellers of in-force life policies should treat the transactions.
IRS Revenue Ruling 2009-13 discusses the tax implications for insureds who sell policies.
IRS Revenue Ruling 2009-14 discusses the tax implications for companies or others that buy policies and receive the benefits when the insureds die.
IRS Revenue Ruling 2009-13 – The Seller’s Taxes
In Revenue Ruling 2009-13, officials describe three examples, involving:
1. A policyholder who is also the insured. The policyholder surrenders a policy from a U.S. insurer in policy year 8. The policy has a cash surrender value of $78,000.
2. A policyholder who sells a similar policy in policy year year 8.
3. A policyholder who sells a policy with no cash value in policy year 8.
In the first example, if the policy’s cash surrender value is greater than the total amount of premiums paid, then the difference between the cash surrender value and the total premiums paid will be taxed as ordinary income, officials write.
The rules are different in the second situation, which involves the sale of the policy, officials write.
In that case, the basis, or original cost of the property, is equal to the total amount of premiums paid. The taxpayer then adjusts the basis by subtracting the amount of premiums paid to cover the underlying cost of insurance that was in effect before the policy was sold. In the second situation, the policy has a cash surrender value of $78,000, and the policyholder has paid $64,000 in premiums before selling the policy. The insurer itself says $10,000 of the premiums paid covered the cost of insurance, officials write.
In the second example, the policyholder’s adjusted basis would be $54,000 — $64,000 minus $10,000, officials write.
If a life settlement company pays $80,000 for the policy, the policyholder must pay taxes on an amount equal to the sale price minus the adjusted basis, officials write. In the example given, the amount would be $26,000 — $80,000 minus $54,000.
The difference between the policy’s cash surrender value and the total amount of premiums paid — in this case, $78,000 minus $64,000, or $14,000 — would be taxed as ordinary income. The difference between $26,000 and $14,000 — $12,000 — would be taxed as a long-term capital gain, officials write.
In the third example, involving a term life contract, the policyholder would pay taxes on most of the life settlement proceeds, and the proceeds would be treated as long-term capital gains, officials write.