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.
IRS Revenue Ruling 2009-14 – The Buyer’s Taxes
In IRS Revenue Ruling 2009-14, officials describe the following examples:
1. A company pays $20,000 for an in-force U.S. life contract with a $100,000 death benefit. The company pays $9,000 in premiums to keep the policy in force. The insured dies.
2. A company pays $20,000 for an in-force U.S. life contract with a $100,000 death benefit and $9,000 in premiums to keep the policy in force. But the insured stays alive, and the company that bought the policy sells it to a second company.
3. Everything is the same as in the first example, but the buyer of the policy is a foreign corporation.
In the first example, officials write, the taxed amount is equal to the death benefit, minus the total value of premiums the company pays to keep the policy in force, minus the price paid to the insured. In the example given, the taxable amount would be $71,000 — $100,000, minus $9,000, minus $20,000.
The amount taxed would be treated as ordinary income, officials write.
The sum of the premiums paid and the amount paid to the insured — $29,000 in this case — would be the life settlement company’s adjusted basis.
In the second example, if the life settlement company that bought the policy had an adjusted basis of $29,000 and then sold the policy to another company for $30,000, it would have to recognize $1,000 in revenue — the difference between the adjusted basis and the resale price. The revenue would be taxed as a long-term capital gain, officials write.
In the third example, involving a foreign life settlement company buyer, the buyer would have to recognize $71,000 in taxable income, just as in the first situation, officials write.
The buyer would have to treat the income as ordinary income from sources within the United States, officials write.
The IRS holdings in the second and third sections of Revenue Ruling 2009-13 “will not be applied adversely to sales occurring before August 26, 2009,” officials write.
The principal authors of both rulings are Josephine Firehock and Stephen Hooe. Firehock works at the IRS on international issues. Hooe works on issues relating to financial institutions and products.
CORRECTION: An earlier version of this article incorrectly described the period when IRS officials will begin applying the revenue ruling adversely.