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Feature: Tax experts mull Revenue rulings on settlements

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The Internal Revenue Services’ recent ruling on life settlement taxation was in some respects disappointing to the industry but not a surprise, participants agreed during a recent web conference on the rulings.

The gist of Revenue Ruling 2009-13 is that investors in life settlements can include the cost of buying the insurance in the tax basis but that a seller of a policy can’t deduct the cost of insurance and premiums for tax purposes.

The IRS also held in Revenue Ruling 2009-14 that investors would be taxed on the proceeds of death benefits they receive as ordinary income rather than capital gains. If the buyer resells the policy, however, any profit is capital gain.

Furthermore, Ruling 2009-14 makes clear that international investors who buy policies will be subject to U.S. withholding taxes of 30% on any death benefit proceeds, unless the fund is based in a country that has a tax treaty with the United States.

The IRS rulings actually are not new positions but mirror stances the IRS had taken in a 2004 private letter ruling and confirmed in 2005, speakers noted at the May 14 conference, held by Life Settlement Solutions Inc., San Diego, Calif.

Luc Moritz, tax partner, O’Melveny & Myers L.L.P, Los Angeles, said the rulings seem to create a dichotomy between the profits earned from surrendering a policy and those earned from selling it. Generally, the difference for the seller between the price he or she can get from a settlement versus any gain from a surrender of the policy needs to be large for a sales transaction to be worthwhile on an after-tax basis, he said.

Kirk Van Brunt, a tax partner with Locke, Lord, Bissell & Liddell L.L.P., Washington, said that Rev. Rul. 2009-13 favors insurance carriers by making sale of a policy less favorable from a tax viewpoint than surrendering a policy for its cash value.

“I think insurers were pushing for this,” Van Brunt said.

Life Settlement Solutions’ chief executive Larry Simon, who moderated the web session, commented that the advent of life settlements presented a clear benefit to consumers in that they had an opportunity to receive two or more times their policies’ surrender value.

“This ruling strongly favors insurance companies,” he said. “It pays little attention to the rights of consumers.”

Van Brunt agreed, calling it “weird” that the IRS provided for a different tax result from a surrender than it did from selling a policy.

On the other hand, Rev. Rul. 2009-14 has some good results for the life settlement side, so the IRS may have been trying to appease both sides, Van Brunt added. The ruling holds that capital gain treatment is possible if the holding period of one year were satisfied, he said, noting that capital gain treatment provides lower tax rates than for ordinary income.

It is not entirely clear that there was a sound legal basis for the IRS decision to reduce the tax basis of a life settlement by the cost of insurance, Van Brunt said. On that point, he said, “If there’s a taxpayer willing to take on the IRS, there’d be a fair amount of support from the life settlement industry.”

The IRS ruling leaves it up to the policy holder to figure out what the cost of insurance charges are and to compute the tax basis, and that can be difficult, Van Brunt added. For universal life policies, he noted, the carrier reports the COI charges to the policyholder, who thus can tabulate the tax basis before selling the policy. For policies other than UL, however, it’s not clear how cooperative insurers would be in reporting the COI.

“For non-UL policies, the cost of insurance is almost impossible to calculate,” Van Brunt said. “It’s very likely the policyholder has no real data on what the COIs are. He’s going to be stuck with making a best guess. It’s a case of a rule that gives no practical way to follow it.”

Pete Ritter, a tax partner with O’Melveny & Myers pointed out that the rules take effect August 26, 2009 and won’t apply to life settlements concluded before then for taxpayers who claimed a full tax basis for premiums paid.

This suggests that insureds thinking of selling may want to sell before that date. Moreover, those buying policies through premium finance programs using nonrecourse loans may be wise to unwind the loan before that date, Ritter said.

Ruling 2009-14 appears to have its primary impact on foreign investors who have acquired life insurance policies from Americans and expect to receive the death benefits, speakers observed.

“The rule effectively forces them to structure themselves to eliminate the U.S. withholding tax,” Moritz said. “They can’t simply organize themselves in Cayman Island or wherever and elect to receive death benefits without having to pay income taxes. Now they have to be careful about withholding.”


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