Assume Ellen owns a cash value life policy on which she has paid $64,000 in premiums over 10 years. She has never taken out withdrawals or loans, and the cash value is now $78,000. She decides to surrender the policy, pocket the $78,000, and include $14,000 on her tax return as ordinary income.
The taxes are no surprise, as the law in this area has been well settled for years.
But let’s say Ellen decides to sell her policy to a life settlement company instead. A variety of theories have been advanced for how such a transaction should be taxed, but finally, the Internal Revenue Service has provided some guidance. This is Revenue Ruling 2009-13. It outlines the tax consequences to those selling their policies, beginning with the simple surrender of a permanent, cash value life policy as described above.
In Situation 1, the IRS confirms that the seller (A) must recognize $14,000 of ordinary income, the amount by which the cash value exceeds “investment in the contract.”
Situation 2 uses the same policy but adds the following facts:
o Instead of surrendering the policy for $78,000, A sells it to B for $80,000.
o B is described as “a person unrelated to A and who would suffer no economic loss upon A’s death”–a description that certainly fits a life settlement company.
o The actual cost of insurance protection over the years has totaled $10,000.
This time the IRS analyzes the transaction as “the sale or other disposition of property” rather than as “amounts not received as annuities,” and talks about “adjusted cost basis” rather than “investment in the contract.”
o A’s basis in the contract must be adjusted to reflect the hypothetical $10,000 cost of insurance. Thus, A’s adjusted cost basis drops from $64,000 to $54,000.
o The total gain is $26,000 ($80,000 sale price minus adjusted basis of $54,000). This has two elements: 1) The amount of gain ($14,000) that would have been ordinary income had the policy been surrendered is ordinary income; and 2) The balance of the gain ($12,000) is treated as capital gain.
So, when Ellen sells her policy to the settlement company she gets $2,000 more than if she had surrendered it. However, in addition to the $14,000 of ordinary income tax, she also has $12,000 of capital gains tax. Federal (and possibly state) long-term capital gains taxes may offset the additional gain from the sale, especially considering the intangible costs of the settlement transaction.
Of course, in the real world, the policy will be much larger and the spread between cash surrender value and settlement value may be much wider. But this example points out the need to analyze thoroughly the tax consequences of both approaches before committing to the settlement transaction.
Now let’s say Ellen owns another policy she no longer needs–a 15-year level term policy with a $500 monthly premium, on which she has paid a total of $45,000 in premiums as of June 15, 2008. She can surrender it and collect $250 of unearned premium, or she can sell the policy to a settlement company for $20,000.
This is Situation 3 in the Ruling. The IRS assumes, “absent other proof,” that the cost of insurance exactly equals the monthly premium, and reduces Ellen’s adjusted cost basis in the contract by $44,750 ($500 times 89.5 months) to $250 ($45,000 minus $44,750). $250 is subtracted from the $20,000 sale price, and the resulting gain of $19,750 is treated as long-term capital gain.
Bottom line: Ellen nets a lot more money than under the surrender scenario, but because of the basis adjustment, she must pay capital gains taxes on the lion’s share of the sale proceeds.
Revenue Ruling 2009-13 does raise some questions, such as:
1. In the case of a “bundled” permanent policy or a level term policy, how is the “cost of insurance” to be determined?
2. Would the Ruling apply if the buyer, although not a settlement company, is “unrelated to A and would suffer no economic loss upon A’s death?” What if the transaction is exempt from the transfer for value rule because of a partnership relationship?
3. If the seller must reduce cost basis by the cost of insurance when selling to a settlement company, is it also true that the seller can use the entire investment in the contract when selling to a related party who does have an insurable interest in the seller?
Those questions aside, agents and their clients would do well to attend to the application of this Ruling both to settlement transactions as well as to transactions that have nothing to do with settlements.
Peter M. Weinbaum, JD, CLU, ChFC, is vice president-advanced business and estate planning with National Life Group, Montpelier, Vt. His email address is email@example.com