Life Settlement Tax Issues After IRS Ruling 2009-13

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 protected]