Tax uncertainties for life settlements: 5+ troublesome issues

It’s tax time again, which means yet another year has passed without clarity for life settlement transactions.

In Revenue Ruling 2009-13, issued in May of 2009, the IRS attempted to clarify the tax treatment for consumers who sell a policy in a life settlement, but their questionable interpretation of the Internal Revenue Code raised as many questions as it answered. Unfortunately, neither the IRS nor Congress has seen fit to address those issues.

On the plus side, the ruling confirmed that for sellers other than investors, gain up to cash surrender value is ordinary income, but the gain in excess of cash surrender value is treated as capital gain. However, the ruling drew an illogical and artificial distinction between policies that are sold and policies that are surrendered; and it changed the way basis is determined for policies that are sold. Indeed, the IRS apparently believes the Internal Revenue Code intended that seniors who surrender their policy to an insurance company deserve better tax treatment than those who sell their policy in a life settlement transaction!

The basis for a policy that is surrendered is the cumulative premiums (less withdrawals, surrenders or dividends taken in cash). The IRS ruled, however, that the basis for a policy sold by a policy owner (other than by a life settlement investor) is further reduced by cumulative cost of insurance (COI) charges. This distinction, read into the tax code by the IRS, is troublesome for a variety of reasons:

• There has never been any need or requirement for insurers to keep track of these charges. As a result, the cumulative cost of insurance charges are frequently unavailable. What’s a seller to do?

• Unlike universal life, whole life policies work differently and there are no explicit cost of insurance charges for whole life.

• What about a policy that has been 1035 exchanged? Would the seller have to obtain COI charges from not only the current company, but also one or more prior companies?

• Subtracting the COI charges from the cumulative premiums could produce a negative number. Is it possible for a policy to have a negative basis?

• Finally, why should a senior who sells a policy be in a potentially worse tax position than one who surrenders a policy? What purpose does such tax policy serve?

Although, generally, the additional proceeds of a life settlement should more than offset the additional taxes, there are situations where it will not. In those situations, the ruling has created a lose/lose situation. The seller loses by getting less for a policy; and the government loses tax revenue because the policy is surrendered, rather than sold for a higher amount, which would usually generate additional tax.

A hidden danger of the revenue ruling: It could also apply to non-life settlement transfers or sales (e.g., a business that sells or bonuses a policy to a key employee at retirement). Under the IRS’s artificial distinction between sale and surrender, such a transaction, because it is not a surrender, could require the business to recognize significant additional taxable income.

Since we have to live with these rules for now, clients should be instructed to request the cumulative COI charges from the insurance company (assuming it has them) before closing the life settlement transaction. They should not wait until afterwards because the insurer may be unwilling to deal with them once they are no longer listed as the owner of the policy.

Although the increased value brought by a life settlement will usually more than offset the tax consequences, there are situations where it will not. Among them: those involving older policies that only sell for a small premium over the surrender value.

Knowing the COI charges will help the client estimate the tax consequences of the transaction. (We have a created a worksheet for this that is available upon request.)

Another murky situation is a retained death benefit, which providers are offering as an alternative to a cash-only life settlement. These transactions allow the policy owner to retain some portion of the death benefit, free of additional cost, as part of the selling price in lieu of some or all cash, while the buyer is responsible to pay all future premiums to maintain the policy. Unfortunately, from a tax standpoint, this feature only compounds the ambiguities facing life settlement transactions.

In addition to the previously discussed tax questions, there has been no guidance on how to determine the value to the seller, for tax purposes, of the retained death benefit the buyer is paying for. While the transaction clearly has tax implications to the seller, there are many theories under which the retained death benefit can be taxed.

Some theories, like split-dollar or annuity-type treatment, would cause the client to incur ongoing taxable income. Other theories could add significantly to the value of the sales proceeds for tax purposes by capitalizing the value of the death proceeds to be received in the future.