The new tax law, the Tax Cuts and Job Act of 2017 (TCJA), contains two provisions that provide a boost to life settlements, which should spur added growth of the life settlement market. First, the law makes the tax treatment of a life settlement to the seller more favorable and, second, the increased estate tax exemption could make some policies, which were purchased for estate tax purposes, unnecessary and, therefore, candidates for a life settlement.
It took more than eight years, but the IRS’s poorly reasoned and unworkable ruling on the taxation of life settlements to policy sellers has been retroactively overturned by TCJA.
When Revenue Ruling 2009-13 was published in 2009, the IRS created a distinction in the tax basis between policies that are surrendered and policies that are sold in a life settlement. For policies that are surrendered at a gain, the law has long been that the policy owner’s basis is their cumulative investment in the contract, which is basically the cumulative premiums paid less withdrawals and dividends taken from the policy. But for purposes of a life settlement, the IRS ruled that the basis would have to be reduced by the cumulative cost of insurance charges assessed against the policy.
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For no fathomable reason, the ruling put the seller in a life settlement transaction in a less favorable tax position than someone who surrendered a policy to the insurer – but that’s no longer the case! The new tax law provides that policyholders who sell their policy in a life settlement transaction are not required to reduce their basis by the cumulative cost of insurance charges. So their tax basis is now the same as a policyholder who surrenders their policy to the insurance company. And importantly, the change is retroactive to 2009.
TCJA returns the tax treatment of a life settlement to what it had been widely believed to be prior to the ruling. In brief, a policyholder who sells a policy in a life settlement is generally taxed in three tiers as follows:
1. Amounts received up to the tax basis are received free of income tax,