The Internal Revenue Service has posted three samples of what it thinks the new federal life insurance policy sale tax rules will do to the affected taxpayers’ taxable income.
The scenarios imply that the new tax rules could lead to big cuts in taxable income for many policyholders who sell policies to life settlement companies.
When the life settlement companies sell policies to investors, their own taxable income may stay about the same.
IRS officials published the life insurance policy sale tax scenarios Monday, in Revenue Ruling 2020-05.
- A copy of IRS Revenue Ruling 2020-05 is available here.
- An article about the new Tax Cuts and Jobs Act life settlement transaction reporting regulations is available here.
- An article about IRS Revenue Ruling 2009-13 and IRS Revenue Ruling 2009-14 is available here.
The IRS created the samples to show taxpayers how it’s interpreting Section 13521 of the Tax Cuts and Jobs Act of 2017 (TCJA).
The Old Rules
Life settlement companies have been buying life insurance policies from consumers for decades. The companies keep some policies in their own investment portfolios and sell other policies to other individuals or companies.
The IRS shook up the life settlement market in 2009, when it issued Revenue Ruling 2009-13 and Revenue Ruling 2009-14.
Revenue Ruling 2009-13 showed how the IRS thought the tax rules should apply to taxpayers that sold life insurance policies.
Revenue Ruling 2009-14 showed how the agency thought the rules should apply to the policy buyers.
Here’s the formula the IRS came up with in 2009, for the consumer selling a policy:
Taxable income from a policy sale = The policy’s sale price – The policy’s adjusted basis
The IRS defined a policy’s “adjusted basis” this way:
Adjusted basis = Total premiums paid – The cost-of-insurance portion of the premiums
Issuers of universal life and other forms of permanent life insurance break out the cost of insurance separately.
For term life, the IRS that assumed that the cost of insurance was the same as the premiums.
In 2009, the IRS showed an example of a consumer who had paid $64,000 in premiums for a permanent life insurance policy, and sold it for $80,000. The cost of insurance was $10,000.
Here’s how the IRS calculated the consumer’s taxable income from the policy sale:
Taxable income = $80,000 – ($64,000 – $10,000) = $26,000
The IRS also showed an example featuring a taxpayer who had paid $45,000 in premiums, or $500 per month, for a term life policy. The taxpayer sold the term life policy for $20,000, halfway through a month.
Here’s how the IRS calculated the consumer’s taxable income from the term life policy sale:
Taxable income = $20,000 – ($45,000 – $44,750) = $19,750
When the IRS developed rules for the life settlement companies, and for other companies in the business of buying and selling policies, it did not make the life settlement companies subtract the cost of insurance amounts from their premium payment total.
For a business selling a policy,
Taxable income = The policy’s sale price – Total premiums paid
The IRS provided the following scenario featuring a business that paid $20,000 for a consumer’s policy, paid $9,000 in premiums to keep the policy in force, and then sold the policy to another company for $30,000.
Taxable income = $30,000 – ($20,000 + $9,000) = $1,000
Life settlement brokers and life settlement companies said Revenue Ruling 2009-13 was hard on consumers, partly because it increased consumers’ tax bills, but partly because many consumers had no practical way to figure out what part of the premiums paid went toward the cost of insurance.
TCJA Section 13521
TCJA Section 13521 has eliminated the need for consumers who sell life insurance policies to include the cost of insurance in the taxable income calculations.
Now, when consumers sell policies, they can simply calculate the taxable income by subtracting the total amount of premiums paid from the policy sale price.
TCJA Section 13521 reversed the 2009 IRS rulings by changing Section 1016(a) of the Internal Revenue Code (IRC).
TCJA Section 13521 refers to life insurance policies, but it does not use the term “life settlement,” or any synonym for life settlement. That means it could end up applying to policy sales that are not life settlements.
Similarly, the authors of Revenue Ruling 2020-05 have written about policy sales without using phrases such as “life settlement” or “life settlement provider.” The ruling could apply to other types of deals in which one party acquires the right to collect a life insurance policy’s death benefits from another party.
The New Revenue Ruling
IRS officials have re-used some of the policy sale scenarios used in the 2009 revenue rulings.
Here’s how they calculated the taxable income for the consumer who sold the permanent life policy, under the new, TCJA rules:
Taxable income = Policy sale price – Total premiums paid = $80,000 – $64,000 = $16,000
In this new scenario, the seller’s taxable income from the policy sale is about 38% lower than in the 2009 version.
Here how officials calculated the taxable income for the consumer who sold the term life policy:
Taxable income = Policy sale price – Total premiums paid = $20,000 – $45,000 = a $25,000 loss
Officials noted that the consumer can recognize the $25,000 loss on the sale, but that the consumer cannot actually deduct the loss from taxable income, unless the consumer is in the business of buying and selling life insurance policies.
For an ordinary consumer, in this scenario, taxable income from the policy sale would go to $0, from $19,750 in the 2009 revenue ruling scenario.
For a business that buys and sells life insurance policies, the formula for calculating taxable income from policy sales will stay the same, because a business could already leave cost-of-insurance amounts out of the calculations under the 2009 rules, IRS officials say.
If a business paid $20,000 for a consumer’s policy, paid $9,000 in premiums to keep the policy in force, and then sold the policy to another company for $30,000, its taxable income from the policy sale would still be $1,000, officials say.
Nuts and Bolts
The IRS lists Megan McGuire, of the IRS Office of the Associate Chief Counsel, as the principal author of the new revenue ruling.
The ruling applies to transactions entered into on or after Aug. 26, 2009.
IRS officials are warning consumers who have sold life insurance policies in the past against trying to collect federal income tax refunds based on the new revenue ruling.
Taxpayers still face time limits on when they can ask for income tax refunds, IRS officials write in the new ruling.
Congress sometimes eases the time limits on when taxpayers can ask for refunds. For life insurance policy sellers, Congress did not do that, IRS officials say.
— Read Life Settlement Players Struggle With Tax Form Void, on ThinkAdvisor.