What You Need to Know
- Revenue Ruling 2009-13 caused tax headaches for the policy sellers.
- The TCJA helped fix things.
- Rev. Ruling 2020-05 showed that the TCJA relief helps holders of term life policies, too.
The Tax Cuts and Job Act of 2017 (TCJA) made the income tax treatment of the sale of a life insurance policy in a life settlement more favorable to the seller.
A recent revenue ruling issued by the IRS, Rev. Rul. 2020-05, confirmed the TCJA’s more favorable tax treatment and clarified the tax basis of term insurance.
An issue that has been long debated in the life insurance community is whether a term insurance policy can have a tax basis. The revenue ruling clearly says that it does — the cumulative premiums paid.
Here is the background on how we got here, as well as a complete explanation of the tax treatment of life settlements. In 2017, after more than eight years, the IRS’s poorly reasoned and unworkable ruling on the taxation of life settlements to policy sellers was retroactively overturned by the 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.
For no fathomable reason, the 2009 ruling put the seller in a life settlement transaction in a less favorable tax position than someone who surrendered a policy to the insurer. Thanks to the TCJA that’s no longer the case. The act 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 was made retroactive to 2009.