The
Internal Revenue Service has delivered two revenue rulings to help determine the tax hit on life settlements.
Revenue ruling 2009-13 provides guidance on the tax consequences for insured individuals who surrender their policies or sell them to the secondary market.
In a typical surrender, the client is taxed on the surrender value of a policy, minus the investment in the contract or premiums paid.
That difference is taxed as ordinary income.
If an individual decides to sell his or her policy to the secondary market, he or she will be taxed on the proceeds of the sales, minus the premiums paid, plus the cost of insurance charges.
The amount equal to the surrender value, minus the client’s investment in the contract, is considered ordinary income.
Anything left over is considered long-term capital gains.
In an example provided by the IRS, a client owns a policy with a surrender value of $78,000. That client sells the policy on the secondary market for $80,000.
Up to the time of the sale, the insured individual had paid $64,000 in premiums. The cash buildup, or the surrender value less the aggregate premiums, is $14,000.
In this situation, the client’s adjusted basis is $54,000 (the total premiums, minus the cost of insurance charges), and of that, he or she must recognize $26,000 — or the amount that the client received for selling the policy, subtracted by the adjusted basis of the contract.
Of that $26,000, the client must recognize the $14,000 in cash buildup — or the surrender value, minus the premiums paid — as ordinary income. The remaining $12,000 will be taxed as long-term capital gains.
In the event that a client sells a term policy without cash value, he or she will be taxed on the sales proceeds, minus the premiums paid, plus the cost of insurance charges.
In another example provided by the IRS, a client owns a 15-year term-life policy with a level premium of $500 a month with no cash value. By June 15 in the eighth year, after paying $45,000 in premiums, the client decides to sell the contract for $20,000 to an investor in the secondary market.
In this situation, the client’s adjusted basis equals the total premiums paid, minus the cost of insurance (the monthly premium multiplied by the number of months that the client held the contract): $45,000-$44,750=$250 on an adjusted basis.
The client will recognize $19,750 from the sale of the contract, which is the amount he or she received from the investor, minus the adjusted basis on the contract.
That $19,750 will be considered a long-term capital gain.
But the investor will also take a tax bite, according to revenue ruling 2009-14, which also came out last week.
Using the above situation with the 15-year-contract, say that the insured dies on Dec. 31 of the year in which he had sold the policy. By then, the investor had paid $9,000 in premiums, and he or she receives $100,000 in death benefits.
The $20,000 the investor paid to buy the contract and the $9,000 paid in premiums are excluded from that investor’s gross income. The client is taxed on the difference between the total death benefit he or she gets and the exclusions: $100,000-$29,000=$71,000.
That $71,000 is taxed as ordinary income.
But what if the client doesn’t die and the first investor sells the policy to a second investor for $30,000 at the end of the year?
In this case, the first investor must count the $20,000 he or she paid to the client, plus the $9,000 in premiums to calculate the adjusted basis, which comes out to $29,000.
In this case, the first investor must recognize $1,000 — or the amount received for the second sale of the policy, minus the adjusted basis — as capital gains.
