What is the Tax Treatment of a Life Settlement Transaction?

Please be advised that Welcome Funds Inc. does not provide life settlement tax advice. The following is provided for educational purposes only and is not intended to be used in an advisory capacity.

Please remember that these are general guidelines based on the Tax Cuts and Jobs Act of 2017 (TCJA) and IRS Revenue Rulings 2020-05 and 2009-13, and should not be relied upon as tax advice. The tax implications of a life insurance settlement should be considered prior to the sale of the life insurance policy. We strongly recommend that a policy owner seek professional tax advice prior to accepting any life settlement offer.

The taxation of a life settlement transaction was simplified with the implementation of the TCJA. Below we provide a general outline and examples for informational purposes only. Examples 1 and 2 are illustrative examples prepared by Welcome Funds; Example 3 is taken from Revenue Ruling 2020-05.

Life Settlement Taxation Background

In May 2009, the IRS released Revenue Ruling 2009-13, which provides guidance related to the sale of a life insurance policy. In December 2017, Congress passed the TCJA and the President signed it into law. In February 2020, the IRS released Revenue Ruling 2020-05, which modified portions of Revenue Ruling 2009-13 to reflect the TCJA. Under the TCJA, a policy owner's cost basis is no longer reduced by the cost of insurance charges incurred under the policy, making the basis used for a life settlement consistent with the basis used for the surrender of a life insurance policy.

Revenue Ruling 2020-05 applies to transactions entered into on or after August 26, 2009. Sellers who reported an earlier sale under the prior rules should consult a tax professional, as the ruling notes that the normal time limits for claiming a refund still apply.

Viewed in tandem, IRS Revenue Rulings 2009-13 and 2020-05 outline and define the method for determining both the taxable capital gain component and the ordinary income component, if any. By citing specific examples, the IRS provides guidance related to the basis of the life insurance contract and the application of the "substitute for ordinary income" doctrine. This important doctrine limits the amount that would be recognized as ordinary income to the amount that would be recognized if the contract were surrendered (i.e., the inside build-up under the contract). Hence, if the income recognized on the sale or exchange of a life insurance contract exceeds the inside build-up under the contract, the excess may qualify as gain from the sale or exchange of a capital asset.(1)

(1) See e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n. 3 (4th Cir. 1960).

Click here to access the official Internal Revenue Bulletin (2009-13).

Click here to access the official Internal Revenue Bulletin (2020-05).

Glossary

• Cost Basis (Investment in the Contract) = Total premiums paid into the policy, less any amounts previously received tax-free (for example, policy dividends taken in cash or withdrawals). This figure is reported on Form 1099-SB as "Investment in contract."  Form 1099-SB reports the insurance carrier's estimate of the seller's investment in the contract. The seller's actual adjusted tax basis may differ, particularly if the policy was previously transferred, acquired from another owner, or affected by prior distributions. Policy owners should have their tax professional verify this amount against available policy and premium records.
• CSV (Cash Surrender Value / Surrender Amount) = The amount the policy owner would have received from the insurance carrier if the policy had been surrendered on the date of sale. This figure is reported on Form 1099-SB as "Surrender amount."
• Settlement Amount = Purchase price paid to the policy owner/seller for the sale of the policy.  The amount reported on a seller's Form 1099-LS may differ from the total purchase price of the policy when payments are made separately to other transaction participants. Sellers should provide their tax professional with the final settlement statement, including any broker fees, policy loan balances, and other closing expenses, to determine the correct amount realized and taxable gain.
• Inside Build-Up = CSV minus Cost Basis (if the result is $0 or less, use $0). This is the maximum portion of the gain that can be taxed as ordinary income.

Example #1 | A Life Settlement that Generates a Long-Term Capital Gain

Illustrative example prepared by Welcome Funds.

Based on the IRS guidelines, if a term life insurance policy with no cash value is sold, 100% of the gain (the settlement amount in excess of the premiums paid) should be treated as a capital gain. The premiums paid are returned tax-free as cost basis.

• Term Policy, Death Benefit of $500,000
• Individual sells policy for a Settlement Amount of $70,000
• Premiums paid into policy of $15,000
• Policy held for longer than 1 year by current policy owner

Step 1: Computation of Total Taxable Gain (or Loss):

• $70,000 (Settlement Amount) less $15,000 (Cost Basis) = $55,000 (Total Taxable Gain)

Step 2: Computation of Ordinary Income Component (Inside Build-Up):

• $0 (CSV) less $15,000 (Cost Basis) = -$15,000, so use $0 (Ordinary Income Component). Note: if the result is $0 or less than $0, use $0.

Step 3: Computation of Capital Gain Component:

• $55,000 (Step 1) less $0 (Step 2) = $55,000 (at Long-Term Capital Gain Tax Rate)

Result: $55,000 is the total taxable gain. Of the $70,000 Settlement Amount, $15,000 is a tax-free return of cost basis. This example has no ordinary income component, and the full $55,000 is taxed at the policy owner's applicable long-term capital gain tax rate.

Example #2 | A Life Settlement Generates an Ordinary Income Tax Obligation and a Long-Term Capital Gain

Illustrative example prepared by Welcome Funds.

Cash Surrender Value is Higher than Premiums Paid.

• Universal Life Policy, Death Benefit of $1,000,000
• Individual sells policy for a Settlement Amount of $90,000
• Premiums paid into policy of $64,000
• Cash Surrender Value = $70,000
• Policy held for longer than 1 year by current policy owner

Step 1: Computation of Total Taxable Gain (or Loss):

• $90,000 (Settlement Amount) less $64,000 (Cost Basis) = $26,000 (Total Taxable Gain)

Step 2: Computation of Ordinary Income Component (Inside Build-Up):

• $70,000 (CSV) less $64,000 (Cost Basis) = $6,000 (Ordinary Income Component)

Step 3: Computation of Capital Gain Component:

• $26,000 (Step 1) less $6,000 (Step 2) = $20,000 (at Long-Term Capital Gain Tax Rate)

Result: $26,000 is the total taxable gain. Of the $90,000 Settlement Amount, $64,000 is a tax-free return of cost basis. Of the $26,000 gain, $6,000 is taxed at the policy owner's ordinary income tax rate, and the balance of $20,000 is taxed at the policy owner's applicable long-term capital gain tax rate.

Example #3 | A Life Settlement that Generates a Long-Term Capital Loss

(see IRS Revenue Ruling 2020-05, Situation 3 under Holdings Section #2)

• Level Term Policy, Death Benefit of $100,000
• Individual sells policy for a Settlement Amount of $20,000
• Premiums paid into policy of $45,000
• Cash Surrender Value = No Cash Value in a Term Policy
• Policy held for longer than 1 year by current policy owner

Step 1: Computation of Total Taxable Gain (or Loss):

• $20,000 (Settlement Amount) less $45,000 (Cost Basis) = -$25,000

Step 2: Computation of Ordinary Income Component (Inside Build-Up):

• $0 (CSV) less $45,000 (Cost Basis) = -$45,000, so use $0 (Ordinary Income Component)

Step 3: Computation of Capital Gain Component:

• -$25,000 (Step 1) less $0 (Step 2) = -$25,000 (a Long-Term Capital Loss)

Result: This example is taken from IRS Revenue Ruling 2020-05. The Settlement Amount is less than the cost basis and there is no cash surrender value. In Revenue Ruling 2020-05, it states in the "Holdings" section number 2 that the policy owner ("A") recognizes a long-term capital loss of $25,000 upon the sale of the life insurance contract.

Important: Although Revenue Ruling 2020-05 characterizes this as a long-term capital loss, the ruling also states that the policy owner will not be permitted to deduct the loss unless it is incurred in a trade or business or in a transaction entered into for profit (IRC Section 165(c)(1) or (2)). For most individuals who purchased a policy for personal insurance protection, this loss cannot be deducted and cannot be used to offset other gains.

Other Factors That Can Affect the Tax Treatment

Depending on the seller's circumstances, state income taxes and the additional 3.8% federal Net Investment Income Tax may also apply to taxable proceeds. A tax professional should evaluate these potential taxes when estimating the seller's total tax liability.

Viatical Settlements (Terminally or Chronically Ill Insureds)

The examples above assume the insured is not terminally or chronically ill. Under IRC Section 101(g), proceeds from the sale of a policy insuring a terminally ill individual (generally, someone certified by a physician as having an illness or condition reasonably expected to result in death within 24 months) may be excluded from federal income tax when the policy is sold to a licensed viatical settlement provider. Proceeds for a chronically ill insured may also be excluded, subject to additional conditions, including limits tied to qualified long-term care costs. These exclusions generally do not apply to a business that owns a policy on an officer, director, employee or person with a financial interest in that business. A tax professional should confirm eligibility before the sale.

Policies Held One Year or Less

The examples above assume the policy was held for more than one year by the current policy owner. If the policy was held for one year or less, any capital gain is short-term and is taxed at the policy owner's ordinary income tax rates.

Policy Loans

The examples above assume there is no outstanding policy loan. If a policy has an outstanding loan that is repaid or extinguished as part of the sale, the loan balance is generally treated as part of the amount the seller receives, which can increase the taxable gain even though the seller did not receive that amount in cash. Sellers with an outstanding policy loan should review the calculation with a tax professional.

Life Settlements Tax Reporting

The Tax Cuts and Jobs Act of 2017 created the framework and additional tax reporting requirements for all reportable policy sales covered under section 6050Y. In late 2019, the IRS finalized the reporting forms and processes for those involved in these transactions. The 1099-LS and the 1099-SB were created and adopted for use in order to address the requirements needed for the calculation of all taxable or non-taxable transactions for both policy sellers AND the IRS.

1099-LS – Form 1099-LS is generally required for a reportable policy sale under Internal Revenue Code Section 6050Y, subject to certain exceptions. The purchaser (acquirer), or an authorized reporting party acting on its behalf, is generally responsible for issuing a separate Form 1099-LS to each reportable payment recipient. Payment recipients can include the policy seller and certain intermediaries.

There are multiple copies of this form:

1. Copy A – will be sent to the IRS
2. Copy B – will be sent to the Payment Recipient
3. Copy C – will be sent to the Insurance Carrier that Issued the Policy (the amount paid to the payment recipient is optional on this copy)
4. Copy D – will be retained by the Acquirer of the Policy for its own reporting records

Items contained on the 1099-LS:

1. Acquirer's Name, street address, city or town, state or province, country, ZIP, or foreign postal code, and telephone no.
2. Acquirer's TIN
3. Payment Recipient's TIN/SS#
4. Payment Recipient's Name, address, city, state, zip, country
5. Policy Number of the policy that was sold
6. Amount paid to payment recipient (Settlement Amount)
7. Date of sale
8. Insurer's name
9. Acquirer's information contact name, street address, city or town, state or province, country, zip or foreign postal code, and telephone no. (if different from ACQUIRER)

1099-SB – The IRS mandated that upon the receipt of the Copy C of the 1099-LS by the Life Insurance Carrier, the Life Insurance Carrier must prepare and send this form to the Policy Owner of record that existed on the policy before the change of ownership was completed. Additionally, Life Insurance Carriers must provide a phone number for the previous policy owner to call with any questions. This is a requirement for every reportable policy sale under section 6050Y(a) when a 1099-LS is received:

There are multiple copies of this form:

1. Copy A – will be sent to the IRS
2. Copy B – will be sent to the Seller (Policy Owner prior to the policy's transfer)
3. Copy C – will be retained by the Insurance Carrier for its own reporting records

Items contained on the 1099-SB:

1. ISSUER's Name, street address, city or town, state or province, country, ZIP, or foreign postal code, and telephone no.
2. ISSUER's TIN
3. SELLER's TIN (This is the previous owner of record's TIN or SS#)
4. Seller's name, street address, city or town, state or province, country, ZIP, or foreign postal code
5. Policy Number (of the policy that was sold)
6. Investment in contract (see IRS instructions for the definition – generally, total premiums and other consideration paid for the contract, less amounts previously received tax-free, and the calculation of the figure placed here)
7. Surrender Amount (see IRS instructions for definition – In general, the surrender amount is the amount the seller would have received from the issuer responsible for administering the life insurance contract if the seller had surrendered the life insurance contract to the issuer on the date of the reportable policy sale or the transfer of the contract to a foreign person)
8. Issuer's information contact name, street address, city or town, state or province, country, zip or foreign postal code, and telephone no. (if different from ISSUER)

Welcome Funds is a life settlement broker representing the Policy Owner (Seller) on these types of transactions. Welcome Funds does not issue 1099's. The issuance and delivery of the 1099-LS is the responsibility of the Provider/Fund/Escrow Agent (buyer side) and the 1099-SB is the responsibility of the Life Insurance Carrier that Issued or is currently administering the Policy. Forms 1099-LS and 1099-SB are generally required to be furnished to the appropriate recipients by February 15 of the year following the life settlement transaction, subject to applicable IRS exceptions and deadline adjustments.

If a policy owner does not receive Form 1099-LS after the applicable deadline, Welcome Funds can assist by requesting a copy from the buyer's reporting representative. If Form 1099-SB has not been received, the seller should contact the life insurance carrier directly to request the form.