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LIFE SETTLEMENT
IRS TAX TREATMENT
The IRS has provided guidance on the tax treatment of viatical and life settlement transactions. Below is a summary of IRS Revenue Ruling 2009-13 which provides guidance to policyholders who surrender or sell their life insurance policies.

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 IRS Revenue Ruling 2009-13 and cannot be relied upon as fact. 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 offers.

The taxation for a life settlement transaction is complicated and varies based on the type of life insurance contract that is sold (term vs. cash value life insurance). Below we will provide a general outline and some examples to use as a reference for informational purposes only.



General Background:

In May 2009, the IRS released Revenue Ruling (2009-13), which provides guidance related to the sale of a life insurance policy. In Revenue Ruling (2009-13), the IRS outlines and defines the method for determining both the capital gain component and the ordinary income component, if any. By citing specific examples, the IRS also provides guidance related to the adjusted basis of the life insurance contract. The IRS also provides guidance related to the substitute for ordinary income doctrine. This important doctrine limits the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to 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)

Click here to access the official Internal Revenue Bulletin.



IRS Circular 230 Disclosure:

To ensure compliance with requirements imposed by the IRS, we inform you that any information contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.

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



Glossary:

CSV = Cash Surrender Value

Cost Basis = Total dollar amount of premiums paid into the policy less annual cost of insurance

Settlement Amount = Purchase price paid to policy owner/seller for the sale of the policy



EXAMPLE # 1 | LIFE SETTLEMENT ON A TERM LIFE INSURANCE POLICY

Based on the IRS Guidelines, if a term life insurance policy is sold, then 100% of the life settlement proceeds should be treated as a capital gain.
  • Term Policy, Death Benefit of $500,000
  • Individual sells policy for a settlement amount of $70,000
  • Premiums paid into policy of $15,000
  • Cost of insurance = $14,500 (excludes current period premiums)
Step 1: Computation of Adjusted Basis:
  • Based on the above example, the adjusted basis is $500 (premiums paid of $15,000 less $14,500 cost of insurance).
Step 2: Computation of overall tax liability:
  • The Settlement Amount ($70,000) less adjusted cost basis ($500) = $69,500
Step 3: Computation of Ordinary vs. Capital Income:
  1. Ordinary Income = limited to inside build-up or = $0 (paid premiums of $15,000 -> CSV = $0);
  2. Capital Gain = Remaining portion or $69,500


If a cash value product is sold, then there are additional calculations and due diligence that must be determined in order to properly calculate the portion of the proceeds that may be treated as ordinary income vs. long term capital gain. The complexity of this calculation lies in the fact that it is difficult to determine the historical cost of insurance charges and life insurance carriers do not typically provide that information for multiple years. If the annual statements have been maintained by the policy owner, then the calculation may be available.



Example #2 | THE SALE OF A CASH VALUE LIFE INSURANCE POLICY

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
  • Cost of insurance = $20,000
  • Cash Surrender Value = $70,000
Step 1: Computation of Adjusted Basis:
  • Based on the above example, the adjusted basis is $44,000 (premiums paid of $64,000 less $20,000 cost of insurance).
Step 2: Computation of overall tax liability:
  • The Settlement Amount ($90,000) less adjusted cost basis ($44,000) = $46,000
Step 3: Computation of Ordinary vs. Capital Income:
  1. Ordinary Income = limited to inside build-up or = $6,000 (paid premiums of $64,000 -> CSV = $70,000);
  2. Capital Gain = Remaining portion or $40,000 (total gain of $46,000 less $6,000 ordinary income)


Example #3 | THE SALE OF A CASH VALUE LIFE INSURANCE POLICY

CASH SURRENDER VALUE IS LOWER THAN PREMIUMS PAID
  • Universal Policy, Death Benefit of $2,000,000
  • Individual sells policy for a settlement amount of $300,000
  • Premiums paid into policy of $250,000
  • Cost of insurance = $225,000
  • Cash Surrender Value = $0
Step 1: Computation of Adjusted Basis:
  • Based on the above example, the adjusted basis is $25,000 (premiums paid of $250,000 less $225,000 cost of insurance).
Step 2: Computation of overall tax liability:
  • The Settlement Amount ($300,000) less adjusted cost basis ($25,000) = $275,000
Step 3: Computation of Ordinary vs. Capital Income:
  1. Ordinary Income = limited to inside build-up or = $0 (paid premiums of $250,000 -> CSV = $0);
  2. Capital Gain = Remaining portion or $275,000