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 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 was simplified with the implementation of the TCJA. Below we will provide a general outline and the examples that were used in the Revenue Rulings to use as a reference for informational purposes only.

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, the Federal Government passed the TCJA and the President signed it into law. Lastly, in January 2020, the IRS released Revenue Ruling (2020-05), which modified portions of Revenue Ruling 2009-13 to make the taxation of a Life Settlement transaction consistent with the surrender of a life insurance policy.

Viewed in tandem, the 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. The IRS and 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) .(1)

Click here to access the official Internal Revenue Bulletin (2009-13).
Click here to access the official Internal Revenue Bulletin (2020-05).

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

Example #1 | Life Settlement on a Policy that generates a Long-Term Capital Gain

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
• Policy held for longer than 1 year by current policy owner

Step 1: Computation of Overall Tax Liability:

• $70,000 (Settlement Amount) less $15,000 (Cost Basis) = $55,000 (Overall Tax Liability).

Step 2: Computation of Ordinary Income Tax Component:

• $0 (CSV) - $15,000 (Cost Basis) = $0 (Ordinary Income Tax Component aka limited inside build - up). Note, if result is $0 or less than $0 then use $0

Step 3: Computation of Capital Gain Tax Component:

• $55,000 (Step1) – $0.00 (Step 2) = $55,000 (at Long Term Capital Gain Tax Rate)

Result: $55,000 used to determine the total tax liability. This example has no ordinary income tax component and the full amount is taxed at the policy owner’s appropriate long-term capital gain tax rate.

Example#2 | Life Settlement on a Policy that generates an Ordinary Income Tax Obligation and a Long Term Capital Gain Tax

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 Overall Tax Liability:

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

Step 2: Computation of Ordinary Income Tax Component:

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

Step 3: Computation of Capital Gain Tax Component:

• $26,000 (Step1) – $6,000 (Step 2) = $20,000 (at Capital Gain Tax Rate)

Result: $26,000 used to determine the total tax liability. This example has $6,000 that would be used to calculate the ordinary tax component and then the balance of $20,000 is used to calculate the tax owed at the appropriate long-term capital gains tax rate for the Policy Owner.

Example #3 | Life Settlement on a Policy 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 Overall Tax Liability:

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

Step 2: Computation of Ordinary Income Tax Component: 

• $0 (CSV) - $45,000 (Cost Basis) = $0 (at Ordinary Income Tax Rate)

Step 3: Computation of Capital Gain Tax Component:

• -$25,000 (Step1) – $0 (Step 2) = -$25,000 (a Long Term Capital Loss)

Result: This example is taken from the 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 settlement contract.

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.

• 1.

  1099-LS – The IRS mandated that at least one be filed for every reportable policy sale under section 6050Y (covers all Life Settlement Transactions):

• a. There are multiple copies of this form

• i. Copy A – will be sent to the IRS

• ii. Copy B – will be sent to the Payment Recipient

• iii. Copy C – will be sent to the Insurance Carrier that Issued the Policy

• iv. Copy D – will be sent to the Acquirer of the Policy

• b. Items contained on the 1099-LS

• i. Acquirer’s Name, street address, city or town, state or province, country, ZIP, or foreign postal code, and telephone no.

• ii. Acquirer’s TIN

• iii. Payment Recipient’s TIN/SS#

• iv. Payment Recipient’s Name, address, city, state, zip, country

• v. Policy Number of the policy that was sold

• vi Amount paid to payment recipient (Settlement Amount)

• vii. Date of sale

• viii. Insurer’s name

• ix. Acquirer’s information, contact name, street address, city or town, state or providence, country, zip or foreign postal code, and telephone no. (if different from ACQUIRER)

• 2.

  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:

• a. There are multiple copies of this form

• i. Copy A – will be sent to the IRS

• ii. Copy B – will be sent to the Seller (Policy Owner prior to the policy’s transfer)

• iii. Copy C – will be sent to the Insurance Carrier that Issued the Policy

• b. Items contained on the 1099-SB

• i. ISSUER’s Name, street address, city or town, state or province, country, ZIP, or foreign postal code, and telephone no.

• ii. ISSUER’s TIN

• iii. SELLER’s TIN (This is the previous owner of record’s TIN or SS#)

• iv. Seller’s name, street address, city or town, state or province, country, ZIP, or foreign postal code

• v. Policy Number (of the policy that was sold)

• vi. Investment in contract (see IRS instructions for definition Total Premiums Paid and other consideration paid for the contract and the calculation of the figure placed here)

• vii. 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)

• viii. Issuer’s information contact name, street address, city or town, state or providence, 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. If a 1099-LS was not received by the 2nd week of February of each year after the sale, then Welcome Funds can request a copy of such form from the buyer’s side. If a 1099-SB is not received in the same timeframe, then the Policy Owner (Seller) must contact the Life Insurance Carrier directly and ask that the Life Insurance Carrier’s accounting department complete and resend the form directly to the Policy Owner (Seller). Welcome Funds and the buyer’s side are unable to obtain a copy of the 1099-SB.