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Tax and Financial Information

Please be advised that Welcome Funds Inc. does not provide tax advice.

The taxation for a Life Settlement transaction can be very complicated. We will attempt to provide a general guideline that has been used in past transactions, however, we cannot stress enough that each case can be treated differently by the IRS and the taxation of a life Settlement may vary on a state by state basis.

The following is provided for informational purposes only. Advice from a professional tax advisor is recommended.


General Background:

Click here to access the official Internal Revenue Bulletin.

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).


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

  • 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 #2

  • 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

Example #3

  • 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

Please remember that these are general guidelines and cannot be relied upon as fact. The tax implications of a settlement should be considered prior to the transaction. We strongly recommend that a policy owner seek professional tax advice prior to accepting any offers.

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).

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*WFI's Services May Not Be Available In All States.

*The Texas Department of Insurance has not approved all the material contained on www.welcomefunds.com and
therefore, until such approval is granted, the information contained herein is not intended for Texas consumers.