People investigating the opportunity offered by a life insurance settlement want to sell their insurance policy so they can monetize it. Some believe that since the investment vehicle is a life insurance policy it is exempt from taxes. This belief stems from beneficiaries of life insurance that a relative named as a beneficiary on the policy does not pay taxes on the payment from the insurance company.
Life Settlement Sales are Taxable
The rules are different though when a company or individual owns a life insurance policy through a life insurance settlement. In 2009, The United States Internal Revenue Service issued rules on when the proceeds of a life settlement are taxable.
Thanks to the 2009 issuance of rules, life insurance settlements for federal income tax purposes are the same across the country. However, each state, at the state level, handles taxation differently. For this reason, it is important that you arrange a conference with a qualified tax advisor to find out the state tax implications of selling your life insurance policy.
Content presented here is for information only and no one should rely on it or make a decision based on it. Life Settlement sales are complicated financial transactions. Seek the advice of a qualified life settlement tax advisor or your own finance advisor before concluding a sale.
The ability to enter in a life settlement agreement has been legal for over 100 years. It was almost a well-guarded secret, as insurance companies would rather pay the insured the cash surrender value of his or her life insurance policy rather than the full face value to an owner not related to the insured. This is a financial decision by the companies. By being silent about life settlements, they encouraged people to either abandon their policies or cash it in for face value only. This is good for an insurance company’s bottom line.
However, during the 1980s, viatical settlements started to become popular. While a viatical settlement is very similar to a life settlement, the sales were from young, terminally ill patients who usually needed the money for health care and end of life care. As the viatical market matured so did the life settlement industry.
Since life settlement transactions were rare, the Internal Revenue Service had no written policies on how to tax them. This lack of direction from the IRS continued for nearly a decade, until May of 2009 when the IRS issued IRS revenue ruling 2009-13 – life settlement taxation guidelines.
IRS Ruling 2009-13
There are two buckets of cash that interest the IRS when a sale of a life settlement occurs. First are capital gains. Second is ordinary income.
Ordinary Income Taxes
The ordinary income portion of the transaction is the cash surrender value of a life insurance policy – it is what the seller receives when surrendering the policy.
Capital Gains Taxes
The amount a seller receives from the life settlement broker less the surrender value is a capital gain under most circumstances. Even if it is a capital gain, the tax rate is usually lower than if treated as ordinary income.
Settlement proceeds up to the total premiums paid beyond the cost of insurance (COI) required to keep the policy in force is the basis. That amount tax-free. Monies paid out over the basis are a capital gain and taxed.
Universal Life Insurance and Whole Life Insurance Policies
These classes of policies have more complicated tax requirements. According to the 209 ruling calculating the basis is the same for these policies as it is for term policies. Settlements up to the amount of the cash surrender value (CSV) less premium payments great than cost of insurance is ordinary income and taxed as such.
Finally, life settlement proceeds that exceed the CSV are capital gains and taxed as such. For Universal Life and Whole Life policies, the taxation is more complex. The revenue ruling says that settlement proceeds up to the total premiums paid over and above the cost of insurance (COI) needed to keep the policy in force is considered basis and is tax free (same as a term policy). Settlement proceeds up to the cash surrender value (CSV) minus premium payments exceeding COI is ordinary and subject to ordinary income tax. Lastly, settlement proceeds above the CSV are capital gain and taxed using the capital gain formula.
The federal government has one set of rules for life insurance settlement taxes that work all over the United States, each state handles life settlement taxation differently. The federal rules need to be followed carefully, as do each state’s regulations making it a good idea to hire an expert in life settlement taxation to advise you.