Life settlement taxation explained

Life settlement taxation hadn't been covered by the IRS because the industry is so new. Even though the life settlement industry has been around since the late 1990's, the IRS didn't give clear direction on how the proceeds from a life settlement should be taxed. There were some generally accepted practices among tax professionals that seemed to be the de facto rule, but the Internal Revenue Service was conspicuously silent. That has changed. The recent ruling still has some scratching their heads.

Previously, tax professionals handled life settlement taxation by focusing on a cost basis based on the aggregate premiums paid. This amount of the life settlement proceeds was then treated as tax free. From the aggregate premiums paid up to the cash value was usually treated as ordinary income, while the amount in excess of the cash value was treated as capital gains.

IRS Revenue Ruling 2009-13 on May 1, 2009 finally gave clear guidance on life settlement taxation. No doubt in part because of the preceding Senate hearings on aging in which the IRS and SEC were asked to review their treatment of life settlements. The IRS ruling affects all life settlement transactions completed on or after August 29, 2009.

As a result the IRS did something that has raised more questions than answers. First the IRS differentiated between surrendering a policy back to an insurer and selling a policy to a 3rd party. When surrendering a policy, the aggregate premiums are treated as the cost basis and that entire amount of the life settlement proceeds are not taxable.

However, when a policy is sold in a life settlement, the aggregate premiums do not receive the same tax free treatment. Life settlement taxation adds the twist of "cost of insurance". Essentially, the amount of premium required to keep a policy in force is considered the cost of insurance. Since a consumer is getting something for this amount i.e. insurance, and not going towards buying an investment it is not considered tax free. Only the amount of premiums paid above the cost of insurance are tax free in a life settlement. Why selling (surrendering) a policy back to an insurance company and selling one to a 3rd party are treated differently, most experts can not explain. Nonetheless, the IRS has decided they are two different acts requiring two different types of taxation.

From there, the life settlement taxation is very similar to the standard practice of most accountants before the ruling. The amount up to the cash value is treated as ordinary income, while the amount above the cash value is considered a capital gain.

One distinction that was made by the IRS also seemed confusing to many. That is life settlement taxation of term policies is now slightly different from permanent insurance. All premiums paid in term policies are considered cost of insurance and therefore no term policy premiums may be treated as tax free. The reasoning is that since term policies do not build up cash value the premiums are solely going towards cost of insurance.

Does the new life settlement taxation guidelines mean life settlements are not a good means of handling one's assets? No, because life settlements still offer liquidity and typically much higher payments than other options. However, those thinking of selling their life insurance policies should be aware of their overall financial picture in order to make the best financial decisions.