Life Settlement Taxes and 1099s

What You Need to Know

The Tax Cuts and Jobs Act of 2017 created the framework.
Regulation Ruling 2020-05 fleshed out the rules.
A typical transaction may lead to some cash being received free of income tax, some subject to ordinary income rates and some to capital gains treatment.

It’s tax season, so we thought now would be a good time to review the tax consequences to the seller of a policy in a life settlement transaction.

The Tax Cuts and Job Act of 2017 and Revenue Ruling 2020-05 confirmed rather favorable income tax treatment for the seller of a life insurance policy.

The tax on a life settlement transaction is calculated using three tiers, as follows:

Amounts received up to the tax basis are received free of income tax,
Amounts received in excess of the tax basis up to the amount of the cash surrender value are taxed at ordinary income rates, and
Amounts received in excess of the cash value get favorable capital gains treatment.

Here is an example of how the three-tiered approach works.

A hypothetical policy with a tax basis of $50,000 and a cash surrender value of $60,000 is sold for $100,000.

The first $50,000 is received tax-free as return of basis.
The next $10,000, which is gain attributable to the cash value, is taxed at ordinary income rates.
Finally, the next $40,000, which is gain attributable to the life settlement, is taxed at capital gain rates.

As a practical matter, given the extended period of low interest rates and that many policies sold in a life settlement have little or no cash surrender value and are near lapse, we rarely see policies that have cash surrender values that exceed basis.

So policies which are sold for an amount exceeding their basis are usually taxed — almost always at capital gain rates.

The proceeds from policies sold for less than their tax basis, which is also very common, are not taxed at all.

The Tax Basis

In order to calculate the tax using the three-tiered system, it is fundamentally important to know the policy’s tax basis.

The way to determine the tax basis of a life insurance policy has been clarified.

For most policies, the tax basis is cumulative premiums less any surrenders, withdrawals or dividends taken in cash.

Term premiums paid on the policy are included in the computation of cumulative premiums as well.

This is significant because term policies that are convertible to universal life represent some of the best life settlement prospects, and being able to include term premiums in the basis reduces any tax consequences.

Note: If a policy is sold, surrendered or lapsed at a loss, there is a long-standing tax principle that the loss is not deductible for tax purposes, unless the policy was bought for profit rather than protection.