2018 Life & Viatical Settlement Taxation Guide

The taxation of life settlement proceeds should be considered when deciding to sell your life insurance for a cash settlement. Although the IRS has refused to provide clarification for many questions presented by the life insurance settlement industry, there have been specific revenue rulings passed to give some guidelines on how life settlement taxation & viatical settlement taxation should be determined. It is important to note the tax of the proceeds of a viatical settlement (where the insured is terminally or chronically ill with a life expectancy of two years or less) is different and proceeds are often considered exempt from tax. This guide will discuss the revenue rulings pertaining to viatical/life settlements.

Tax Cuts and Jobs Act 2017 – Section 13522:

Within the Tax Cuts and Jobs Act of 2017, section 13522 (Clarification of Tax Basis of Life Insurance Contracts) outlines a fundamental change in the way the cost basis is determined when a life insurance policy is sold through a life insurance settlement. This section provides clarification to adjustments that can be made to the amount received by a seller through a life settlement transaction and determines that no modifications should be prepared for “for mortality, expense, or other reasonable charges incurred under an annuity or life insurance contract.”

Previously where the cost of insurance has been deducted from the total amount of premium paid to determine the cost basis, this deduction is no longer needed. This is a benefit for anyone who sells their life insurance because the cost basis will remain higher, lowering their potential tax burden.

Comparing the following examples to those above reflecting the previous IRS treatment of life settlement proceeds, it is apparent the new tax reform benefits policy owners who sell their life insurance. Most notable is the decrease in tax liability for the seller of term life insurance, where the cumulative premiums paid can now be treated as the cost basis.

1. Where a policy owner surrenders their life insurance for the surrender value.

Example: Policy Owner A surrenders his whole life insurance policy for $50,000 & has paid $34,000 of premiums. The amount of proceeds that will be treated as ordinary income is $50,000 – $34,000 = $16,000.

2. Where a policy owner sells their whole life insurance policy through a settlement.

Example: Policy Owner A decides to sell his whole life insurance policy for $80,000, has paid $34,000 of premiums and the CSV from the carrier is $50,000. The amount of taxable proceeds is $80,000 – $34,000 = $46,000. Taxable proceeds that will be treated as ordinary income is $50,000 – $34,000 = $16,000. The remaining taxable proceeds will be treated as capital gains; $46,000 – $16,000 = $30,000.

3. Where a policy owner sells their term life insurance policy through a settlement.

Example: Policy Owner B decided to sell his term life insurance policy for $25,000 and paid $16,000 of premiums over the past 15 years. The amount of proceeds that will be treated as capital gains is $25,000 – $16,000 = $9,000.

Revenue Ruling 2009-13

The IRS explains the tax consequences of three scenarios in this revenue ruling:

1. Where a policy owner surrenders their life insurance for the surrender value.

2. Where a policy owner sells their whole life insurance policy through a settlement.

3. Where a policy owner sells their term life insurance policy through a settlement.

When a policy owner surrenders their life insurance, the Cash Surrender Value (CSV) is paid to them by the insurance carrier. The CSV is determined by taking the policy account value and subtracting the surrender charge. The surrender charge is an amount that decreases every policy year until it reaches zero (typically the surrender charge reaches zero after 14 years). Within the policy, there is a surrender charge table that shows how much of a surrender charge there is each policy year. Due to the potential surrender charge and policy performance, there is sometimes zero CSV, in which case the policy owner will receive nothing for surrendering the policy. Considering a situation where there is CSV the insurance carrier will pay the policy owner the CSV amount when the policy is surrendered. The policy owner must then find the cost basis (amount of premiums paid over the life of the policy) and deduct this from the CSV in order to determine the taxable amount. Revenue Ruling 2009-13 states the cost basis deducted from the CSV will be treated as ordinary income for tax purposes.

Example: Policy Owner A surrenders his whole life insurance policy for $50,000 & has paid $34,000 of premiums. The amount of proceeds that will be treated as ordinary income is $50,000 – $34,000 = $16,000.

When a policy owner sells their whole life insurance, they will typically receive a cash settlement from a buyer. This cash settlement must be a higher value than the CSV available from the insurance carrier. Determining the policy owner cost basis in the policy for this type of transaction involves determining the number of premiums paid over the life of the policy and deducting the amount used to cover the Cost of Insurance (COI). The cost basis is, therefore, less (and amount of proceeds subject to taxation higher) than in the first scenario since the COI is deducted from the total amount of premiums paid. Ruling 2009-13 determines that the amount of gain that would have been recognized as ordinary income through the first scenario (above) would still be considered as ordinary income, and the remaining proceeds amount above the cost basis would be taxed as capital gains.

Example: Policy Owner A decides to sell his whole life policy for $80,000, has paid $34,000 of premiums, $14,000 of premium paid has been used to cover COI, and the CSV from the carrier is $50,000. The cost basis is $20,000; determined by deducting $14,000 from the $34,000. The amount of taxable proceeds is $80,000 – $20,000 = $60,000. Taxable proceeds that will be treated as ordinary income is $50,000 – $34,000 = $16,000. The remaining taxable proceeds will be treated as capital gains; $60,000 – $16,000 = $44,000.

When a policy owner sells their term life insurance, almost all, if not all, proceeds are taxable. Since all premiums paid for a term life insurance policy can be considered the actual COI, these premiums may not be included in the cost basis. However, if a policy owner has paid a premium that will carry the policy past the date of ownership & beneficiary change confirmation (when the life insurance settlement is considered complete), this pre-paid premium amount can be treated as cost basis and deducted from proceeds. Since there is no ordinary income element to this type of transaction, Revenue Ruling 2009-13 concludes the number of proceeds minus the limited cost basis will be treated as capital gains.

Example: Policy Owner B decides to sell his term life policy for $25,000 and paid a full annual premium of $500 six months ago. Since the premium payment will cover the policy for another six months, the cost basis is half of the annual premium paid; $250. The amount of proceeds that will be treated as capital gains is $25,000 – $500 = $24,500.