Life Settlements Taxation Controversy

Posted by Bob Burton on Tue, May 26, 2009 @ 12:59 PM

This is an important follow-up to my “post-AALU” post on the Taxation of Life Settlements. Additional posts on the other subjects covered by Larry Brody and Steve Leimberg will follow in a few days.

More on the Taxation of Life Settlements

Since my prior post, many professional commentators have expressed their opinions regarding the most important (and unfortunately adverse) holding in Rev. Rul. 2009-13: the required adjustment to basis that must be made when a policyowner sells a policy under a life settlement transaction, namely, that the “cost of insurance” charges must be subtracted from premiums paid. Since these “cost of insurance” charges have already been subtracted internally in determining the policy’s cash value, this appears to be the equivalent of a double subtraction of the same amounts, especially since the policy’s cash value is an important determinant of the purchase price a purchaser is willing to pay, because it directly affects the future premium payments required to maintain the policy.

Many commentators agree, then, that this is a very controversial holding, and I personally believe it might well be successfully challenged in court. However, I do not think any of us would encourage any of our own clients to be the guinea pig who challenges the IRS … unless, of course, a large amount of money is at stake, which might be the case if long-term capital gain rates are increased in the future. Even now, if the policy being sold is a rated policy, the actual “cost of insurance” charges will be significantly higher, meaning (if actual charges are the correct method of calculating “cost of insurance” for this purpose) a larger amount will need to be subtracted in determining adjusted basis, leading to a larger amount being subject to tax as a capital gain.

RIGHT NOW, HOWEVER, PERHAPS THE MOST IMPORTANT MESSAGE TO KEEP IN MIND IS AS FOLLOWS: THIS HOLDING WILL NOT BE APPLIED ADVERSELY TO SALES OCCURRING BEFORE AUGUST 26, 2009. THIS MEANS THAT, IF YOU HAVE ANY CLIENTS WHOSE POLICIES COULD POTENTIALLY BE CANDIDATES FOR A LIFE SETTLEMENT TRANSACTION, RIGHT NOW IS THE TIME TO ACT. SINCE THESE TRANSACTIONS DO NOT COME TO FRUITION OVERNIGHT, THE TIME HORIZON TO START THE BALL ROLLING IS VERY SHORT INDEED.

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