New Rulings on Taxation of Life Settlements

Posted by Bob Burton on Tue, May 12, 2009 @ 01:51 PM

The final morning of the AALU meeting featured a “What’s Hot, What’s Not” presentation by two of the industry’s leading experts, Steve Leimberg and Larry Brody, who discussed three important subjects.  We will highlight these subjects in this and the next two posts.

Taxation of Life Settlements

Ever since the advent of life settlements, the tax consequences to the seller and to the purchaser have been the subject of conjecture, and while most agreed as to what those tax consequences were likely to be, there was never any authority for those conclusions.  We now have two IRS Revenue Rulings to guide us.

The first ruling, Rev. Rul. 2009-13, deals with the tax consequences to the seller (i.e., our client).  In most respects, it confirms what most had surmised would be the result, i.e., that gain over basis up to cash value would be taxed as ordinary income (the same as if the policy had been surrendered) and any gain above that amount would be taxed as capital gain.  The only surprise was the definition of “basis”, which, on a sale of the policy as distinguished from a surrender, is stated to be premiums paid minus the internal “cost of insurance” charges.  This adjustment to basis, however, serves only to increase the capital gain portion of the profit, not the ordinary income portion, which remains the same as if the policy had been surrendered.  While this basis adjustment increases somewhat the tax consequences of a life settlement, as long as the federal long-term capital gains tax rate remains at 15%, the additional tax will be relatively nominal.  Incidentally, the ruling also states that, if a term policy is sold, there is no basis other than unearned premium.

The second ruling, Rev. Rul. 2009-14, deals with the tax consequences to the buyer.  While this is not really of concern to us, here are the results in a nutshell:  (1) The buyer’s basis in the policy is the purchase price paid plus premiums subsequently paid.  (2) If the buyer re-sells the policy, the gain is capital gain.  (3) If the buyer collects the death proceeds, the gain is ordinary income.

Certainty in the tax law always stimulates interest in the underlying subject matter.  These rulings, therefore, can be expected to add even more life to the recovering life settlement marketplace.  Be sure to take advantage of this renewed interest.