Tony Ondrusek, Publisher

NAIFA (National Association of Insurance and Financial Advisors) sent out another alert recently outlining tax ramifications of life settlement transactions. Following is the text from that alert, along with NAIFA’s take on the subject:

Action Taken: On May 1, the Internal Revenue Service (IRS) issued two revenue rulings on the taxation of life settlement transactions. Revenue Ruling 2009-13 deals with the seller’s tax liability when he/she sells an insurance policy. Revenue Ruling 2009-14 addresses the tax consequences on the buyer of a life insurance policy that is part of a life settlement transaction.

Generally, the rulings find that tax liability can be ordinary income tax, capital gains tax, or a combination of both. How much tax liability is ordinary versus capital will depend on an analysis of the policy’s insurance/cost of insurance value, versus how much of the policy’s value is attributable to the policy values characterized as property held for profit. The rulings use variations of specific fact patterns to illustrate when tax liability will be under ordinary income tax rules, and when it will be under capital gains tax rules.

Both rulings are complex. Below is NAIFA’s initial analysis of them. NAIFA anticipates providing more detailed analysis after more fully digesting these complicated rulings.

Buyers of life insurance policies that are part of life settlement transactions, the rulings make clear, will have to pay ordinary income tax on death benefits payable from a term policy purchased as part of a life settlement transaction. Capital gains tax liability can arise when and if the buyer resells the term policy.

The revenue ruling addressing the buyer’s tax liability deals only with a 15-year level term life insurance policy. It examines tax implications when the policy’s buyer receives death benefits, or sales proceeds prior to the insured’s death. It also looks at whether the transaction involved a non-U.S. taxpayer (buyer).

Background: The Senate Special Committee on Aging asked Treasury Secretary Timothy Geithner to issue clarification of the tax consequences of life settlement transactions. These revenue rulings are in response to that request.

Rev Rul 2009-13—tax implications for sellers:  In this revenue ruling the IRS considered tax liability imposed on the owner/insured/seller of a life insurance policy. The ruling started with a fact pattern involving the complete surrender of a life insurance policy. A complete surrender results in ordinary income tax liability on the gain (the amount of surrender value paid that exceeds the amount paid by the policyholder (the cost basis) for the policy).

In the example considered by the IRS, there was a $14,000 ordinary income gain on a surrender payment of $78,000 and a cost basis of $64,000.

The revenue ruling also considers the policyholder’s tax liability if he/she sells the policy rather than surrenders it. Again assuming a $78,000 cash value amount and a $64,000 cost basis, the ruling looked at a situation involving an $80,000 sale price on a  permanent insurance policy. It also looked at the sale of a 15-year level term policy for $20,000, on which $45,000 in premiums had been paid.

The ruling goes through the relevant law (determination of cost basis, determination of the extent to which insurance protection was purchased and used during the time the policy was held by the insured, whether or not the policy was or could be a capital asset versus insurance protection (the cost of which is relevant to determination of basis), whether death benefits were paid or if instead the proceeds being analyzed were the result of a sale during the insured’s lifetime, etc.

The end result is that the sale of the permanent policy threw off a combination of gain on the life insurance element of the policy that is taxable as ordinary income ($14,000) and gain attributable to the property interest of the policy and thus characterized as capital gain ($12,000), and subject to capital gain tax. The sale of the term insurance policy resulted in $19,750 in capital gain subject to capital gains tax because there was no cash value to contribute to cost of insurance later in the policy’s life.

Rev Rul 2009-14–tax implications for buyers: This revenue ruling deals with the buyer’s tax liability. It considers the tax liability upon the buyer’s receipt of death benefits when the insured dies. It also looks at tax liability when the buyer receives sales proceeds after reselling the policy. The policy examined is a 15-year level term life insurance policy purchased by an unrelated (no insurable interest) party and then resold.

The ruling looks at three separate fact patterns—whether the buyer is domestic or international, whether the buyer received death benefits upon the death of the insured (the seller of the policy), and whether the buyer resold the policy to another buyer prior to the insured’s death. All the fact patterns assume continuous payment of premium, and sale of the policy by the insured mid-way through the 15-year term of the policy.

Under the facts assumed in the revenue ruling, the death benefit was $100,000; the purchase price (from the insured) was $20,000 and the purchase price by the second buyer was $30,000. The buyer had paid $9,000 in premium after purchasing the policy and prior to receiving death benefits and/or reselling the policy.

The revenue ruling finds that the sale by the insured to the buyer should be taxed under Internal Revenue Code section 101(a)(2), the transfer for value rules, which limit the amount of death benefit excludable from taxable income by reason of the insured’s death to an amount not in excess of the amount paid for the policy (in this case, $20,000) and amounts paid on the policy by the buyer (in this case, $9,000). Thus, the buyer who receives death benefits under these facts would have to pay tax on $71,000 ($100,000 death benefit minus $20,000 paid for the policy and $9,000 in premium paid by the buyer to keep the policy in force). The taxable gain is ordinary income, the ruling says, citing IRC sections that provide that neither surrender values nor death benefits are capital gains.

On the other hand, when the buyer of the policy resold it to a subsequent buyer, the life insurance policy became a capital asset, the ruling found, because the buyer bought it purely for profit-making reasons. Thus, its tax consequences were analyzed under capital gains tax rules. The result was the first buyer/reseller had a $1000 capital gain ($20,000 in original purchase price plus $9,000 in premiums paid subtracted from the $30,000 second purchase price), taxable under capital gains rules.

The analysis becomes more complex when/if a foreign (non-U.S.) buyer acquires the policy. But generally, gains from this policy (whether from sale/resale or from death benefits), which was sold by a U.S. citizen, will be viewed as gains from sources within the U.S. and thus subject to ordinary income tax (for death benefits paid, adjusted for basis), or capital gains tax (if it’s a resale situation).