A life settlement involves the cash sale of a life insurance policy to a non-related third-party, or investor. The sale provides a cash payment for the seller, while the investor collects the death benefit payout upon the death of the original owner, or seller. Special considerations affect the tax treatment of life settlement investments due to the combined insurance-investment aspects of the transaction.
Life Settlement Investments
With the ongoing advances in medical treatments, the average lifespan has increased over the years. As a result, life insurance policyholders have a higher likelihood of outliving their insurance policy coverage. A policyholder may also choose to sell a cash value policy as a way to access its cash reserve. These conditions have created a new, secondary market for life insurance policies with investors purchasing policies from sellers. With a life settlement sale, the amount of profit investors receive equals the difference between the death benefit payout and the costs required to purchase and maintain the policy. As the newest sub-sector within the life insurance market, definitive tax treatment measures involving life settlements were not enacted until August 2009 under the Internal Revenue Rulings 2009-13 and 2009-14, according to OnWallStreet, an investment reference news site.
Tax Treatment for Sellers
Internal Revenue Rulings 2009-13 sets the tax treatment guidelines for people who sell their life insurance policy to a third-party investor. When the original owner of a life insurance policy sells her policy to an investor, the seller pays two different tax rates for different portions of the cash amount earned through the sale. One tax rate applies for any amounts up to the surrender value of the policy. The other tax rate applies for any amounts over and above the surrender value. For example, imagine someone who’s paid $20,000 in premiums for a cash value policy with interest earnings of $10,000 and a total of $30,000 worth of cash value in the policy. If she were to surrender the policy, she would pay her regular income tax rate on the $10,000 worth of interest earnings generated by the policy. If the policy were sold rather than surrendered, the seller must subtract the cost of insurance charges from the total premium amount paid to determine the base, or nontaxable portion of the sale. In addition to the taxes imposed on interest earnings, sellers must pay their regular income tax rate on any monies over and above the nontaxable portion up to the surrender value. For money amounts above the surrender value, sellers pay the capital gains tax rate.
Tax Treatment for Investors
Tax treatment guidelines for third-party investors who purchase life insurance settlements appear in the Internal Revenue Ruling 2009-14. Based on the “transfer for value rule,” investors must pay their regular income tax rate on profits made once a death benefit is collected. As investors must maintain the premium payment schedule until the death of the original owner, they can add the total premium payment amount to the amount paid for the policy. So, any monies made over and above the purchase price plus the total premium payment amount becomes taxable income for the investor. After purchasing a life settlement policy, investors have the option of reselling the policy before the original owner dies. The tax treatment for “resale” life settlements requires investors to pay the capital gains tax rate for any profits generated by the resale transaction.
Policy owners who choose to sell their life insurance policy may run into some difficulty when trying to calculate the cost of insurance charges on their policy. The issuing insurance company provides this information and may or may not have it readily on hand depending on how the company tracks these charges. As the cost of insurance charge determines the nontaxable portion of a sales transaction, sellers need this information in order to determine their total tax obligation. Since the amount of taxes owed may make surrendering a policy more profitable than selling it, sellers should obtain the cost of insurance charge amount from their insurance company before completing a life settlement sales transaction.
- Siri Stafford/Digital Vision/Getty Images