Tax Implications
In May 2009, the Internal Revenue Service issued Revenue Ruling 2009-13, which establishes the following federal tax rules for life settlements completed on or after August 26, 2009:
- For term policies, the life settlement proceeds will be taxed as ordinary income.
- For universal or whole life policies, the treatment is a bit more complex:
- Up to the amount of premiums paid to date minus the cost of insurancei, the settlement amount is federal tax free.
- Over the amount of premiums paid to date, the settlement amount up to the cash surrender value will be taxed as ordinary income.
- The settlement amount in excess of the cash surrender will be taxed as a capital gain.
For example:
Situation 1: Policyowner sells a universal policy for $100,000, with a $70,000 cash surrender value, and had paid $64,000 in premiums.
1. How much will be taxed?
| Settlement amount: | $100,000 |
| - Premiums paid to date: | $64,000 |
| + Cost of Insurance:i | $10,000 |
| = Taxable Gain: | $46,000 |
2. What happens to the Taxable Gain? The taxable gain will be split into two categories: capital gains and ordinary income.
| Settlement Amount: | $100,000 |
| - Cash Surrender Value: | $70,000 |
| = Capital Gains: | $30,000 |
| Taxable Gain: | $46,000 |
| - Capital Gains: | $30,000 |
| = Ordinary Income: | $16,000 |
Situation 2: Policyowner sells a term policy for $80,000. The entire $80,000 would be taxed as ordinary income, as the IRS ruling assumes that the entirety of the premiums paid go to cover the cost of insurance.
Where can I get more specific information?
Please consult your tax advisor regarding your specific situation, and for any applicable state tax advice.
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