Back in May we wrote about the need for trustees to be aware of life settlements. A life settlement can provide a TOLI trust with more value than a policy surrender. The role of a TOLI trustee dictates that all assets are maximized – including “unwanted” life insurance policies.
In the past, tax reporting around a life settlement was onerous, primarily because of an IRS ruling enacted in 2009. IRS Ruling 2009-13 dictated that policy sellers reduce the cost basis in the policy sold by the cumulative cost of insurance charges incurred. The requirement was, at best, burdensome. Often it was impossible to comply with. Most carriers had difficulty providing the information, for some policies it was virtually impossible to compute the amount. The reduction in cost basis also increases the tax burden to the seller, reducing the net amount available to the trust and the beneficiaries.
The new tax bill, The Tax Cut and Jobs Act, in Section 13521, Clarification of Tax Basis of Life Insurance Contracts, reverses the IRS ruling, allowing for “proper adjustment” … for… “mortality, expense or other reasonable charges incurred under an annuity or life insurance contract”.
The taxation of a life settlement is now similar to the taxation of a policy surrender – with a twist since in a sale the policyholder is receiving an amount greater than just the cash surrender value. In a policy surrender, ordinary income tax rates apply to the amount received (cash surrender value) above cost basis. With a life settlement, the policyholder receives more than the cash surrender value and that amount is considered an “investment” taxed at capital gains rates.
Determining the taxation of a life settlement is now an easier three-step process. Let’s look at an example:
Assume a policy holder sold a policy and received $375,000. Further assume total premium paid (we will assume this is the cost basis for simplicity, as it usually is) was $100,000 and the policy had cash value of $125,000.
In the first step, you simply subtract the cost basis from the amount received to arrive at the total gain in the sale.
In Step #2, you determine the amount that is attributable to ordinary income tax rates by subtracting the cash value from the cost basis to arrive at the ordinary income received. In Step #3, to compute the capital gains amount you simply subtract the ordinary income amount in the second step from the total gain found in the first step. Note that if there is no cash value (a term policy, for example) the entire amount received would be taxable at capital gains rates.
The change in the tax code will simplify the tax computation of a policy sale and perhaps prompt more policyholders to investigate a life settlement. It will certainly make the transaction more profitable for those that do. In our example above, the policyholder received $375,000, with taxes due on $275,000 ($25,000 at ordinary rates, $250,00 at capital gains rates). If the policy in question had $50,000 in cost of insurance taken out, taxes would be due on $325,000 ($25,000 at ordinary rates, $300,000 at capital gains rates).
One final note…the effective date of the amendment was listed in the new bill for “transactions entered into after August 25, 2009,” which corresponds to the date of IRS Ruling 2009-13. Does this mean that those who may have paid higher taxes in the last eight years are in for a tax rebate? That part is not clear.