Understanding Tax Implications of Life Settlements
As tax season approaches, it’s crucial to grasp the tax implications of life settlements. Selling a life insurance policy involves tax consequences that every seller should understand.
The Tax Cuts and Jobs Act of 2017, alongside Rev. Rul. 2020-05, established favorable income tax treatments for life settlement sellers. The taxation is categorized into three tiers, each handling specific portions of the proceeds differently.
First Tier
Firstly, proceeds up to the policy’s tax basis are exempt from income tax. This means that if your policy’s basis is $50,000, the first $50,000 of the amount received would not be taxed. Understanding the tax basis of your life insurance policy is fundamental. Typically, the tax basis is found by summing all cumulative premiums paid, minus any surrenders, withdrawals, or dividends taken in cash. Including term premiums in this computation can considerably lower any tax liabilities, especially for term policies convertible to universal life.
Second Tier
Next, proceeds exceeding the tax basis but within the cash surrender value are taxed at ordinary income rates. For example, if the surrender value of your policy is $60,000, the $10,000 above the tax basis ($50,000 to $60,000) would face ordinary income tax rates.
Third Tier
Finally, amounts received exceeding the cash surrender value enjoy capital gains treatment. Continuing with our example, if the policy sold for $100,000, the last portion of $40,000 (from $60,000 to $100,000) would be taxed at the capital gains rate, generally offering a more favorable rate compared to ordinary income.
Policies nearing lapse often have little or no cash surrender value. Thus, the gains are customarily taxed at capital gain rates. It’s worth noting that life settlements rarely fit a one-size-fits-all scenario, and policyholders should always determine the exact tax consequences with the help of a qualified tax advisor.
Another key aspect is determining the precise tax basis for correct tax reporting. Policyholders typically receive two crucial tax forms post-transaction: Form 1099-LS and Form 1099-SB. The former, provided by the purchasing entity, indicates the proceeds a seller received. The latter, from the insurance company, states the policy’s basis during ownership transfer. However, the basis reported often omits term premiums paid, which necessitates an adjustment by the policyholder when reporting to the IRS.
In situations where policies are sold, surrendered, or lapsed at a loss, it’s important to remember that such losses usually aren’t deductible. There’s an exception if the policy was initially purchased for profit rather than protection. This long-standing tax principle underlines the importance of understanding the original intent behind acquiring the policy.
Each life settlement case can present unique complexities beyond these standard guidelines. Thus, always consulting with a tax advisor ensures that all parties understand the specific implications for their circumstances. For clarity and convenience, a prepared worksheet that outlines tax calculations can be immensely beneficial.
We offer a comprehensive guide to assist policyholders in estimating the tax consequences of their transactions, reinforcing our commitment to transparency and trustworthiness in the life settlements market.
Understanding tax ramifications can significantly elevate your value as a trusted advisor, fostering loyalty and trust with clients and their consultants. Being well-versed in these taxation details showcases your dedication to providing exceptional service.
We emphasize the importance of informed decision-making. We aim to help clients navigate the complexities of life settlements effortlessly. Our approach ensures that every action taken aligns with clients’ evolving needs and financial goals. Whether you’re considering selling your policy or seeking investment opportunities, we are here to guide you through every step.
