If you’re thinking of “selling” your life insurance policy, you need to understand the possible tax consequences of the sale.
As a life insurance policy settlement it is in effect the sale of the policy to a third party, and not a surrender of the policy to the insurance company. In reality, the policy does not need to have a cash value to be eligible for a life settlement transaction. The tax implications are twofold and relatively complex. While the IRS has not issued definitive guidance on life settlement transactions, it has relied on the application of its laws and regulations that address similar situations.
Income tax basics clearly state that profits and losses are calculated by taking the selling price of an item and reducing it by selling expenses and investment in the item. The investment in the item is known as your “basis.” When it comes to life insurance policies, the basis of the policy is the total of all premium payments made on the contract. The basis amount in the policy has a direct relationship to the amount of gain that will be recognized from both a surrender and liquidation transaction. In general, the calculation of the base is simple, being simply the sum of the premiums paid to the insurance company.
When a policy is delivered to the issuing insurance company, the difference between the product of the delivery and the base of the policy is subject to income tax at the ordinary rates on income. This concept is important, since it is the first computation of taxable profit made in a settlement transaction. In effect, this surrender value less base gain is treated identically whether the policy is surrendered or liquidated. If the salvage value is less than the basis, there is no ordinary gain to report and the income is treated as a return of the basis without tax cost.
The second taxable gain calculation is unique to a liquidation transaction and results in a gain that is taxable at favorable capital gains rates. In this calculation, proceeds from liquidation are compared to the surrender value used in determining ordinary profit. Because a settlement transaction involves the sale of the contract, and the insurance contract is treated as a capital investment, this part of the gain is treated as a capital gain.
To see an illustration of the above tax consequences, visit Insurance Settlement Review:
click here for examples of capital gains
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