Implications for Policyholders and Financial Reorganization Strategies

Selling policyholders life settlement were subject to a greater tax burden due to the lower cost basis because proceeds up to the policyholder’s cost basis are not subject to taxation. As record-high inflation erodes wealth and buying power, high-net-worth clients may take interest in financial reorganization strategies. Life settlement can have taxation implications for those who choose to use them to liquidate their life insurance. 

The Taxation Cuts and Jobs Act of 2017 (TCJA), which former President Trump signed into law in early 2018, regulates life agreement taxation. By improving the expense premise definition, the TCJA improved the duty structure for policy owners.

The sum of all premiums paid on the sold policy is now the cost basis of a life agreement. Before TCJA, the cost basis was determined by subtracting the cost of insurance (COI) from total premiums paid. This was problematic for two reasons. First, policy owners were frequently unable to obtain COI. Furthermore, lowering premiums by COI resulted in a lower cost basis.

Selling policyholders faced a higher tax burden due to lower cost basis, as proceeds up to it isn’t taxable.

Life agreement proceeds that exceed the cost basis undergo taxation in two stages:

• Proceeds above the cost basis and up to the cash surrender value of the policy are taxed as ordinary income.
• Proceeds in excess of the cash surrender value of the policy are taxed as long-term capital gains.

Take a $110,000 insurance policy as an example. A $50,000 collective premium payment made by the policy owners would result in a $60,000 total taxable gain. For a $55,000 cash surrender value, the policyholder’s marginal income tax rate taxes $5,000 of the $60,000 gain. The IRS treats the remainder of the gain, $55,000, as long-term capital gain.

The state taxes life settlements.

Selling policyholders’ home state may also require them to pay state taxes. Each state’s general tax policy treats life settlements as capital gains and income. There are three options:

Only policyholders in states without income or investment gains taxes are responsible for federal taxes on life agreement proceeds.

States without a lower capital gains rate will apply the policyholder’s state income tax rate to either the entire taxable gain or the net proceeds less collective premiums.

Policyholders would first compute the two tiers of gains required by TCJA in states with capital gains regulations. The proceeds would be taxed at the state’s income rate for the portion that would be considered income, and the remaining sum would be subject to the state’s standard capital gains laws.

The proceeds are greater than the cash value after taxes.

The after-tax proceeds of a life agreement exceed those from surrendering the life insurance policy, regardless of the policyholder’s location.

The policyholder can either sell the policy for $110,000 or surrender it for $55,000 based on the example figures. The net cash proceeds from the $110,000 sale, after broker commissions, federal taxes, and state taxes, will still exceed the $55,000 cash surrender value.

Assuming minimal changes to the tax code, life agreements will continue to be subject to income and capital gains taxes. Although the Biden administration advocated significant tax rate increases on high earners in the 2021 American Families Plan, there hasn’t been enough congressional support for that initiative to date.

For the time being, policyholders can consider life agreements as a way to maximize the value of their life insurance. Net proceeds from the transaction will exceed the cash surrender value of the policy despite the taxable gain. A skilled tax advisor can determine how the additional gain will affect the policyholder’s overall tax burden for the year.

As you can see, life agreement taxation is a complex issue with various implications for policy owners. While the Tax Cuts and Jobs Act of 2017 improved the expense premise definition and lowered the tax burden for selling policyholders, there are still federal and state taxes to consider. Furthermore, tax regulations may change in the future, making it more important than ever to work with a experienced tax advisor.

To fully understand the tax implications of using life agreements to restructure finances for high-net-worth clients, it is crucial to actively engage in the process. A skilled tax advisor can help your clients navigate the complexities of life settlement taxation and determine the best strategy to maximize their life insurance value while minimizing their tax burden.

At IfindTaxPro, we can connect you with experienced and highly experienced tax specialists who can provide personalized advice tailored to your client’s unique situations. Our marketplace offers tools and resources to help clients achieve financial goals with full-time or ad hoc assistance. So why not consider posting your project and signing up with us today? We welcome licensed tax professionals to our marketplace who want to expand their services. Register now and start connecting with clients who need your expertise!