Revised IRS Guidance for Sale of Existing Life Insurance Policies

In January 2020, the Internal Revenue Service issued an important revenue ruling that all financial advisors with clients who own life insurance policies should understand.

IRS Ruling 2020-5 updated the agency’s official position regarding how much income an individual must recognize upon the sale of a life insurance policy contract. The ruling was needed because the previous IRS Rule (2009-13) had been impacted by changes to the federal tax law in the landmark Tax Cuts and Jobs Act of 2017, the largest overhaul of the federal tax code in three decades.

The “Cost Basis” Issue

The heart of the issue is the tax treatment of the “cost basis” for a life insurance policy that is eventually sold by the policy owner. Pursuant to the previous IRS position, for purposes of determining the taxable gain on the sale of a policy, the policy’s cost basis did not include cost of insurance (“COI”).

Anyone interested in selling his or her policy as a life settlement was required to subtract the cost of insurance from total premiums paid to determine an adjusted cost basis, a difficult task considering that life insurance carriers were often unable or unwilling to verify past cost of insurance charges as required by the IRS, particularly for older policies.

Instead of cooperating, carriers simply told policy owners to refer to their annual statements from as far back as 20+ years ago (something very few consumers have on hand), add up each year’s total monthly COI charges and then deduct that sum from the total premiums paid. Needless to say, this exercise discouraged many seniors from proceeding with the sale of their policy, which was exactly what the carriers sought to achieve.

Amending the Tax Law

Fortunately for American consumers, The Tax Cuts and Jobs Act amended Sec. 1016(a)(1)(B) of the federal tax code to mandate that the basis of a life insurance contract does not need to be adjusted for the expired cost of insurance. This important legislative change corrected an illogical and harmful situation in which individuals received a more favorable tax basis if they just surrendered their policy back to the insurance carrier, as opposed to selling the policy for its fair value on the secondary market.

The new law affords sellers of existing life insurance policies the same tax treatment as those who surrender their policies. However, for over two years, the life settlement industry had been waiting for a new revenue ruling to provide guidance on how the law would be interpreted by the IRS.

The New IRS Rule

In 2020, IRS guidance reaffirmed that “total premiums paid” forms the cost basis for a life insurance contract and clarified that any gain realized by the sale of a policy must be recognized as taxable income. 

According to The Tax Adviser’s recap of IRS Revenue Rule 2020-5, the new IRS guidance actually summarizes three unique situations involving taxpayers who sell their life insurance policies under varying circumstances. Rule 2020-5 makes it clear how each of those unique scenarios will be treated under the new tax regime, laying out specific direction on what the agency will view as ordinary income, long-term capital gains or long-term capital losses.

This new revenue ruling now provides the official guidance that allows advisors to confidently discuss with clients the important tax implications from the sale of their life insurance policies on the secondary market.

A Good Time to Reassess

The ruling is an important positive step to encourage financial advisors to evaluate their clients’ life insurance policies and ensure that they are serving their intended strategic purpose within their portfolios.

“It has always been a good idea to regularly review your life insurance policies to make sure they still meet your needs,” according to Kiplinger’s Retirement Report. “But the changes in the tax law provide extra incentive to reassess your policies’ costs and benefits.”

Clients who own life insurance policies that are obsolete — or simply own a policy they no longer need or can afford, for whatever reason — need to work with an experienced life settlement broker who can help evaluate those policies in the aftermath of the revised tax law and IRS Revenue Rule 2020-5. 

For more detailed information, please visit welcomefunds.com/tax-treatment or call 877.227.4484.

Welcome Funds, Inc. is not a tax advisor, does not issue tax advice and encourages all clients and their advisors to consult their own CPAs, attorneys and/or tax experts regarding general or specific tax ramifications. The above information is provided for educational purposes only.