Earlier this month, the Obama Administration released its 2011 Budget and accompanying revenue proposals (“Revenue Proposals”) which set forth the means by which the U.S. Government proposes to pay for the items set forth in the 2011 Budget. This year, the Revenue Proposals include provisions that would modify the exiting life settlement reporting and tax calculation rules. The modifications come in response to a recent increase in life settlement transactions and concern that current exceptions to tax rules may allow investors to develop life settlement transactions that avoid tax.

Currently, where an insured sells a life insurance contract with cash value to a third party purchaser, the insured must include in income an amount equal to the excess of the amount received on the sale of the contract over the insured’s adjusted basis in the contract. In order to calculate the insured’s gain on the sale of a life insurance contract, it is necessary to reduce the insured’s basis by that portion of the premium paid for the contract that was expended for the provision of insurance prior to the sale. (See Example 1 below for further explanation.)

As a general rule, gross income does not include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured. However, in the case of a transfer for valuable consideration (i.e., where a third party with no insurable interest in the life of the insured purchases a life insurance contract from the insured), the amount excluded from gross income cannot exceed an amount equal to the sum of the actual value of the consideration paid and the premiums and other amounts subsequently paid by the transferee. The “transfer for value” rule does not apply in the case of a transfer involving a carryover basis or in the case of a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. (See Example 2 below for further explanation.)

Under the Revenue Proposals, purchasers of life insurance contracts in the secondary market with death benefits equal to or exceeding $1 million must report the purchase price, the buyer’s and seller’s tax identification numbers, and the issuer and policy number to the IRS, the issuing insurer, and the seller. The Revenue Proposals would also amend the transfer for value rule to ensure that the exceptions to that rule would not apply to buyers of policies. Upon the payment of any policy benefits to the buyer, the issuing insurer would be required to report to both the IRS and the payee the gross benefit payment, the buyer’s tax identification number, and the insurer's estimate of the buyer’s basis.

If the Revenue Proposals are adopted as part of the budget process, the revisions with respect to life settlements would apply to sales or assignment of interests in life insurance policies and payments of death benefits for taxable years beginning after December 31, 2010. Note that the budget process begins in February and generally ends by October 1, the start of the U.S. Government’s fiscal year.

Click here for general explanations of the Revenue Proposal published by the Treasury Department (see page 69).

For additional information on the tax consequences of life insurance transactions, click here to view our 2009 post regarding two IRS revenue rulings.

Example 1

Assume A, an individual, enters into a life insurance contract with cash value on January 1, 2009. On June 15, 2016, A sells the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death. Through the date of sale, A paid premiums totaling $64,000 and $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. A’s adjusted basis in the contract as of the date of sale is $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance). Accordingly, A must include $26,000 in income on the sale of the life insurance contract to B, which is the excess of the amount received on the sale ($80,000) over A’s adjusted basis in the contract ($54,000).

Example 2

Assume that on June 15, 2008, B purchased a life insurance contract on the life of A from A for $20,000. The contract, which was originally issued to A on January 1, 2001, is a level premium fifteen-year life insurance contract without cash surrender value. At the time of purchase, the remaining term of the contract is 7 years, 6 months, and 15 days. The monthly premium for the contract is $500, due and payable on the first day of each month. On December 31, 2009, A dies and the issuing insurer pays $100,000 under the life insurance contract to B by reason of A’s death. Through the date of A’s death, B had paid monthly premiums totaling $9,000 to keep the contract in force. B’s acquisition of the contract is a “transfer for valuable consideration”. Assuming neither the carryover basis exception nor the exception for a transfer involving parties related to the insured applies, B is required to include $71,000 in income, which is the difference between the total death benefit received ($100,000) and the amount excluded under the tax law (i.e., the sum of the actual value of the consideration paid, $20,000, and the premiums subsequently paid by B to keep the contract in force, $9,000, or $29,000 total).