If you are considering “selling” your life insurance policy, you should understand the potential tax consequences of the sale.
As a life settlement of an insurance policy it is in effect the sale of the policy to a third party, and not a delivery 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 gains and losses are calculated by taking the sale price of an item and reducing it by the 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 policy basis is the total of all premium payments made on the contract. The amount of the basis in the policy has a direct relationship to the amount of gain that will be recognized from both a surrender and settlement transaction. In general, the basis calculation is straightforward, 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 delivery proceeds and the policy basis is subject to income tax at ordinary income rates. This concept is important, since it is the first computation of taxable profit made in a liquidation transaction. In effect, this surrender value less the 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 income 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 gain rates. In this calculation, the proceeds from the liquidation are compared to the salvage value used in the determination of ordinary profit. Because a wind-up transaction involves the sale of the contract, and the insurance contract is treated as a capital investment, this portion of the gain is treated as a capital gain.
For an illustration of the above tax consequences, visit Insurance Settlement Review:
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