Forbes’ recent article entitled “How The Biden Administration Might Affect Life Settlements And After-Tax Profitability” provides a breakdown of taxation on life settlements under the Trump administration and how President Biden’s tax plans could impact this.
Life Settlements Under the Tax Cuts and Jobs Act Of 2017 (TCJA). When the Trump administration passed the TCJA, life settlements became more attractive. Section 13521 of the TCJA states that “in figuring the basis of a life insurance contract or an annuity contract, no adjustment is made for mortality, expense, or other reasonable charges incurred under the contract.” In effect, this killed the IRS rule that said the life insurance policy seller’s basis is reduced by the cost of insurance (COI) for mortality, expense or other reasonable charges incurred. Therefore, whether a policyholder surrenders his policy to the insurer for a gain or sells it outright, the basis is calculated as the full premiums, which benefits policyholders. Under the TCJA, settlement amounts:
- Up to cost basis (full premiums) are free of income tax.
- Above cost basis and up to cash surrender value (CSV) are taxed as ordinary income.
- Above CSV and up to the life settlement amount are taxed as capital gains.
President Biden has said he will repeal parts of the TCJA, which may negatively impact life settlements. Before the TCJA, the cost of insurance inside a policy didn’t count as cost basis. This increased the tax. If some of the TCJA is repealed, including the beneficial elements to taxation of surrendered or sold life insurance policies, it could mean higher taxation and difficulty calculating cost basis. The Biden tax plan is also looking to remove capital gains for anyone with an income over $1 million. So, for some, taxes could nearly double from 20% to 39.6%. This, along with a proposed reduction of most of one’s cost basis, could be hard for owners of life insurance, if they want to exit a policy.
IRS Form 1099-LS. Now IRS says that all life insurance and life settlement companies must submit to former policy owners and the IRS. Any Biden administration policy changes will not impact this form, only the taxes a person may pay as a result of receiving the form. Remember that it’s the seller who will receive a 1099-LS.
IRS Form 1099-LTC. The only life settlement that likely won’t be included in changes in taxation, is sellers who are facing a chronic or terminal illness. Form 1099-LTC may be issued by a life settlement provider or life insurance carrier in any transaction where an insured is chronically or terminally ill. Life settlement transactions where a 1099-LTC is issued are usually tax-free to the seller.
Life settlements can make life insurance more valuable and provide additional financial options, when a policy is no longer needed, wanted or affordable. If President Biden repeals much of the TCJA, the cost basis and tax ramifications for life insurance policies that are surrendered for their cash value or sold as a life settlement could be affected.
If you would like to discuss your options with an estate planning attorney in Jupiter, Palm Beach Gardens, or Naples, Florida, schedule a complimentary call with Edward J. Welch at Welch Law, PLLC.
Reference: Forbes (Feb. 16, 2021) “How The Biden Administration Might Affect Life Settlements And After-Tax Profitability”