Taxation on Life Settlement Proceeds

From the Life Insurance Settlement Association:
http://www.thevoiceoftheindustry.com/content/42/Tax-Implications-of-Life-Settlement-Transactions.aspx

Tax Implications of Life Settlement Transactions
The sale of a life insurance policy from a consumer to the investor.
Section 101(g) of the Internal Revenue Code allows a “terminally” or “chronically” ill consumer to receive viatical settlement payments tax free. However, there is no such exclusion for consumers that are not terminally or chronically ill. In other words, the federal income tax treatment of life settlements differs a great deal from the treatment of viatical settlements. Life settlements generate taxable income that is based upon the gain a consumer receives on the sale of his life insurance. The gain is the difference between the sales price (including any outstanding policy loan) and the consumer’s basis in the contract, which includes the total premiums the insured paid, reduced by the “cost of insurance protection” provided throughout the date of the sale, and nontaxable dividends the insured has received under the contract.

The investor’s receipt of life insurance proceeds upon death of the insured.

Although the general rule is that life insurance proceeds paid as a result of the death of an insured are excluded from taxable income, Section 101(a)(2) provides an exception in the case of a life insurance policy that is transferred for valuable consideration, by assignment or otherwise. If a transfer for value occurs, the only amount that is excluded from gross income is the amount of the actual value paid to the consumer and the premiums paid after the transfer has occurred. This is the so called “transfer for value” exception for life insurance proceeds. Simply put, in the life settlement scenario, the investor will have federally taxable income to the extent that the life insurance proceeds exceed his tax basis (i.e., purchase price plus premiums or similar fees paid).

The life insurance industry has implied that life settlement transactions may cause Congress to reevaluate the positive tax treatments of life insurance. This position is based upon the mistaken belief that life settle-ment investors receive the death benefits tax free. The truth is that the tax code has already dealt with these issues and the Government receives a greater tax payment when a life settlement occurs. The tax treatment on the consumer’s side of the transaction is dependent upon whether a viatical settlement (which involves a terminally ill person) or a life settlement (which does not involve a terminally ill person) is involved.