Two pieces of the new tax law, the Tax Cuts and Job Act of 2017 (TCJA), have a significant impact on life settlements: the increased estate tax exemption and the clarification of the income tax treatment for life settlements.
TCJA doubled the estate tax exemption, which, indexed to inflation, in 2018 will become $11.2 million per individual and $22.4 million, with portability, for a married couple. This change further reduces, by about two-thirds, the already small number of estates that will have to pay this tax. It is estimated that now only about 1,800 estates, annually, will be subject to federal estate taxation.The higher estate tax exemption means that many policies previously bought for estate tax purposes must be reviewed. It could be determined that some of these policies, including second-to-die contracts, may no longer be necessary or wanted. Although tax laws can always change and it might be prudent to retain the policy for reasons other than estate taxes, some policies will likely be surrendered. Before that happens, it is your responsibility to your clients to investigate the possibility of a life settlement as it could provide substantially more value to the policy owner than surrendering it back to the issuing insurance company. Trust officers, tax advisors and attorneys should be contacted to be sure that they are also aware of potential life settlement opportunities resulting from the new law. You want them to know that they can call you to assist them with this transaction.
With respect to income taxation, TCJA retroactively returned the tax treatment to what it was prior to 2009 when the Internal Revenue Service issued Revenue Ruling 2009-13. In that revenue ruling the IRS created a difference in the tax basis for policies sold in a life settlement and policies surrendered to the insurance company.
For policies that are surrendered at a gain, the law has long been that the policy owner’s basis is their cumulative investment in the contract, which is basically the cumulative premiums paid less withdrawals and dividends taken from the policy. But for purposes of a life settlement, the IRS ruled that the basis would have to be reduced by the cumulative cost of insurance charges assessed against the policy.
TCJA rejects the IRS ruling and says policies sold in a life settlement receive the same, more favorable, basis as policies that are surrendered.