Insights

Surrender Versus Sale of a Life Insurance Policy

 

Surrender Versus Sale of a Life Insurance Policy

Prior to the TCJA, there was a significant difference between how taxpayers calculated their taxable gain on the surrender of a life insurance policy to the insurance company versus how they calculated their taxable gain on the sale of a life insurance policy. Note that for this purpose, a sale is the transfer of a life insurance policy to a third-party acquirer who has no substantial family, business, or financial relationship with the insured, apart from the acquirer’s interest in such life insurance contract. This is often referred to as a life settlement sale. Previously:

  • Taxable gain on the surrender of a policy was calculated by comparing (a) the surrender proceeds with (b) the taxpayer’s total premiums paid over the life of the policy, reduced by withdrawals and dividends.
  • Taxable gain on the sale of a policy was calculated by comparing (a) the sales price with (b) the taxpayer’s total premiums paid over the life of the policy, reduced by withdrawals and dividends and by the cumulative cost of insurance charges assessed against the policy.

The TCJA has now eliminated that difference in basis calculation, retroactive to 2009, by eliminating the requirement to reduce the taxpayer’s total cost by the cumulative cost of the insurance coverage when calculating gain on sale of a policy.  This change may make taxpayers more inclined to consider life settlement sales when faced with a policy they no longer require or that they wish to monetize as a result of cash needs. 

The TCJA’s doubling of the estate tax exemption (which in 2018 is $11.2 million per individual and $22.4 million, with portability, for a married couple) means that taxpayers should be reviewing the continuing need for policies that were previously bought for estate tax purposes. Some of these policies, especially second-to-die policies, may no longer be needed for that purpose. However, keep in mind that these increased exemption amounts are temporary and are scheduled to “sunset” in 2026 and that life insurance can serve a purpose other than just the payment of estate taxes. If it is ultimately determined that a policy is no longer required, the taxpayer and their advisors should now consider the after-tax implications of not only a surrender, but also a life settlement sale.

Just a reminder that when calculating the tax implications of a surrender or sale, there are three tiers of taxation:

  • Amounts received up to the tax basis are tax-free.
  • Amounts received in excess of tax basis, up to the amount of the cash surrender value, are taxed at ordinary income tax rates.
  • Amounts received in excess of cash surrender value get favorable capital gains treatment.

The “price” of this pro-taxpayer change is twofold and is likely intended to improve sellers’ compliance with reporting their sales of life insurance policies:

  • The life settlement houses (the acquirers), are now required to file an information return with the IRS, reporting the sale, the parties to the sale, the proceeds, and the policy number. Acquirers are also required to issue written statements containing the information required to be reported on the return to the life insurance company issuing the policy and to the seller. 
  • The insurance company is then required to file an information return with the IRS that includes the seller’s amount of investment in the contract. It is also required to issue a written statement containing the information required to be reported on the return to the seller.

Because the TCJA made this change retroactive to transactions entered into after August 25, 2009, a taxpayer who had a taxable gain on a life settlement sale that occurred in an open tax year could potentially file an amended tax return to apply for a refund.

Author(s)

Christenson_Crystal
Crystal Christenson, CPA, MST
Partner
View Profile