Leimberg’s - SFSP



Leimberg’s

Think About It

Think About It is written by

Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

July 2009 # 401

RE-EVALUATING LIFE SETTLEMENTS

IN THE NEW TAX ENVIRONMENT

Introduction

Traditionally, the owner of a permanent life insurance policy had one choice when he or she wanted to cash in a policy—surrender the policy and receive the cash value.

Beginning about twenty years ago, some third party companies began to offer the owners of policies on terminally ill insureds the ability to viaticate the policy. In such cases, the viatical settlement company would make an offer to the owner to purchase the policy for a substantial percentage of the policy’s death benefit.

As the market for viatical settlements developed, variations appeared. For example, some life carriers offered accelerated benefit options, effectively allowing policyowners early access to the death benefit when the insured was determined to be terminally ill.

Companies that formerly focused on viatical settlements expanded their offers to buy policies with older or medically impaired insureds—not just from those terminally ill.

The expansion of the viatical settlements to situations involving more healthy insureds transformed the focus of the market from viatical settlements to life settlements.

From the policyowner’s perspective, when should a life settlement be pursued?

The first decision a policyowner must make is based on the need for the coverage. Are the original reasons for the policy purchase still important? Are there any new compelling factors that would argue in favor of keeping the policy? If the answers to these questions are no, then perhaps a life settlement should be considered.

The second decision to be made is economic. Does it make financial sense to settle a policy? The answer to this question depends in part on how much the settlement company will offer, and in part on the tax treatment of the settlement amount.

In Revenue Ruling 2009-13, issued earlier this year, the IRS published its stance on the tax results when a policy owner settles a life policy. In the ruling, the Service answered many of the questions that experts had been unsure about. The IRS’s answers have a significant impact on those who are—or will be—considering life settlements.

How Life Settlements Work

To understand the context for the Revenue Ruling, a basic understanding of life settlements is needed. For a detailed discussion about how life settlements work, see Tools & Techniques of Life Settlement Planning, by Stephan Leimberg, Caleb Callahan, Brian Casey, James Magner, Barry Reed, Lawrence J. Rybka and Paul Siegert. It is published by and available from the National Underwriter ().

Procedures and details of how life settlements are structured depend on the particular settlement organization. Here are a few generalizations about how the sale of a particular policy to the settlement company might be accomplished.

Mechanics

Most settlement companies will have the policyowner (which could be a trust, business, or charity) complete an application. They will also require the insured to cooperate in the process, as medical information will be required from the life insurance company and insured’s doctors. The information is used to estimate the insured’s life expectancy.

Offers to purchase the policy are based on the following facts:

• Age of insured

• Life expectancy

• Premium amount needed to keep the coverage in force until death

• Financial stability of the insurance carrier

• Policy type

• Policy provisions

Once a policy is “settled” (sold), the settlement company assumes ownership of the contract—including the obligation to pay future premiums.

The settlement company’s intention is to keep the policy in force until the insured’s death. From the settlement company’s perspective, they are making a bet that the present value of the settlement amount plus projected future premiums—plus a reasonable interest amount adjusted for risk—will be less than the present value of the policy’s death benefit.

As is the case with underwriting a new life case, it is possible for different settlement underwriters to evaluate a settlement case differently. That fact, in addition to other factors such as desired profit margin, business expenses, and the desire to build market share can lead to varying offers from one settlement company to another.

The Consumer’s Perspective: Hold or Fold?

Say a client received a $3 million life settlement for a $15 million trust owned policy insuring her life. If the policy had little or no cash value, on the surface the settlement seems like it was a good economic decision.

Say then that two years later the client unexpectedly dies. The trust beneficiaries will want to know why the trustee sold the policy and only received a $3 million life settlement, when in fact they could have received a $15 million tax-free death benefit had the policy been kept in force.

In order to properly do their jobs—and to manage their professional liability exposures—attorneys, CPAs, financial advisors, trustees, selling agents, compliance personnel, broker-dealers and life settlement brokers must be able to assist a client in assessing a potential life settlement on an objective and professional basis. They need to come up with the proper responses before the life settlement, when the client is looking for advice on whether to retain a policy until the insured’s death (“hold”) or sell the policy in a life settlement (“fold”).

To be able to address these issues, there must be a sensible rationale for making the hold versus fold decision. We will describe a basic framework for analyzing a hold versus fold decision in this article. For a more comprehensive discussion, we recommend reading S. Leimberg, M. Weinberg, B. Weinberg, and C. Calahan, “Life Settlements: How to Know When to Hold and When to Fold,” Estate Planning, August 2008, Vol. 35, No. 8.

Hold versus fold analysis should be done in two parts: planning analysis and economic analysis.

Planning Analysis

Hold versus fold planning analysis starts with the question, “Does the client still need this life insurance?” To perform an effective needs-based review, some helpful questions for advisors to ask are:

1. Why did the client originally purchase this insurance?

2. How have the client’s needs changed over time?

3. Is there a current or reasonably anticipated future need or realistically potential need for the insurance for reasons other than or beyond the original needs?

If, after a needs-based review of the insurance has been performed, it is determined that the coverage is no longer necessary, a life settlement may be a good option for a client to explore.

However, even if existing coverage is no longer needed, the client’s attitude towards the life settlement marketplace and the client’s overall comfort level with the transaction also need to be considered. The second set of planning analysis questions to be asked are:

1. How does the client feel about third party investors owning a large life insurance policy on his or her life?

2. How does the client feel about being contacted on an ongoing (perhaps as often as monthly) basis by investors which want to know if he or she is still living (and profits only when he or she is not)?

3. How does the client feel about the possibility of the policy on his or her life being resold by the original investors to other investor groups – with no knowledge of who those new investors are and no veto power over the sale?

If a client is not unduly concerned with such issues, and truly no longer needs the coverage, then it is appropriate to begin an economic analysis of a life settlement.

If the client continues to have an ongoing need for coverage, then a different set of questions must be asked. “Can a way be found to help the client continue paying required premiums?” “Is the client still insurable? The answers to these types of questions can either favor or disfavor a life settlement.

For example, if a client needs coverage, but cannot afford to pay premiums, a life settlement may be a good option if the after-tax settlement proceeds can be used to purchase new insurance that more appropriately meets current needs with respect to face amount, policy type and premium requirements.

There are other alternatives available that may be more appropriate than a life settlement for a client who still needs coverage but cannot afford to pay premiums. The client may be able to find a family member who is interested in helping fund a part, or all, of the necessary premiums. Perhaps the client can take advantage of policy loans or other non-forfeiture options, such as a reduced death benefit paid-up policy or extended term insurance. In certain situations, terminally ill insureds may qualify for accelerated or living benefits that allow them to access a portion of their death benefit while they are still living. Finally, certain premium financing arrangements from reputable lending companies may be available under certain circumstances.

If there is no reasonable way for the client to keep needed life coverage in force, then it may be appropriate to ask the second set of planning analysis questions described above. If a client is not unduly concerned with such issues, then a life settlement may be considered.

Economic Analysis

In order to properly analyze the hold versus fold decision from an economic point of view, the following key data is needed to properly compare holding a policy until the insured’s death vs. folding it into a life settlement:

1. An in-force policy illustration (based on stipulated assumptions for interest or dividends) that projects the premiums (carrying cost) necessary to continue the insurance coverage to a specified age,

2. Projected income, gift and estate tax consequences of holding vs. folding,

3. Current information on policy ownership and beneficiary, current policy values, and policy loans (if any),

4. Life expectancy assumptions,

5. A reasonable expected average rate of return (ROR) on the client’s investments, i.e., an assumed discount rate, and

6. The amount of the life settlement offer.

Professionals need to have a method of synthesizing this and other relevant economic information to be able to quantify the consequences of settlement versus keeping the policy.

There will certainly be times when, after applying hold versus fold analysis, it will not only makes sense to life settle the policy, but in fact a life settlement is actually the very best available choice. This will be true especially in cases where the client no longer needs the coverage and the life settlement offer produces a higher value, net of taxes and commissions, than does any other course of action.

The best economic prospects for life settlements are owners of policies where coverage is no longer needed, and under which the insured is at substantially greater risk for death than at policy issue. The increased risk of death may be due to the passage of time, or because of the insured has had a deterioration of health. In the majority of settlement cases, the insured will be older than 60.

Edges of the Market

The life settlement market addresses a legitimate financial niche. Since the surrender value of a life contract doesn’t always reflect its fair market value, life settlements help close that gap. In that sense, life settlements are good for consumers.

However, in some instances, life settlements have too often been packaged in a way that is at the least morally objectionable and in many cases are fraudulent. The best (or worst) example of this is stranger-owned life insurance (STOLI).

STOLI has often been used as an investment technique. Some life settlement companies and brokers have actively encouraged its use. Under a typical implementation, investors will encourage someone (usually an elderly person) to purchase life insurance. The investors will provide money to the insured to pay the premium. After the policy has been in force for two years, the investors will have the insured transfer the policy to them. The investors, depending on circumstances, may hold the policy – or sell it themselves.

The insured is usually paid for participating in the transaction, an action which may be an illegal rebate – depending on the law of the state involved.

STOLI undermines the primary purpose and objective of life insurance. The investors, at the policy’s inception, have no insurable interest in the life of the insured.

In many jurisdictions, there are specific laws to discourage or prevent STOLI. Most life companies include questions on their applications designed to weed out STOLI cases prior to issue. In some cases, the courts have allowed carriers to rescind STOLI contracts, and have provided other remedies against offending agents and promoters.

For more information about STOLI, see: Leimberg, Gibbons, and Nelson, “TOLI, COLI, BOLI, and Insurable Interests,” Estate Planning Magazine, Vol. 28, No. 1, July 2001, Pg. 333; Jones, Leimberg, and Rybka, "'Free' Life Insurance: Risks and Costs of Non-Recourse Premium Financing,” Estate Planning Journal, Vol. 33, No. 7, July 2006, Pg. 3; S. Leimberg, “Investor Initiated Life Insurance: Really a “Free Lunch or a Prelude to Acid Indigestion?”, 41st Annual Heckerling Institute on Estate Planning: 41 Inst. Est. Plan. Ch. 4 (2007); J. A. Jensen and S. Leimberg, “Stranger Owned Life Insurance: A Point/Counterpoint Discussion,” 33 ACTEC Journal II (2007).

STOLI is mentioned here because the tax rules that affect life settlements may also affect the economics of a STOLI transaction.

Prior Guesses About Tax Results

Before Revenue Ruling 2009-13, there were two main schools of thought regarding the tax treatment of life settlements.

Ordinary Income Treatment

The ordinary income position was simple. IRC Section 72 governs the income taxation of amounts received during the insured’s lifetime. In cases where a contract is surrendered, the amount of gain over the policyowner’s basis is taxable at ordinary income rates.

Based on Section 72 analysis, some experts reasoned that a life contract was an ordinary income asset rather than a capital asset. Ordinary income assets are taxed at ordinary income rates. Applying that logic to life settlements would say that settlement proceeds in excess of basis would be taxed at ordinary income rates.

Capital Gain Treatment – In Whole or In Part

Advocates of the capital gain position for life settlements also had some authority on their side. They argued that the IRS itself, in PLR 9443020, said that Code Section 1001 should be applied to calculating basis for a life settlement. Since that Code Section is designed to deal with capital assets, proponents argued that the IRS was saying that life insurance is a capital asset.

So if a life policy is settled, what would the tax result be?

Some said all proceeds in excess of basis should be subject only to capital gains tax. Others argued that the difference between basis and surrender value was subject to ordinary income tax, and only the balance received would be subject to capital gains tax.

Why does the difference between ordinary income and capital gains treatment matter? At least under current law, there is a big difference between the top federal income tax rate of 35%, and the top federal capital gains tax rate of 15%.

Revenue Ruling 2009-13

To address the unanswered questions about tax results to the policyowner upon settlement of a life policy, the IRS on May 1, 2009, issued Revenue Ruling 2009-13.

What It Says

The Ruling sets out three hypothetical situations and does an analysis of each.

• surrender of a cash value policy,

• sale of a cash value policy, and

• sale of a term policy.

Situation 1 – Surrender of Cash Value Policy

Taxpayer A purchased a cash value policy on his own life. Taxpayer A paid a total of $64,000 in premiums for the policy’s first eight years. Taxpayer A did not take any withdrawals from the policy, nor did he have any policy loans. The policyowner surrenders the policy for $78,000, which is the cash surrender value of the policy.

The IRS ruled this situation is covered by Code Section 72(e). Section 72(e)(5)(A) states amounts received upon the complete surrender of a life insurance contract are includible in the owner’s gross income to the extent the amount received exceeds the owner’s investment in the contract.

The owner’s investment in the contract is the total of all premiums or other consideration paid into the contract, minus all amounts received under the contract to the extent otherwise excludable from gross income.

Taxpayer A receives $78,000, which exceeds his investment in the contract ($64,000) by $14,000. He must report $14,000 of gain as ordinary income.

In describing the tax treatment of Situation 1, the IRS stated the life policy is a capital asset. However, because it was surrendered instead of being sold, Code Section 72(e) rather than the capital gain rules apply, and under Section 72, the gain is taxed as ordinary income.

Situation 2 – Sale of Cash Value Policy

The facts for Situation 2 are the same as in Situation 1, except that rather than surrendering the policy, Taxpayer A sells the policy to B, an unrelated third party, for $80,000.

The Ruling notes that because this is a sale rather than a surrender, Code Section 72 does not apply. The tax consequences will instead be governed by general income tax rules.

Under general income tax rules, the taxable gain on the sale of an asset is the amount received minus the taxpayer’s basis.

The Ruling states that Taxpayer A’s preliminary basis in the life policy is the $64,000 premiums paid. The IRS asserts that preliminary basis must be reduced by the cumulative cost of life insurance protection during the ownership of the policy.

The Ruling’s Situation 2 assumes that the cost of life insurance protection (COI) is $10,000. Subtracting the $10,000 of COI from the preliminary basis of $64,000 yields an adjusted basis of $54,000.

The policyowner’s taxable gain on the sale is the $80,000 received minus the adjusted basis of $54,000, or $26,000.

The IRS held that the gain is partly ordinary income and partly capital gains. The Ruling states the amount that would have been recognized as ordinary income if the policy had been surrendered will also be considered ordinary income upon sale. This income taxation theory is the “substitution of ordinary income doctrine.”

To the extent the total gain exceeds that amount that would have been ordinary income on surrender, it will be considered capital gain.

Situation 3 – Sale of a Term Policy

In Situation 3, Taxpayer A is assumed to have a level premium fifteen-year term life insurance contract with zero cash surrender value. The monthly premium is $500, and total premiums of $45,000 have been paid prior to the policy’s sale.

Under the facts presented, the policy is sold mid-month for $20,000.

In Situation 2, IRS ruled the basis in a life policy is the investment in the contract reduced by the cost of insurance. In Situation 3, the Revenue Ruling states that in the absence of other proof, the cost of pure life insurance protection (COI) in a term policy will be presumed to be equal to the aggregate premiums paid.

Thus, Taxpayer A’s adjusted basis in the contract is one-half month’s unused premium, or $250. On the sale for $20,000, Taxpayer A will have taxable gain of $19,750.

The IRS asserted that the substitute for ordinary income doctrine will not be applied in the case of a term policy with no cash value. Therefore, all taxable gain should be taxed as a capital transaction.

Unanswered Questions

Revenue Ruling 2009-13 took many in the life insurance business by surprise. It was particularly shocking that in the event of policy settlement, the contract’s basis—according to the IRS—must be adjusted by COI.

The Revenue Ruling also left a few tax questions regarding life settlement transactions unanswered.

How Should COI Be Calculated?

When a life policy is settled, the contract’s owner must subtract COI charges from basis. In its Situation 2, the IRS asserted that aggregate COI for the policy in question was $10,000. The IRS did not explain anywhere in Revenue Ruling 2009-13 how COI should be calculated.

In the absence of IRS guidance, how could COI be calculated?

1. Rely on the Insurance Company. Companies that administer universal life-like policies calculate cost of insurance charges as those charges are defined within the policy. Perhaps the IRS will ask life companies to figure out COIs for the purpose of Revenue Ruling 2009-13. That alternative begs more questions than it answers. For example, will the IRS define COI the same way as the life carrier? How should policy riders be treated? Will companies be able to easily report aggregate COIs to the policyowner upon request? Will there be a future IRS requirement that companies report aggregate COIs upon policy disposition? What about permanent policies for which COIs are not usually calculated for each policy by the life company—such as participating whole life?

2. Use a Table. The IRS has given us cost of insurance tables for split dollar in the past. Perhaps a table can be used to calculate COI when a policy is settled. The information needed to perform such a calculation may be hard to get. For example, COI is based on the amount at risk—the difference between cash value and death benefit. If the client has to calculate aggregate COIs for a twenty year old policy, determining prior years’ cash values—or even the actual amount of death benefits—may be a difficult task.

3. Create a Formula Based on Premium or Other Factors. To address the practical problems with either of the prior suggestions, could some other formula be used? It would be simpler to say that for a permanent policy, COI is equal to, say, 20% of the aggregate premium. Unfortunately, simpler formulas will probably tend to be inaccurate.

How Should Step-Up in Basis Rules at Death Apply to Life Policies?

The IRS concluded in Revenue Ruling 2009-13 that life insurance is a capital asset. What implications does that have for basis step-up when a third-party owner dies?

Here’s an example that illustrates that the question about basis step-up isn’t easy to answer. Say that Ned owns a policy on Burt’s life. Ned has paid twenty annual premiums of $5,000 for the $1 million policy. The policy now has cash value of $200,000. Assume Ned dies, passing the policy to Burt, who is the contingent owner.

Burt, who doesn’t need the policy, decides to sell it to a settlement company. What is Burt’s basis? Does Burt get a step-up to $200,000 at Ned’s death, or does Ned’s basis of $100,000 carry over? Does COI prior to Ned’s death act to adjust Burt’s basis?

How would the answer change if Burt is planning to surrender the policy rather than sell it? Would the analysis be different if Ned owned a term policy on Burt’s life instead of a cash value policy?

What Extra Tax Reporting Obligations Will Be Imposed on Life and Settlement Companies?

We should expect additional IRS guidance with regard to the COI and basis step-up issues. When that guidance is published, it seems likely that life carriers and settlement companies will get handed at least some additional tax reporting burdens.

We are seeing the first signs of enthusiasm for tax reporting related to life settlements. Among the Obama Administration’s fiscal year 2010 tax proposals, there is a specific procedure that would require tax reporting when a person or entity purchases an interest in an existing life insurance contract with a death benefit equal to or exceeding $1 million. Under the proposal, the settlement company would be required to report to the Revenue Service, to the insurance company that issued the policy, and to the seller (a) the purchase price, (b) the buyer’s and seller’s taxpayer identification numbers (TINs), and (c) the issuer and policy number. 

Why Revenue Ruling 2008-13 Matters – An Example

Say that Buck owns a policy on his life with a face amount of $10 million, basis of $500,000, and surrender value of $550,000. If Buck surrenders the policy, the first $500,000 of surrender value is tax free. The other $50,000 is taxable gain, subject to ordinary income tax. If Buck is in a 35% tax bracket, the income tax hit is $17,500. Buck would receive $532,500 of net proceeds in the event of a surrender.

Let’s also say that Buck shops around to see if the policy is worth more in the life settlement marketplace. If Buck gets an offer for $575,000, it would seem to be a good deal for him.

However, by applying the new tax analysis, Buck may actually be better off surrendering the policy.

Here’s the logic and the math. Since Buck is settling a cash value policy for more than he could have surrendered it for, the substitution of income doctrine applies, and $50,000 of the settlement proceeds are subject to ordinary income tax. At Buck’s assumed 35% tax bracket, that’s a $17,500 tax hit.

The rest of the gain—according to Revenue Ruling 2009-13—is subject to capital gains tax. Gain on a settled policy is calculated by measuring the extent to which the settlement proceeds exceed adjusted basis. To calculate adjusted basis, we have to subtract COI from “normal” basis.

Say that the cost of insurance charges for the policy had been a total of $200,000 during Buck’s ownership. That means adjusted basis is $500,000 minus $200,000—or $300,000. If Buck gets $575,000 for settling the policy, that means the total gain is $275,000. The first $50,000 of that gain is taxed under the substitution of income doctrine. The other $225,000 gets hit with capital gains tax. This year, the maximum capital gains rate is 15%. If that rate applied to Buck, the capital gains tax is $33,750.

The total tax on life settlement would be the ordinary income tax of $17,500 plus $33,750, making the total tax $51,250. Subtracting the $51,250 tax from the settlement proceeds of $575,000 leaves Buck with $523,750. That’s $8,750 less than the after-tax proceeds he keeps if the policy is surrendered.

Conclusion

Owners of life insurance now have access to an organized secondary market for their life insurance policies. The life settlement market offers a source of ready cash to compete with the issuing company’s surrender value. From that perspective, life settlements are good for consumers.

Unfortunately, the development of the settlement market has not been all good. Due to the abusive practices of some agents, settlement companies and individuals, life settlements have also had their share of bad press. Some customers have been induced to participate in fraud, or have had access to needed insurance blocked. From that perspective, life settlements can be bad for customers.

The IRS, in Revenue Ruling 2009-13, stepped in to answer some questions about the tax treatment of life settlements. Some aspects of the Revenue Ruling were favorable, while others were not. The Ruling has definitely changed the economics of life settlements, and must be considered as part of the settlement evaluation process.

The new tax rules have the benefit of adding a degree of certainty to one financial aspect of entering into a life settlement transaction. One of our senior clients may have reason to consider a life settlement, and is likely to need our help in evaluating whether a life settlement makes sense. By helping to shop for the best deal, weigh the risks and calculate the costs, financial professionals will be in the best position to offer competent advice.

Advanced Planning Update for the Summer of 2009

On Thursday, July 9, Advanced Underwriting Consultants (AUC) will be sponsoring an Advanced Planning one-hour webinar titled “How to Profit from the Coming Changes” from 3-4 p.m. Central Time. 

The call will feature life and annuity industry experts talking about current topics of interest, including

• Estate Planning Update

• Getting a Head Start on 2010 Opportunities

• Recent Developments Affecting the Life Insurance and Annuity Business

o Taxation of Life Settlements

o Capitalizing on the Current Economy

The conference call is open to all current AUC companies and Think About It subscribers at no additional charge.  Reservations are required.  Please call 1-888-263-0640 or email brenda.harvill@ to save a spot, and to arrange for the companion materials to be provided.

This call is a great opportunity to see and hear AUC’s expert panel discuss the latest technical developments and how the new rules will affect your business in 2009.  Reserve your spot today.

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