Life Settlements — IRS Finally Clarifies Open Tax Issues

Yesterday, the Internal Revenue Service issued two Revenue Rulings that constitute the official position of the IRS on certain key tax issues in the life settlement arena. Uncertainty in this area had plagued taxpayers and tax practitioners for years. The guidance is therefore welcomed.

Revenue Ruling 2009-13
In the first ruling, Revenue Ruling 2009-13, the IRS provides guidance to original holders of life insurance policies who surrender or sell their policies. Where an original holder of a life insurance policy surrenders that policy, the ruling confirms that the holder’s taxable profit is reduced by the full amount of any premiums paid,without any reduction for the cost of insurance. The ruling also concludes that any such profit is ordinary (and not capital gain).

Where instead the original holder sells the policy to a third-party, however, the IRS confirms its somewhat controversial position (set forth in prior Private Letter Rulings) that the holder’s basis is not equal to the full amount of premiums paid, but instead must be reduced by the portion of the premiums paid expended for the provision of insurance (i.e., the cost of insurance). If the policy being sold is a pure term policy (with no cash
surrender value), essentially all premiums paid are presumed to be the cost of insurance for this purpose. The IRS does finally confirm, however, that a portion of any gain can be capital in nature upon such a sale. In particular, the component of any gain that is represented by “inside build up” on the policy (i.e., cash surrender value less aggregate premiums paid) is ordinary income, while any gain in excess of the “inside build up” is capital gain. Because term policies do not ordinarily have an “inside build up” component, gains from the sale of term policies should qualify as capital gain in their entirety.

Importantly, the holdings of Revenue Ruling 2009-13 applicable to sales of policies will not be applied adversely with respect to sales of policies occurring before August 26, 2009. Therefore, it appears that policy holders selling policies prior to that date may not be required to reduce their basis by the cost of insurance.

This ruling resolves one open point for participants in premium finance programs. In particular, if a participant were to surrender his or her policy in full satisfaction of a non-recourse loan under such a program, such participant may not get full tax basis for premiums paid, thereby increasing (phantom) gain in such scenario.
Interestingly, there is now a confirmed disparity in tax treatment between policy surrenders and policy sales.
Upon a surrender, a taxpayer will in essence receive a full basis offset for premiums paid, but will be taxed at ordinary income rates. Upon a sale, however, he or she will not have a full basis offset, but may be taxed at capital gain rates (in part). Depending on the facts, a taxpayer may have a better tax result upon either a sale or surrender.

Revenue Ruling 2009-14, on the other hand, clarifies to some degree the tax treatment to life settlement providers with respect to policies they hold that mature or are sold. If a policy matures while held by a secondary market purchaser, the ruling confirms that any profit (death benefit in excess of original cost plus
subsequent premiums paid) constitutes ordinary income. If the secondary market purchaser instead sells the policy (in a tertiary sale), the ruling states that the seller gets full basis for (and therefore its taxable gain, if any, is reduced by the full amount of) any premiums paid (without reduction for any cost of insurance) and that any gain on the sale that is not attributable to “inside build up” is capital. Finally, the IRS states that any death
proceeds received by a non-US secondary market purchaser (e.g., a Cayman fund classified as a corporation for US tax purposes) that is not engaged in a US trade or business constitutes US source income subject to a 30% US federal income (and withholding) tax (subject to reduction under an applicable income tax treaty). No guidance is provided as to whether the non-US secondary market purchaser would be subject to US tax if it had instead sold the policies in a tertiary sale.
Interestingly, the facts of Revenue Ruling 2009-14 are limited to pure term policies without any cash value. It is unclear whether the conclusions summarized above would differ if instead policies with cash value were involved. In addition, while Revenue Ruling 2009-14 provides guidance regarding the amount, character, and source of income to life settlement providers, the ruling unfortunately does not address at all the important question of whether non-deductible interest expense incurred by a secondary market purchaser to purchase or carry a policy in this case can be added to the purchaser’s basis in such policy. Accordingly, uncertainty remains with respect to this issue.
The two Revenue Rulings provide helpful, albeit incomplete, guidance in this area. Several open tax issues remain, however, and hopefully further guidance from the IRS will be forthcoming.

K. Peter Ritter
San Francisco
+1-415-984-8803
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Luc Moritz
Los Angeles
+1-213-430-6672
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