The Trump administration is now a part of American history. And though many may not agree with everything the former administration brought forth, one thing is certain: Life settlements and life policy owners benefited greatly. Here’s a breakdown of taxation on life settlements under the Trump administration and how President Biden’s tax plans could affect this asset class.
Life Settlements Under The Tax Cuts And Jobs Act Of 2017 (TCJA)
When President Trump’s administration passed the TCJA, life settlements became a more attractive option. Section 13521 of the TCJA states that “in determining the basis of a life insurance contract or an annuity contract, no adjustment is made for mortality, expense, or other reasonable charges incurred under the contract.” This essentially reversed the IRS rule that said the life insurance policy seller’s basis is reduced by the cost of insurance (COI) for mortality, expense or other reasonable charges incurred. In other words, whether a policyholder surrenders their policy to the insurer for a gain or sells it outright, the basis is calculated as the full premiums, which benefits policyholders.
Under the TCJA, settlement amounts:
1. Up to cost basis (full premiums) are free of income tax.
2. Above cost basis and up to cash surrender value (CSV) are taxed as ordinary income.
3. Above CSV and up to the life settlement amount are taxed as capital gains.
How A Rollback Of The TCJA Could Affect Life Settlements
The Biden administration has stated that the president intends to repeal parts of the TCJA, which may negatively affect the life settlement and life insurance industry. Previous to TCJA, the cost of insurance inside a policy did not count as cost basis. This increased the tax. Furthermore, clients and their advisors would often not be able to obtain the COI figures from the carrier to separate them from the premium, making it difficult to calculate taxes on a life settlement transaction.
If parts of the TCJA are repealed, including the beneficial elements to taxation of surrendered or sold life insurance policies, that could lead to higher taxation and difficulty calculating cost basis. In addition, the Biden tax plan also aims to remove capital gains for anyone with an income greater than $1 million. So, for wealthier policy owners, their taxation could almost double from 20% to 39.6%. This, coupled with a proposed reduction of most of one’s cost basis, could be debilitating to the owners of life insurance with regard to their options for exiting a policy.
IRS Form 1099-LS
Adding to all this is the recent mandate and approval of using IRS Form 1099-LS, which all life insurance and life settlement companies are required to submit to former policy owners and the IRS. There has been much confusion among life insurance carriers, life settlement providers, life settlement funds and life settlement escrow companies regarding who should be sending these forms and which amounts should be entered into the fields. This has resulted in clients receiving duplicates of the form, and some have even had differing reporting numbers in the form. These forms are new, and industry players have been working to reduce errors when issuing these to sellers. Any Biden administration policy changes will not affect the form, just the taxes one may pay as a result of receiving the form. What’s important to know here is that a seller will receive a 1099-LS.
IRS Form 1099-LTC
The only life settlement that likely will be spared from any changes in taxation is for sellers who are facing a chronic or terminal illness. Form 1099-LTC may be issued by a life settlement provider or life insurance carrier in any transaction involving an insured who is chronically or terminally ill. Life settlement transactions where a 1099-LTC is issued are usually tax-free to the seller. This form and its tax rules were in place long before the TCJA, so it is not likely to change under the new administration.
Life settlements have become a mainstream, regulated option for life insurance owners where the insured is a senior 65 or older. Life settlements can make life insurance more valuable and provide additional lucrative options when a policy is no longer needed, wanted or affordable. If President Biden repeals much of the TCJA, the cost basis and tax ramifications for life insurance policies that are surrendered for their cash value or sold as a life settlement could be negatively affected.
This possibility raises the question for many policy owners who are considering surrendering or selling their policy: Do I hurry and surrender or sell my policy now, or wait and see? Sellers should consult with their professional financial and tax advisors on tax ramifications before making any financial decisions, but it is important to consider that in the future, after-tax profitability could decrease for surrendering a life insurance policy or entering into a life settlement sale of a policy. Policy owners and trustees should consider a policy review now rather than later.
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