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IRS Issues Two Groundbreaking Rules on Life Settlements

By Steven M. Etkind, Roger D. Lorence and Steven Huttler

The Internal Revenue Service (the “IRS”) has issued two rulings on participants in the life settlements industry.  This ever-expanding investment strategy entails the sale of life insurance policies to third party investors, who may themselves re-sell the policies or hold them to maturity (the death of the insured).  The life settlements industry has grown from a small “niche” market to a major international market where billions of dollars of capital are invested.  Both rulings are “revenue rulings,” which are rulings of general applicability and a high level of authority, albeit not as authoritative as regulations.

Taxation of the Insured

In Revenue Ruling 2009-13, the IRS analyzes three fact patterns in which the insured neither received distributions nor took out policy loans against the policy, which in the first two scenarios has a cash surrender value and in the third case has no cash value.

In the first case, an individual enters into a life insurance contract, which he surrenders for its cash value.  The policyholder paid total premiums of $64,000, and received $78,000 on surrender.  The IRS ruled that the $14,000 gain is ordinary because the surrender was not a sale or exchange of the policy (which is required to trigger recognition of capital gain or loss).

In the second scenario, the dollar values were similar to those of the first case, except that the individual sold the policy to a third party.  The sales price was $80,000.  The IRS ruled that the insured’s adjusted tax basis in the contract must be decreased by the cost of insurance (here, $10,000) during the time the policy was outstanding.  The IRS further ruled that the difference between the cash surrender value at the time of the sale ($78,000) and the policy holder’s adjusted tax basis ($54,000, which was the total premiums paid of $64,000 less the $10,000 cost of insurance) is ordinary income.  This prong of the ruling was based on case law holding that the “inside buildup” (increase in policy value due to investment of premiums in excess of the cost of insurance and related charges) represented investment income, analogous to a dividend on stock or interest on a bond.  After applying this “substitute for ordinary income” rule, only the excess of the sales proceeds above the cash surrender value was treated as long-term capital gain.

The facts of the third scenario differ from those of the first two because in the last case the policy had no cash value.  This case involved the sale of a 15 year level – premium policy with a $500 monthly premium.  The policyholder sold the contract to a third party during the fifteenth year of the policy for $20,000.  The ruling holds that the gain on sale is all long-term capital gain, except for one-half of the last-month’s premium, which represented the policyholder’s tax basis.

Taxation of the Secondary Market Holder (Domestic)

Revenue Ruling 2009-14 also sets out three factual cases. The first is a mirror image of the third case discussed above, involving the sale of a 15 year level – premium policy with no cash value.  The insured (“Party A”) sold the policy for $20,000 to a third party (“Party B”), who holds the policy to maturity and receives the $100,000 death benefit.  The ruling concludes that the excess of the death benefit over the basis in the contract (price paid plus premiums paid) is ordinary income because there was no sale or exchange of the policy.

The second scenario is the same as the first case, except that Party B later sells the policy to another third party (“Party C”) for $30,000. Party B paid $20,000 to acquire the policy and $9,000 in premiums up to the time of sale to Party C, so his adjusted basis in the contract was $29,000.   The IRS ruled that Party B’s profit (here $1,000) was long term capital gain because there was a sale or exchange of the policy.  Because the policy had no cash value, the “substitute for ordinary income” doctrine discussed above was inapplicable.

Treatment of Foreign Holders

The third scenario, which we believe may prove controversial, involves the sale of the policy to a foreign corporation that is not engaged in the trade or business in the United States, but is otherwise the same as the first case.  The ruling concludes that all of the gain realized upon the receipt of the death benefits, in this case, $71,000, is income subject to 30% U.S. withholding tax as “fixed or determinable annual or periodical income ” (“FDAP”) under Section 881(a)(1) of the Internal Revenue Code.

The ruling requires that any U.S. withholding agent (the life insurance carrier or its paying agent) withhold 30% of the amount of the death benefit in excess of the foreign holder’s tax basis in the contract.  The U.S. withholding agent will not have any formal basis to know what that excess amount is: there is no IRS form or other procedure provided in regulations or otherwise for a foreign party such as the one referred to here to provide tax basis information to a withholding agent.

In our view, the ruling’s conclusion appears to be contrary to the general principles dictating what types of income are subject to withholding taxes.  Withholding tax regimes are driven by the requirements of ease of  administration and certainty, to which Revenue Ruling 2009-14’s authors have failed to give due consideration.

We note that life settlement funds offered to non-U.S. investors and U.S. tax-exempt investors may qualify for exemption from withholding taxes on FDAP under the U.S. tax treaties with Ireland and Luxembourg.  Although these treaty-based structures will require more effort than a fund organized under  a non-treaty jurisdiction, e.g., Cayman Islands, the new rulings may be the drivers in that regard.

If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com), Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com) or Steven Huttler, 212.573.8424 (shuttler@sglawyers.com).  We welcome your input.

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2 Responses to IRS Issues Two Groundbreaking Rules on Life Settlements

  1. Charles Quinn says:

    I was told that revenue ruling 2009-13 became effecitve 8/26/09 and then someone else said that it was 8/28/08
    Is there any period of time in the past where the ruling does not aqpply?
    How much of it is retroactive? Client sold policy in March of 08
    Atty at law with a problem in this area.
    CF Quinn

  2. FWIW, Situation 2 just seems wrong. The only way any portion of this transaction can generate ordinary income is to treat the policy as if it were surrendered. But if you do that, then only the balance of the proceeds in excess of cash value ($2,000) is capital gain. The IRS shouldn’t have it both ways: either section 72 does not apply, and the entire $26,000 gain is capital, or section 72 does apply, and only $16,000 is taxed, $14,000 of it as ordinary income. (I believe the latter is the correct result: if the taxpayer cannot escape section 72 by sellig the policy, the government should not escape it, either.)

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