Life Settlements: Alternative Investment in Death a New Trend?
By Robert S. Schachter, CPA and Michael C. Nader, CPA Marcum LLP
These days, people are living longer and want to do more during retirement. They have seen their net worth decrease in this current economic recession which results in an uneasy feeling and harsh reality that it will be much harder to maintain the lifestyle to which they are accustomed. An increasing number of life insurance policy holders have found themselves borrowing against their policies to the maximum cash value or being unable to financially meet policy premiums. These choices result in the policy holders exploring new options to avoid implications of surrendering or permitting the policy to lapse. One increasingly explored option (typically for those aged 65-80) is a “life settlement” on their life insurance policy.
The concept behind the life settlement option is simple: a life insurance policyholder sells his or her policy, usually through a broker, for a lump sum of money that is typically three to four times the amount they would obtain by simply surrendering their policy to the life insurance company who issued the policy. The key issues determining the market value of the life insurance policy are the amount of death benefits, the cost of premiums and the life expectancy of the insured. The buyer, usually an institutional investor or broker, steps into the shoes of the insured, takes over payment of the premiums and collects the death benefit once the insured person passes away. The investor’s return depends on the insured life expectancy and date of death. If the insured dies before the estimated life expectancy, the investor may receive a higher return. If the insured lives longer than expected, the return will be lower. The risks associated with selling a life insurance policy on the secondary market are manageable for many consumers. Before the market existed, the only value a consumer could realize in giving up their life insurance policy was its stated cash value, or the amount of reserves in the contract based on the total principal and interest in the account. More specifically, the surrender value is typically about 5 percent of the face value of a universal life policy. Life settlements, on the other hand, provide a much higher payout. As a result, secondary life settlement markets have grown very rapidly in the last decade. With the increased capacity, a fast new alternative investment opportunity has been created for investors.
The beauty and attractiveness of this alternative investment is that it has no correlation to stocks, bonds or currency markets and no correlation to economic or political volatility. We have already begun to see the pooling of investor funds into vehicles which pursue the acquisition of life insurance settlements.
Subsequent to the acquisition of a life settlement contract by an investor, there are only two possible outcomes. The first being the policy is held until the insured dies. The second outcome is the policy is sold to a third party or expires (term policy). These two outcomes produce two vastly different tax results. On May 1, 2009, the Internal Revenue Service (“IRS”) issued two rulings, Revenue Ruling 2009-13 and Revenue Ruling 2009-14, to clarify uncertainties that surrounded taxability on these alternative investments.
Key considerations include:
- Proceeds from death benefit: Proceeds received from a life insurance contract less the costs of investment of the policy should be included in ordinary income.
- Contract sold or held to maturity: Gain/loss realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis (including all costs to purchase and maintain the policy). In other words, if the policy is sold to a third party before maturity, any gain/loss realized from the sale is capital gain/loss.
Example 1: Proceeds from Death Benefit
A is a 65 year old male who owns a life insurance policy “life settlement” on A’s life. The contract is a level premium fifteen-year term life insurance contract without cash surrender value and pays a $100,000 death benefit. The monthly premium for the contract is $500, due and payable on the first day of each month. The contract is originally issued by IC, a life insurance company, to A on January 1, 2001. B is an investment entity that invests in life settlement contracts.
On June 1, 2008, B purchases A’s life insurance policy for $20,000. At the time of purchase, the remaining term of the contract is 7 years, 7 months.
On December 31, 2009, A dies, and IC pays $100,000 under the life insurance contract to B by reason of A’s death. Through that date, B paid 19 monthly premiums totaling $9,500 to keep the contract in force.
B will include $70,500 as taxable income, which is the difference between the total death benefit received ($100,000) less the sum of the value of the consideration paid for the transfer ($20,000) and premiums paid by B ($9,500), or $29,500 “cost of the investment”. The $70,500 of income is taxed as ordinary income.
Example 2: Contract Sold Before Maturity
The facts are the same as in Situation 1, except that A does not die and, on December 31, 2009, B sells the contract to C (a person unrelated to A or B) for $30,000.
Proceeds received on B’s sale of the life insurance contract to C is $30,000, and the adjusted basis is $29,500 therefore B recognizes $500 gain on the sale to C. The $500 of realized gain is taxed at long term capital gain rates because B held the policy for greater than 1 year.
NOTE: If the policy expires under the term of the contract (B holds the policy and A does not die during the term of the policy), B receives no proceeds on the sale of the contract and incurs a capital loss of $65,500 ($20,000 (purchase price) + $45,500 (7 years 7 months of premiums paid)).
It is interesting that in current times, investments can include mortality. Presently, the sale of life settlement contracts are considered investments and therefore, are deemed capital gains transactions. However, Congress is considering changing the taxability by enacting new regulations. They have no definite time horizon but are considering that 100% of the resulting income from these types of transactions be treated as ordinary income. This would imply fresh analysis of the tax options and consequences for those involved with life settlements. We will update you on any changes as they occur.