Life Settlement

A life settlement is the sale of an in-force life insurance policy by its owner to an investor, for a cash price higher than the policy's cash surrender value and lower than its death benefit. The buyer becomes the owner and beneficiary, pays the remaining premiums, and collects the death benefit when the insured dies. In everyday use the term describes a sale where the insured is not seriously ill, in contrast to a viatical settlement, where the insured is terminally or chronically ill.

That contrast is real but it is a tax distinction rather than a regulatory one, and the naming reflects an accident of drafting rather than two different products. The NAIC's Viatical Settlements Model Act, which is the source of most state regulation of the market, carries a drafting note saying that in implementing it "states may elect to use terminology referring to life settlements rather than viatical settlements," and its definition of the seller expressly is not limited by health. What is not a drafting choice is Internal Revenue Code section 101(g), which reaches only a terminally or chronically ill insured. A sale outside those categories gets none of section 101's treatment and is taxed as what it is: a disposition of property.

The seller's tax, in two steps. The first step is the amount of gain: the price received less the owner's adjusted basis in the contract. Basis is the premiums paid, and the reason that is worth stating precisely is that it used to be less. Revenue Ruling 2009-13 held that basis was reduced by the cost of insurance charges the policy had absorbed, which made the taxable gain larger than the difference between the price and the premiums. The Tax Cuts and Jobs Act reversed that by adding section 1016(a)(1)(B), which provides that no basis adjustment shall be made "for mortality, expense, or other reasonable charges incurred under an annuity or life insurance contract." The amendment applies, by its own terms, "to transactions entered into after August 25, 2009," which is the day before the effective date the revenue ruling gave itself. So the arithmetic in the ruling's own examples no longer describes current law, while its reasoning about character still does.

The second step is the character of that gain, and this is where a life insurance policy behaves unlike an ordinary asset. Revenue Ruling 2009-13 applies the "substitute for ordinary income" doctrine, under which a taxpayer cannot convert earned but unrecognized ordinary income into capital gain by selling the asset that holds it. The ruling limits the doctrine "to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract)," and says that where the income on sale exceeds the inside build-up, "the excess may qualify as gain from the sale or exchange of a capital asset." Inside build-up is the cash surrender value less the premiums paid. So the gain up to that figure is ordinary and the rest is capital gain, long-term if the policy was held more than a year.

A term policy has no inside build-up, and that changes the answer. Because the doctrine has nothing to bite on where there is no cash surrender value, the ruling's own term-insurance example produces gain that is entirely long-term capital gain. A term policy also cannot be surrendered for anything, which makes a sale the only route to value other than letting it lapse.

The buyer's side, and why the sale is usually reportable. Section 101(a)(2) limits what a transferee can exclude from a death benefit where the policy was acquired for valuable consideration, and then provides exceptions, notably where the transferee's basis carries over and where the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Section 101(a)(3)(A) switches those exceptions off for a "reportable policy sale," defined in (a)(3)(B) as an acquisition of an interest in a life insurance contract "if the acquirer has no substantial family, business, or financial relationship with the insured apart from the acquirer's interest in such life insurance contract." An investor buying a stranger's policy is the paradigm case. The practical consequence is that the buyer's exclusion is capped at the price paid plus premiums paid afterwards, so the buyer is taxed on the rest of the death benefit. That tax cost sits inside the price a buyer is willing to offer, which is part of why an offer is well below the death benefit even on a policy the buyer expects to collect.

What state regulation adds. Where a state regulates the market under the NAIC model act, the seller gets a licensed counterparty, a mandatory written disclosure document delivered before signing, and a conditional rescission right. Those protections and the licensing architecture come from the same statute that governs viatical settlements. What matters here is that they are a function of state law rather than of the transaction, so they vary.

The realistic alternative set is short. For a policy the owner no longer wants, the options are to keep paying, to stop paying and let it lapse, to surrender it for the cash surrender value if it has one, to reduce it to a paid-up or extended-term form if the contract offers that, or to sell it. A sale is worth investigating precisely when the policy has a large face amount and a small cash surrender value, because that is where the gap between what the insurer will pay and what a buyer will pay is widest. What makes an offer hard to judge is that it is a price quoted against an estimate of the insured's remaining lifetime, produced by or for the buyer, which the seller has no way to audit and no second quote is obliged to use.

1. The owner submits the policy and medical records, usually through a broker, and the buyer commissions a life-expectancy estimate. Price is a function of the death benefit, the remaining premiums and that estimate.

2. Offers come back as a cash figure. The seller compares them against the cash surrender value, against any paid-up or reduced-coverage option in the contract, and against simply keeping the policy.

3. Ownership and beneficiary designation transfer to the buyer, who takes over every future premium.

4. The seller reports the sale, splitting the gain between ordinary income and capital gain as below. The buyer's own exclusion at death is limited if the sale was a reportable policy sale.

A hypothetical, showing the two-step split. Priya has paid $120,000 of premiums on a universal life policy. Its cash surrender value is $150,000 and a buyer offers $200,000. She has held the policy for more than a year and is in good health, so section 101(g) does not apply.

Her adjusted basis is the $120,000 of premiums, with no reduction for cost of insurance charges, because section 1016(a)(1)(B) forbids that adjustment. Total gain is therefore $200,000 − $120,000 = $80,000.

The inside build-up is the cash surrender value less the premiums paid: $150,000 − $120,000 = $30,000. Under the substitute for ordinary income doctrine that $30,000 is ordinary income. The remainder, $80,000 − $30,000 = $50,000, is long-term capital gain.

Compare the alternative. Surrendering the same policy pays $150,000, and the entire $150,000 − $120,000 = $30,000 of gain is ordinary income. The sale produces $50,000 more cash, and the extra amount is taxed at capital gain rates rather than ordinary rates. Figures are illustrative; state income tax and the net investment income tax are ignored.

Pros

• A sale usually pays materially more than surrendering, and it is the only route to value on a term policy, which has nothing to surrender.
• It ends the premium obligation on coverage the owner no longer needs.
• The portion of the gain above the policy's inside build-up is capital gain rather than ordinary income, which a surrender never achieves.
• Basis is the full premiums paid, with no reduction for cost of insurance charges, since section 1016(a)(1)(B) was added in 2017 and applied retroactively.

Cons

• The coverage is gone. Anyone who would have received the death benefit receives nothing, and buying replacement coverage later is priced at the insured's age and health then.
• Part of the gain is ordinary income, and the tax lands in a single year.
• The price is built on a life-expectancy estimate the seller cannot verify, and a longer estimate means a lower offer.
• The buyer holds a financial interest in the insured's early death and typically retains the right to confirm health status periodically.
• Proceeds are an asset in the seller's hands, so they can be reached by creditors and can affect eligibility for means-tested programs that a policy would not have affected.
• The seller's protections, including licensing, disclosure and rescission, depend on whether and how the state regulates the market.