Recent Developments: Regulation and Taxation of the Life Settlement Industry
by Troy E. Thompson (1)
Like all catastrophes, the market turmoil of 2008-09 will produce winners as well as losers. With conventional portfolios depleted, and with some overly excitable pundits sounding the death knell of modern portfolio theory, one aspiring winner is the growing market for life insurance policies, known as life settlement.
Life settlement is the purchase of an in-force life insurance policy by an unrelated investor, who expects to profit at the death of the insured by collecting more than she paid to acquire and maintain the policy. Such a buyout can represent a genuine boon for seniors who no longer need life insurance or can’t afford the premium anymore, and who might otherwise expect to recover only the cash surrender value of the policy. Investors are attracted to life settlements as an asset class for their supposed non-correlation—proponents tout relative immunity from stock market volatility and the uncertain credit markets. Other market participants are less enthusiastic. Life insurance companies themselves, who fund the benefits, view life settlements as a drain on mortality cost and a fly in the ointment of their underwriting assumptions. And regulators must confront an industry with a checkered history in an area ripe for abuse.
Life settlement represents a booming business. By one estimate the market for life settlements reached $12 billion in 2007, up from only $2 billion five years earlier. (2) Compared to the size of the life insurance industry as a whole, with over $500 billion in life premiums written in 2008,(3) this may not seem large. But rapid growth and the impact on one of the life insurance industry’s key metrics—lapsed policies—command attention. Not surprisingly, firms like Goldman Sachs, Credit Suisse and Deutche Bank all maintain a presence in this corner of the market. Whether the industry continues to thrive will be influenced part by two important recent legal developments. First, Oregon and a number of other states have enacted new regulatory legislation in the last year that will impact the way policies are bought and sold in the marketplace. (4) Second, the Internal Revenue Service has released formal guidance that will shape the fundamental economics of the transaction. (5)
Background and Legal Framework
The basic legal framework governing life settlements has long been settled. Public policy as well as state laws prohibit taking out an insurance policy on the life of a stranger—someone in whom you have no “insurable interest.” (6) Such a policy is said to represent nothing more than a pure wagering contract. More to the point, it would create an unsavory and perhaps criminal interest in the death of the insured, with no counterbalancing interest in his continued survival. Modern insurance law continues to prohibit so-called “stranger-originated life insurance” or “STOLI” practices. In an important exception to the insurable interest rule, the Supreme Court long ago confirmed in the case of Grigsby v. Russell (7) that the rule does not prevent the subsequent assignment of a policy that was valid when issued.
Except for the number of zeroes before the decimal point, the facts in Grigsby might have taken place last year rather than a century ago. Facing financial difficulty, John Burchard could no longer continue paying the premiums on his life insurance policy. Worse for him, he also couldn’t afford the medical treatment that he badly needed. He agreed to sell his policy to a Dr. Grigsby in exchange for $100. Burchard later died. (Accounts are inconsistent as to whether Grigsby was actually Burchard’s doctor as well as his life settlement provider. If so, the fact aroused no comment from the Court.) In any case, Dr. Grigsby claimed the death benefit under the policy. In the fight that ensued between Grigsby and Burchard’s estate, the insurance company refused payment. The case made its way to the Supreme Court, where the foundation for the modern life settlement marketplace was established.
The Special Case of Viatical Settlements
The modern life settlement market emerged in the 1980s and 1990s with a special form of the transaction known as a viatical settlement. (8) This form of settlement offer was usually made to terminally ill patients and is associated in the public mind with the AIDs crisis. Since the mortality of that disease was so terribly high and the cost of medical treatment so exorbitant, many patients followed John Burchard’s lead and sought cash from their life insurance policies. Investors came forward, seeing the chance for a reasonably certain payout over a short period of time. Especially in the early years of the epidemic, before effective treatments were developed, there was a brief opportunistic surge in market activity.
Regulation of the Viaticals Marketplace
During this early period rules remained sparse. Due in part to well-publicized abuses within the industry, various states moved to regulate the market in the mid-1990s. To supplement enforcement efforts under existing state insurance law, states began to enact consumer protection measures designed to regulate settlement providers in their dealings with policy-holders and investors.
Consumer protection measures derived largely from the draft of a model law and regulations promulgated by the National Association of Insurance Commissioners (“NAIC”). (9) At least 40 states have now adopted some version of this model law or another form of regulation governing life settlement companies in some way. These laws generally require i) licensing of providers and brokers, ii) filing and approval of settlement agreements, iii) mandatory disclosures to insureds and sellers, and iv) periodic reporting by settlement companies. The model legislation also specifically prohibits certain business practices deemed to be abusive. As originally enacted, these statutes were limited in scope, reflecting the predominance of the viatical model at the time.
Oregon Viaticals Law
Oregon’s original viatical settlement statute, which was enacted in 1995, was typical of the period. (10) The scope was limited to transactions involving an insured “with a terminal illness or condition” where a life insurance policy, including the right to name the beneficiary, was assigned for value. (11) Within that narrow field, life settlement providers and brokers were for the first time required to be licensed (12) and subject to examination, bonding and insurance requirements.(13) The settlement contract itself was required to be in writing and contain a 15 day rescission period. The form of the contract was required to be filed and approved in advance by the Department of Consumer and Business Services. (14) The terminally ill insured was required be certified as to both mental competency and physical condition by her own physician.(15) Finally, disclosure to the seller was required as to i) possible alternatives, including those offered by the insurer, ii) possible tax consequences, iii) exposure to claims of creditors, iv) risk of loss or reduction of government benefits, v) the seller’s 15 day rescission right and vi) the source of funds and the date on which funds would be disbursed to the seller. (16)
Federal Taxation of Viaticals
By 1996 the viatical settlement was a well established tool for financing palliative care for AIDS patients and other terminally ill patients. Insurance companies during this same time began to offer accelerated death benefits under limited circumstances, to be used largely for the same purposes. In recognition of these developments, Congress included a provision as part of the Health Insurance Portability and Accountability Act of 1996 that treats accelerated death benefits and proceeds of viatical settlements as non-taxable life insurance proceeds. (17) In the absence of legislative relief, such proceeds would have been subject to erosion by taxation. (18) The exclusion of accelerated death benefits and viatical proceeds from taxable income was perhaps the most important development in the life settlement market since Grigsby. As life insurers jockeyed with the upstart life settlement providers for control over pre-death benefits choices, parity in tax treatment was seen as vital.
Section 101(g)(2) of the Internal Revenue Code of 1986, as amended, generally limits the favorable viatical treatment to transactions between a licensed settlement provider and an insured who is either terminally or chronically ill. Payments to the chronically ill can only be excluded from income if they are used to pay for qualified long-term care services. Most importantly, a policy holder receives exactly the same tax treatment whether he decides to accept an accelerated death benefit or a viatical settlement. Neither life insurers nor settlement providers are favored.
Today’s Marketplace
As the AIDS crisis crested in the 1990s, the certainty of viatical payouts diminished and the investment horizon lengthened. The early investors took their profits, and some later investors were left holding insurance policies on relatively healthy insureds who now expected to live for decades. More generally, increased competition and an effective response from life insurers in the form of more flexible policy loans and accelerated death benefits also drove profits down.
The industry has quietly regrouped as investors, settlement providers and life underwriters have identified broader market opportunities. What has emerged is a market quite removed from the viatical model. Today’s seller is likely to be a high net worth individual in relatively good health. He doesn’t necessarily need the proceeds to pay for medical expenses or anything else. Rather, he has in place a number of large special purpose insurance policies that are no longer useful. His company might hold a key-man policy in connection with his leadership role, but he is now retired. He may have taken out another to support a buy-sell agreement with his partners, but the business has been wound down, or the partners have since died. A target policy typically has a face amount in excess of $250,000. Compared with the number of policies on identifiable terminally ill patients sought by the viatical market, these kinds of policies are more numerous, carry higher face values, and therefore offer a potentially much wider market opportunity. (19)
The economic and financial turmoil of the past two years has impacted the market for life settlements in two positive ways. First, older retirees have seen retirement assets shrink, and many are seeking new sources of liquidity to pay for basic living expenses. Life insurance is often an easy asset to sacrifice. Second, investors who saw what they thought were adequately diversified portfolios plummeting in value are actively seeking alternatives that won’t be as vulnerable to market shocks.
In this environment of opportunity, the industry confronts a basic legal framework that is already well understood. Likewise, the issues facing the special viatical segment have been fought to a draw. Two of the most important remaining areas of contention are broad new consumer protection and regulatory statutes and the proper income tax treatment of the underlying transactions.
S.B. 973
Unlike the earlier wave of consumer protection legislation, which was narrowly focused in scope, recent legislation is the product of broader thinking on the part of the legislature, and more sophisticated lobbying by the private sector players. In July 2009, Governor Ted Kulongoski signed into law Senate Bill 973, which greatly expands Oregon’s life settlement legislation. The legislation includes valuable consumer protection measures and sensible anti-STOLI provisions, but also contains disclosure language designed to shape market perceptions of and participation in life settlement transactions.
The economic tensions between life insurers and life settlement providers are readily apparent. Life insurers expect that a certain predictable percentage of policies will lapse before death and never pay benefits. They price these expectations into the product. They also compete directly with life settlement providers by offering cash surrender payments and various other more flexible forms of pre-death payout. Life settlement transactions upset settled industry expectations and extract value from the insurers.
Settlement providers view the insurance policy as an illiquid investment that can and should be freed-up in a rational market. They also perceive correctly that the value locked up in these policies can be stripped away from the original insurer, and that the policy owner holds the keys. It is no surprise to see these tensions played out in the struggle for regulatory reform.
Consumer Protection
Leading up the consumer and investor protection measures is the flagship 5 year waiting period provision. In general, policy owners are not permitted to enter into settlement transactions within the first five years after a new policy has been issued. (20) Prior law in Oregon and many other states generally required only a two year waiting period, corresponding to the typical non-contestability period for life insurance policies. The measure has been heavily promoted by the insurance industry nationwide as a way to discourage STOLI transactions.
Exceptions are permitted in limited circumstances. Settlement after two years is permitted if the policy has been financed entirely by the insured, a close relative or a person having a substantial economic interest in the life of the insured, and neither the insured nor the policy has previously been evaluated for settlement. (21) Settlement by the insured is permitted at any time in the event of chronic or terminal illness, death of a spouse, divorce, retirement, full disability, or bankruptcy. (22)
Closely allied to the five year waiting period is the 60 day rescission period, increased from 15 days under prior law. All life settlement contracts entered into in Oregon must contain the absolute right to rescind the contract within 60 days of execution or 30 day of disbursement of funds, whichever is earlier. (23) Death of the insured during the 60 day period automatically rescinds the contract. Together these two provisions should go a long way toward reducing the opportunity for STOLI-type abuses.
Responding to the concerns of health privacy advocates, the legislation imposes modest limits on the sharing of personal and health-related information of the insured.(24) It also restricts the frequency of contacts by the new owners and beneficiaries for the purpose of monitoring the health of the insured. (25) In addition, the legislation imposes an ongoing duty to notify the insured whenever the new owner resells the policy or changes the designated beneficiary. (26) These measures are aimed preserving some measure of privacy and sense of control in the face of the unavoidably ghoulish aspect of life settlements—waiting for the insured to die.
Notably, the legislation expands the existing mental competency requirements to all persons entering into life settlements, not just the terminally or chronically ill, regardless of age. The policy owner must have an attending physician certify that the owner is of sound mind and not under undue constraint. (27) Further, the owner must represent in writing and before witnesses that he understands the life settlement contract and consents to it; and that he also understands the benefits of the life insurance policy being given up. (28) Such heightened formality requirements, comparable to those found in real estate and testamentary settings, offer considerable additional protection against elder-abuse and other potentially fraudulent activity.
Disclosures
As important as the consumer protection measures are, the real nature of the struggle between life insurers and settlement providers is revealed in a raft of mandatory disclosures and contract provisions comprising the bulk of the bill’s new provisions. The policy arguments confronting the legislature are reflected to an unusual degree in the text itself. Many of the specific disclosure items appear to have been culled directly from interest group talking points. Putatively designed for consumer protection, the disclosures are perhaps better understood as part of a wider effort to control public perception of the proper role for life insurance and the legitimacy of life settlements.
Most of the required disclosures burden the life settlement side, and express the viewpoint of the life insurance industry. Before even being considered for settlement, policy holders are required to receive greatly expanded written disclosures, including:
• there may be other alternatives to life settlement, including any available accelerated death benefits or policy loans offered by the insurance company under the policy;
• proceeds might be taxable;
• proceeds might be subject to creditor’s claims;
• settlement may affect eligibility for public assistance; (29)
• conversion rights and other rights under the policy may be forfeited and that the settlement may cause the insured to be ineligible for future coverage;
• family members or others under a joint policy may lose coverage;
• the owner’s right to benefits under the policy, including the death benefit, will be transferred to the provider. (30)
The savvy consumer will recognize between these lines many of the most heavily promoted selling points for life insurance.
In addition to policy holder disclosures, the legislation also requires warnings to the prospective investor that:
• the contract pays no dividend or interest;
• there will be no return until the insured dies;
• the actual rate of return cannot be measured until the time of death;
• the investment is illiquid, with no established secondary market;
• the investor must pay premiums to maintain the policy in force;
• benefits may be lost if the insurance company goes out of business. (31)
Investors must further be advised of the risks of policy contestability, either by the insurance company or by the insured’s heirs (remember John Burchard?). (32) Finally, prospective investors must be given the bona fides of the life underwriter who actually estimates the life expectancy of the insured in order to price the settlement offer, and must be shown the policy holder certifications on which the estimate is based. (33)
Not only must the investor and the policy holder be properly advised, the insurer itself must be notified of the intended settlement and given an opportunity to open a fraud investigation before verifying the policy. (34) Special disclosures are required if a policy is settled under the exceptions to the five year waiting period. (35)
Life settlement providers have not been completely forgotten, however. Under the new legislation insurers are not permitted to engage in stalling tactics or obfuscation when dealing with life settlements. Insurers must promptly respond to coverage verification requests by providers and brokers and must take timely steps to transfer policies pursuant to a life settlement. (36) They may not impose documentation requirements or demand waivers or consents other than those set forth in the legislation, and must comply with instructions to change ownership and beneficiary designations without unreasonable delay. (37) Most strikingly, while providers must mandatory warnings about the dangers of life settlement, the new legislation requires life insurers to sing its praises. Whenever an insured age 60 or older offers to surrender a policy for cash, seeks an accelerated benefit under the policy, or is in danger of lapse, Oregon insurers are now required to advise the insured of alternatives, including life settlement. (38) Insureds must also be advised to seek information from the Insurance Commissioner, who is required to provide information on policy holder options. The right to pursue alternatives other than those available under the insurance contract has been one of the major marketing messages for of life settlements.
It is unclear whether consumers and investors will be enlightened by all of this information or simply confused. It is just as uncertain whether a vibrant and established market for life settlements will ultimately develop in Oregon and elsewhere. But if such a market does develop, its features will have been shaped in large part by these legislative ground rules.
Taxation
Income taxes weigh heavily in decisions concerning life settlements, and more so because the rules have been uncertain. Because life insurance contracts are generally afforded favorable tax treatment, life settlement contracts confront a difficult challenge. Policy holders who retain their policies can count on the death benefit being excluded from income of the beneficiary. Those who surrender their policies generally must include only the excess of the cash surrender proceeds over the cumulative paid-in premiums, which is treated as ordinary income. In contrast, the proper treatment of life settlement transactions has been the subject of widespread uncertainty. The prevailing view (perhaps the better word is hope) within the life settlement industry had been that life settlements could be treated at least as well as cash surrender. This would preserve the broad parity between the two options that had been achieved in the viatical context. Optimists had even hoped for more favorable capital gains treatment to place life settlements in a clearly advantageous light. Last May, Treasury (under pressure from Congress) issued Revenue Rulings 2009-13 and 2009-14, upsetting the optimists and potentially eroding the market appeal of life settlements.
Revenue Ruling 2009-13
Revenue Ruling 2009-13 addresses the tax consequences to the holder of a life insurance policy in three Situations: 1) cash surrender for of a cash value policy, 2) sale to a third party of a cash value policy, 3) sale to a third party of a term policy. As compared with cash surrender, Rev. Rul. 2009-13 produces a considerably less favorable tax-free basis recovery for life settlements, and provides only limited capital gain treatment.
Cash Surrender
To begin with, the ruling confirms the treatment of cash surrender. In the facts given, the taxpayer surrenders a whole life policy for its $78,000 cash surrender value, which reflects a $10,000 reduction for “cost-of-insurance” charges imposed by the issuer. The taxpayer has paid $64,000 in cumulative net premiums. Because the policy is being surrendered, the proceeds are considered to be an amount received under the insurance contract, and therefore subject to the special rules of Section 72(e). In general, Section 72(e)(5)(A) requires that the amount be included in income, but only to the extent it exceeds investment in the contract. Thus, only $14,000 ($78,000-64,000) is included in income, without regard to cost-of-insurance charges.
Although the Section 72(e) rules operate in some respects like the capital gains basis rules, the income is treated as ordinary rather than capital gain. The character of the income is not specified in Section 72(e), and it does not otherwise qualify for capital gain treatment because the surrender of a life policy is not a “sale or exchange” of the policy. (39)
Life Settlement
The ruling next introduces the life settlement transaction. In the facts given, the taxpayer sells the same policy to a third party for $80,000 rather than surrendering it for cash. Here, the parties are clearly in a “sale or exchange” setting, with important implications. There is now at least the potential for capital gain treatment of amounts received in excess of basis. And, because, Section 72(e) does not apply, the specific statutory rules give way to more general tax basis concepts. Despite these promising signals, the ruling ultimately produces a disadvantageous tax result, stemming from two complicating factors. First, basis recovery works very differently than in the case of cash surrender. Second, most of the remaining income is converted to ordinary in character through a judicial substitution doctrine.
The first step in the analysis is premised on the dual nature of life insurance, with both insurance and investment characteristics. Because the cost of insurance is personal and not a capital investment, the IRS concludes that the amount paid by the taxpayer must be allocated to the cost of insurance protection on the one hand and the investment element on the other. (40) Thus, although the taxpayer may be said to have a “Section 72(e) basis” equal to the full $64,000 in premiums, the adjusted basis for sale purposes is only $54,000 ($64,000 reduced by the $10,000 cost of insurance) and taxable income is $26,000. As a result, taxable income increases by $12,000 when compared to cash settlement, even though the taxpayer is only $2,000 richer.
The additional income might not be so bad if it could be treated as capital gain. However, although the sale is eligible for capital gain treatment, the IRS determines that a large part of the income is still ordinary. The reason lies in the “substitute for ordinary income” doctrine. Under the doctrine, ordinary income that has been earned but not yet recognized by the taxpayer cannot be converted into capital gain by a sale or exchange. The IRS concludes that the “inside build-up” under the contract represents unrecognized ordinary income to the taxpayer, which must be recognized on sale. Thus, $14,000 of the taxable income from the life settlement is treated as ordinary, and capital gain treatment is allowed only as to the remaining $12,000. (41)
Settlement of a Term Policy
In a final wrinkle, the ruling considers the effect of these principles on the sale of a term life policy. In the facts given, the taxpayer sells a term life contract for $20,000. As with the sale of a cash value policy, basis is equal to aggregate net premiums minus cost-of-insurance. However, since a term policy is pure insurance with no investment element, the entire investment in the policy is allocable to the cost of insurance. Absent proof to the contrary, the IRS will look to the monthly premium, with the added complication that the sale takes place mid-term. Thus, only the unearned portion of the premium is included in basis. The excess proceeds are capital gain in their entirety, since there is no inside build-up under the contract and therefore no ordinary income under the “substitute for ordinary income” doctrine.
Revenue Ruling 2009-14
Rev. Rul. 2009-14 addresses the income tax consequences to the direct buyer of the life policy and to secondary purchasers with mixed results for investors. (42) Primary investors are generally treated less favorably than secondary investors, with the result that a sale on the secondary market during the life of the insured is generally preferred to holding the policy until death.
The Primary Investor
In the facts given, the primary investor purchases a term policy from the insured for $20,000. The policy is a 15-year level premium term policy with a $100,000 face amount and no cash surrender value. The primary investor continues to pay premiums in order to keep the policy in force, with a view toward profiting from the death of the insured or from the subsequent sale of the policy in the secondary market.
Proceeds at Death of the Insured
If the primary investor holds the policy until the death of the insured, he receives $100,000 under the contract. As in the case of cash surrender, taxable income is determined under Section 72(e)(5)(A) and is equal to the amount received under the contract minus the investment in the contract. Because Section 72(e) governs, there is no basis reduction for cost-of-insurance, and the entire amount invested, plus premiums paid to keep the policy in force, is included in basis.
Section 101(a), which controls the treatment of death benefits paid under a life insurance policy, produces the same result. Death benefits are generally excluded from income, except where the policy has been transferred for consideration, in which case Section 101(a)(2) limits the exclusion to the amount of consideration and subsequent premiums paid by the transferee.
The character of the income is once again ordinary. Although neither Section 62 nor Section 72(e) specifies the character, the sale or exchange element required for capital gain treatment is missing.
Proceeds from Sale of the Policy
If the primary investor sells the policy for $30,000 during the life of the insured, his tax treatment changes dramatically. Because the sale or exchange element is now satisfied, there is the potential for capital gain treatment of amounts received in excess of basis. Neither Section 72(e) nor Section 101(a) applies, because the amounts are not received under the life insurance policy. In that case, the specific statutory rules give way to more general tax basis concepts.
The investor’s gain is measured by the $30,000 amount realized, minus basis. Basis is equal to the cost of the policy plus subsequent premiums. Note that, unlike the insured, the investor pays premiums not for the personal purpose of protecting against economic loss in the event of the insured’s death, but to prevent the policy from lapsing and thus preserve the value of the investment. Thus, the investor is not required to reduce its basis by any cost-of-insurance amount and is entitled to recover the full investment on a tax-free basis.
Under these facts, the ruling also confirms the capital gain treatment of the investor’s income. In the facts given, the policy is a term policy without any cash surrender value or “inside build-up”. Therefore there is no ordinary income to be recognized upon the sale under the “substitute for ordinary income” doctrine. (43)
Summary of Tax Rulings
The rulings will bring certainty and comfort to the market in some respects.(44) In particular, an authoritative rule for policy holders, the least sophisticated market participants as a class, will pave the way for broader participation and more transparent pricing. The proper analysis of capital gains treatment is confirmed, however limited its availability. And investors will be reassured that basis includes premium payments made to keep policies in force, notwithstanding the cost-of-insurance doctrine. Perhaps most welcome, in light of the widespread uncertainty preceding their issuance, the rulings confirm the IRS will not challenge tax positions taken by policy holders with respect to settlements made before August 26, 2009.
In their result, if not in any express policy rationale, Revenue Rulings 2009-13 and 2009-14 create significant disparities within the life settlement marketplace. A policy holder will be taxed more heavily on a life settlement than on a cash surrender of the same policy. The disparity will offset a portion of the higher price received, and in some circumstances absorb it entirely. In theory and in practice this disparity should drive up prices for life settlements, reducing their attractiveness for investors. Likewise for investors, death benefits are taxed more heavily than proceeds from a secondary market sale. All other things being equal, a “buy and hold” strategy is disfavored, and “flipping” or secondary trading is encouraged. This result gives no comfort to anyone troubled by the prospect of an active “death futures” market.
1 Troy E. Thompson is a member of the Oregon and California Bars and a Certified Financial Planner® practitioner. His company, Thompson Advisory Services, LLC, provides comprehensive, fee-only financial planning services to individuals and families throughout Northern California and the Pacific Northwest.
2 Conning Research & Consulting, Inc., Life Settlements: New Challenges to Growth (2008).
3 Insurance Information Institute, Insurance Factbook 2009-2010 (2009).
4 S.B. 973, 75th Leg., 2009 Sess., (Or. 2009), 2009 OR. LAWS c.711.
5 Rev. Rul. 2009-13 & Rev. Rul. 2009-14, IRB 2009-21 (May 26, 2009).
6 The insurable interest rule for life insurance is codified in Oregon at OR. REV. STAT. § 743.024, and rooted in the common law, Brett v. Warnick, 75 P. 1061, 1063-64 (Or. 1904).
7 222 U. S. 149 (1911).
8 In the Western Christian tradition, the Viaticum is the Eucharist or Holy Communion administered to a dying person as part of last rites.
9 Viatical Settlements Model Act (National Association of Insurance Commissioners).
10 995 OR. LAWS c.342.
11 1995 OR. LAWS C.342 § 2, former OR. REV. STAT. § 744.319(3).
12 1995 OR. LAWS C.342 §§ 4-10, former OR. REV. STAT. §§ 744.321-744.338.
13 1995 OR. LAWS C.342 §§ 13, 18, former OR. REV. STAT. §§ 744.346, 744.358.
14 1995 OR. LAWS C.342 § 11, former OR. REV. STAT. § 744.341.
15 1995 OR. LAWS C.342 § 15, former OR. REV. STAT. § 744.351.
16 1995 OR. LAWS C.342 § 14, former OR. REV. STAT. § 744.348.
17 Pub. L. 104-191, § 331, 26 U.S.C. § 101(g).
18 It was not clear until last summer exactly what the proper tax treatment had would have been. See the discussion of Rev. Rul. 2009-13 and Rev. Rul. 2009-14, below.
19 The face value of policies eligible for settlement in the current market is estimated to be $170 billion. Steven A. Morelli, “Are Life Settlements the $170 Billion Elephant in the Room?”, InsuranceNewsNet Magazine, http://insurancenewsnet.com.
20 2009 OR. LAWS c.711 § 14(1).
21 2009 OR. LAWS c.711 § 14(1)(c).
22 2009 OR. LAWS c.711 § 14(1)(b).
23 2009 OR. LAWS c.711 § 8, amending OR. REV. STAT. § 744.341.
24 2009 OR. LAWS c.711 § 9, amending OR. REV. STAT. § 744.343.
25 2009 OR. LAWS C.711 § 13(7)(a).
26 2009 OR. LAWS c.711 § 11(4).
27 2009 OR. LAWS c.711 § 13(1)(a).
28 2009 OR. LAWS c.711 § 13(1)(e).
29 However, the provider is also permitted to note that settlement proceeds may reduce the owner’s risk of becoming impoverished and having to rely on public assistance.
30 2009 OR. LAWS c.711 § 11(1).
31 2009 OR. LAWS c.711 § 11(5).
32 2009 OR. LAWS c.711 § 11(5)(k).
33 2009 OR. LAWS c.711 § 11(5)(m); 2009 OR. LAWS c.711 § 11(7)(a).
34 2009 OR. LAWS c.711 § 13(1)(b)-(d).
35 2009 OR. LAWS c.711 § 14(2).
36 2009 OR. LAWS c.711 §§ 13(1)(d), 14(3).
37 2009 OR. LAWS c.711 § 14(4)-(5).
38 2009 OR. LAWS c.711 § 22(2)(a)-(b). “Life insurance is a critical part of a broader financial plan. There are many options available, and you have the right to shop around and seek advice from different financial advisers in order to find the option best suited to your needs.”
39 Section 1222(3) defines long-term capital gain as gain from the sale or exchange of a capital asset held for more than one year. The conclusion is consistent with the longstanding position of the IRS expressed in Revenue Ruling 64-51, 1964-1 C.B. 322 (1964).
40 In the real world, the taxpayer may have difficulty making this allocation, as life insurers do not routinely disclose the information.
41 This part of the ruling suggests that taxpayers contemplating settlement may benefit in at least some cases from reducing or eliminating inside build-up by means of policy loans or use of value for premium payments. The optimal strategy would depend on the amount of the anticipated settlement offer, the existing basis in the policy, the taxpayer’s marginal rate, and the options available under the policy.
42 A third area of the ruling holds that income from the disposition of a policy issues by a U.S. insurer on the life of a U.S. person is U.S. source income. This ruling principally affects withholding for foreign investors, and may tend to dampen enthusiasm for cross-border investment in U.S. life settlements.
43 The ruling does not address the secondary market sale of a cash value policy. Presumably, the “substitute for ordinary income” doctrine should apply to convert some or all of the capital gain to ordinary income. However, this may not present a practical issue. Even in the case of a cash value policy it is typical for investors to strip out the cash value using policy loans or by using inside build-up to pay premiums. The effects of this strategy, implicit in the ruling, are to reduce basis and increase capital gain.
44 Other important issues remain open. Neither ruling addresses the proper treatment of any losses arising from these transactions. Nor does Rev. Rul. 2009-14 address whether nondeductible interest used to finance a life settlement contract may be added to basis in either of the scenarios it describes.
