Life settlement, in which life insurance policies are sold in a secondary market, has become a major financial market and viable opportunity for CPA clients to convert unneeded policies for more than their cash surrender value (CSV), often with favorable tax treatment.
As an indicator of interest in such transactions , an increasing number of states are introducing model legislation to ensure they are transparent and ethical and, particularly, to protect seniors against abuses of stranger-originated life insurance (STOLI).
Although tax law provides little definitive guidance on the treatment of a life insurance policy being sold to a third party, the Tax Court has supported capital gain treatment for the excess of sale price over the higher of CSV or basis.
A safe life settlement should be made through an institutionally owned and funded purchasing entity and a contract that features a rescission period, HIPAA-compliant forms and notification of next of kin.
Alan Breus , CLU, ChFC, is principal of The Breus Group of San Jose, Calif., a qualified member of the Appraisers Association of America and an appraisal and insurance adviser to the planned giving departments of Northwestern University and Ohio University. He can be reached at email@example.com .
L ife settlement, boosted by aggressive marketing, has developed into a major secondary market for existing life insurance policies. The rise of this now $15 billion annual market has brought with it fresh regulatory scrutiny to crack down on the parallel growth of stranger-originated life insurance (STOLI). Given the growing importance of this segment of the life insurance business, CPAs should understand how and when life settlement can be a good investment for clients as well as the possible tax implications and hazards.
Individual life insurance protection totaled $10.056 trillion at the end of 2006, according to the Life Insurers Fact Book 2007 , published by the American Council of Life Insurers. This vast pool of in-force policies underscores the potential importance of life settlement. Furthermore, through lapse, more than 70% of existing life insurance policies are destined not to survive to pay a death benefit (see “ Life Insurance: What’s It Worth? (And Who Says?) ,” JofA , Jan. 08, page 32).
Often, the policies are no longer needed to meet their original purpose of protecting a family’s income stream, sending a child to college, compensating for the loss of a so-called “key man” or paying for a partner’s share in a suddenly defunct partnership. Life settlement may offer seniors significantly more than a policy’s cash surrender value or, in the case of term insurance, allow them to recapture or exceed their premiums (see “ Turn Unneeded Policies Into Cash ,” JofA , Sept. 05, page 39)—all in a somewhat favorable tax environment.
As the settlement industry grew, it was perhaps foreseeable that accusations of fiduciary blunders or mendacity would also spring up. The obvious virtue of finding an asset in a soon-to-be-discarded policy is countered by the potential evil of STOLI, a small but growing blight on the market where a life insurance policy is a “newly manufactured commodity.”
Investors lend money for or “finance” premiums for unsuspecting seniors who thus get “free” life insurance for the first two years (the contestable period). Sometimes seniors also retain a partial death benefit or split-dollar position. The financial investors keep the settlement proceeds, which far exceed their loaned premium, and the brokers keep the earned commissions. Note that this arrangement may leave gullible seniors with a tax liability for the “loans” or cancellation of indebtedness (which may not be characterized as true indebtedness) on the marketed policies. See news and information by the National Association of Insurance and Financial Advisors at www.naifa.org/advocacy/stolialert/index.cfm.
The industry has acted in its own and its clients’ best interests in demanding transparency. In December 2007 the National Association of Insurance Commissioners (NAIC) and the National Conference of Insurance Legislators (NCOIL) debated the necessary elements for an effective, transparent and ethical system for the life settlement market in preparation for proposing the new Life Settlements Model Act that is being introduced in at least 15 states this year (see www.ncoil.org/ press/life_settlements_PR.pdf ). A copy of the generic NAIC Model Act can be found at www.greenwichsettlements.com/naic.pdf . It establishes: (a) parameters for marketing; (b) a definition of the borderline ethics in “mortality wagering” and how premium financing of manufactured contracts may lead to potential tax liability due to cancellation of indebtedness; (c) a drafting model for purchase agreements; (d) a ban on financial settlement within two to five years of policy issuance; (e) a 30-day right to terminate; (f) definitions of specific terms; (g) transparency as to commissions; and (h) penalties for exploiters.
Twenty-eight states have previously enacted laws to govern life settlements and establish licensing regulations. The NAIC model has been passed, to date, only by North Dakota and, on March 13, by West Virginia, where it was signed into law. California has held legislative hearings on a comparable bill. Debates and hearings also have been held in more than a dozen other states.
IRC § 72(e)(6) provides that premiums paid, less amounts received under the contract (for example, dividends and other prior distributions), set the cost basis for computing gain upon the surrender of a life insurance contract. The Tax Code, however, is silent as to the cost basis when a life insurance contract is sold to a third party. Tax literature and litigation provide very little discussion on the capital gain treatment of sales proceeds in excess of the cash surrender value (CSV). However, in Jules J. Reingold , BTA Memo, 1941-319, the Tax Court supported capital gain treatment for the excess of sale price over the higher of the CSV or federal income tax basis.
Reingold dealt with the disposition of a life insurance policy subject to the transfer-for-value provision of IRC § 101(a)(2) by a subsequent purchaser who sold it for more than his cost and reported the income as capital gain. The court and the government agreed that a life insurance contract is a capital asset within the meaning of what is now IRC § 1221. The only points in dispute were whether the taxpayer owned the life insurance policy and whether a sale or exchange took place. This case confirmed that a life insurance contract is a capital asset. Thus, a taxpayer should expect capital gain treatment on the sale of a life insurance contract, except for the requirement that any inside buildup in the contract be treated as ordinary income. Often, as shown in case studies below, the most advantageous use of proceeds involves a charitable trust.
What are the considerations for the CPA or planned-giving adviser concerning life settlement for a senior client? The following list is not exhaustive (see also sidebar “ What Every CPA Should Know About Life Settlements ”).
Is the purchasing entity institutionally owned and funded and thus more likely to yield competitive and realistic offers? The larger institutional firms will be more likely to provide appropriate due diligence and see to the licensure of the broker and compliance with state and federal regulations.
Is a rescission period offered and are escrow services used, even where not required? These features show the purchaser’s professionalism and concern for ethical conduct. A rescission period allows clients and their advisers to review alternate quotes, review commissions and weigh options.
Are HIPAA-compliant forms required and procedures followed, protecting the senior’s privacy of financial and health information?
Is next-of-kin approval required? It’s best to involve them, to help avoid misunderstandings by heirs and prevent future legal battles, especially in the case of a charitable gifting.
First, however, CPA advisers should determine that their client is a good candidate for a life settlement and the best form of transaction (see sidebar “ What Every CPA Should Know About Life Settlements ”). To illustrate, the cases of two hypothetical clients, “Mr. Harris” and his brother “Bubba,” follow.
Mr. Harris . This 67-year-old former business owner is in complete remission from a bout with colon cancer three years earlier. He has no further use for what was a “key man” $2 million term policy. Mr. Harris can:
Take ownership of the policy and convert it to a level-premium contract so it won’t become burdensome.
Transfer ownership of the policy to a family member. Gifting the policy would subject it to gift taxes, but not income taxes. Or he could transfer it to an irrevocable life insurance trust, and the proceeds would not be taxable.
Cancel the policy or let it lapse for nonpayment.
Mr. Harris has worked hard and is looking forward to a comfortable retirement, believing that his success in life is directly linked to his religious life and his scholarship. He would feel gratified to add to his retirement while giving back to society.
Mr. Harris’ wishes can be met by :
Taking ownership of the policy,
Determining the present value of the death benefit to a sophisticated buyer through a review by a life settlement actuary, and
Increasing his retirement income with an investment or annuity program, while
Making a gift to a charity and, on his tax return, deducting a charitable contribution for whatever is determined as basis and deducting any additional fair market value of the policy.
As Mr. Harris is now covered by Medicare, he has canceled his group health benefits, which include a $400,000 death benefit that is convertible but, as often happens, was overlooked.
Bubba . Mr. Harris’ older brother Bubba, age 73, seems to have inherited the family propensity for medical infirmity, having required triple-coronary bypass surgery four years earlier. Bubba has not been as astute as his brother and, although not poor, is having problems balancing his retirement with his desires for charitable giving and obligations to his grandchildren’s schooling needs. As a valued employee with Mr. Harris’ company, Bubba has a $1 million universal life policy with high premiums and standard cash values, which the company purchased for him as an addendum to his deferred compensation package. He can either:
Leave the insurance intact and, rather than pay the costly premiums, let the cash reserves pay the premium for as long as possible,
Keep the death benefit in place while taking out the cash value as a loan—tax-free, under certain conditions—at a modest level so as not to cause the policy to lapse (which could trigger dire tax consequences), or
Sell a portion of the policy through life settlement. He could sell $500,000 of the death benefit, perhaps through his favorite charity. He could have the proceeds placed in a charitable remainder trust (CRT) with life income to him, giving him the income to pay for the remaining $500,000 of life insurance plus a current deduction. He also could make the retained portion of the death benefit payable to his grandchildren for their educational needs.
These or similar scenarios, modeling careful review and consideration, should allow senior clients to address many personal concerns by resurrecting an unseen asset. The CPA is in the unique position to approach the question of need and advisability with clear knowledge of the tax position and finances of a client.
Senior settlement is like reconditioning an engine whose mission has become obsolete but whose efficiency is without fault. By monetizing an asset normally seen as having little or no current value, the client has money for retirement needs or to buy a membership in a senior community. Or, as a charitable donor, he or she can support a favorite charity, while reaping an unexpected harvest of tax deductions through a CRT. While advising the client of possible pitfalls, the CPA adviser thus can help open many new options.