Life Settlements Get a Boost From Tax Reform

Optimal tax theory is a serious field. You could spend your life studying it. So let's start by referencing examples of fine work:

  • N. Gregory Mankiw, Matthew Weinzierl and Danny Yagan, “Optimal Taxation in Theory and Practice,” Journal of Economic Perspectives, Fall 2009.

  • Peter Diamond and Emmanuel Saez, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations,” Journal of Economic Perspectives, Fall 2011.

  • Emmanuel Saez and Stephanie Stantcheva, “Generalized Social Marginal Welfare Weights for Optimal Tax Theory,” American Economic Review, January 2016.

  • Yoram Y. Margaliath, Economic Growth and Distributive Justice Part I — The Role of the State, Tel Aviv University, 2017.

  • Yoram Y. Margaliath, Economic Growth and Distributive Justice Part II — Maximize Social Wellbeing, Tel Aviv University, 2017.

I don’t expect much from the farcical process that gave us the 2017 tax reform legislation, but I do like the change to the income tax treatment of life settlements.

In Revenue Ruling 2009-13, the IRS provided a safe harbor for determining the taxable gain on the sale of a life insurance policy. It said that the taxable gain would be calculated using the policy’s “adjusted basis”; i.e., premiums paid less cost of insurance (COI) charges.

This rule has led to confusion and wasted time. Where will you get the sum of the COI charges since issue? From the insurance company, if they are willing to provide it? By adding up the charges in all of the annual statements, if you have them?

If a policy is designed with very high face amount charges and very low COI charges, do you need to increase the stated COI charges to get a more “reasonable” number, or can you rely on the insurance company’s classification of the charges?

If the policy is being kept in force under a no-lapse provision that has a shadow account design, which set of COI charges should you use: the nonguaranteed COI charges or the no-lapse COI charges? If you decide to use the nonguaranteed COI charges, what happens if those charges are being waived while the no-lapse guarantee is keeping the policy in force?

These questions could easily have been anticipated and addressed by the IRS before Revenue Ruling 2009-13 was turned loose on the world. So this is a case study in how not to write tax laws.

It also leads to a result that is inconsistent with the tax treatment of real estate. When you sell your house, your basis is not reduced by the imputed value of the rental benefits that you received while you lived there.

The 2017 tax law overrules Revenue Ruling 2009-13. It says that the tax basis is not reduced by “mortality, expense, or other reasonable charges incurred under an annuity or life insurance contract.” This provision is effective for transactions after August 25, 2009.

The 2017 tax law also creates clear reporting requirements for life settlement transactions, effective after December 31, 2017.

The life settlement market still contains significant pitfalls for unwary sellers, but at least the tax inefficiency of a policy sale has been reduced.


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