Question

In: Accounting

Your client, Jacob, turned 66 years old this year. Jacob has decided that he would like...

Your client, Jacob, turned 66 years old this year. Jacob has decided that he would like to sell a life insurance policy to fund a trip to Africa that he has wanted to take. He has no heirs.

Jacob knows that he could surrender the policy (a whole-life policy) back to the insurance company, but a friend told him he could get more for the policy if he sold it to a life settlement company. A life settlement company buys life insurance policies from policyholders who are not ill and who generally have a life expectancy of between 2 and 15 years. In return, the seller of the policy receives a lump-sum payment. The life settlement company either holds the policy to maturity or resells the policy to an investor.

The lump sum received depends on factors such as age, health, and the terms and conditions of the policy, but in general, the amount is more than the policy’s cash surrender value, which is the amount received from the life insurance company upon surrender of the policy.

In November 2019, Jacob (who was not terminally or chronically ill) sold his policy to a life settlement company for $160,000. During the time that he owned the policy, Jacob did not borrow against the policy or receive any distributions. Premiums paid on the policy by Jacob totaled $122,000 (of which $32,000 pertained to the provision of insurance before the sale of the policy).

What are the tax consequences to Jacob on the sale of his life insurance policy?

What are the Internal Revenue Codes and possible current cases that pertain to the problem?

Solutions

Expert Solution

A. What are the tax consequences to Jacob on the sale of his life insurance policy?

  1. Amount received up to the total premiums paid are free of income tax : 122,000
  2. Amount received that are greater than the premium paid up to the amount of the cash surrender value are taxed at ordinary income rates. : The surrender value is not provided in the question. If we assume surrender value was $140,000 then $18,000 would be treated as ordinary income
  3. Proceeds received that are in excess of surrender value taxed as capital gains. : Assuming surrender value was $140,000 then $ 20,000 would have been capital gain

B. What are the Internal Revenue Codes and possible current cases that pertain to the problem?

In 2009 IRS have provided Revenue Ruling 2009-13 which has slight change than the position which exist now after Tax Cuts and Jobs Act of 2017.

The revenue ruling provided that : Amount received upto total premium paid less cost for insurance is free of income tax or that is tax basis.

The Tax cuts and Jobs Act of 2017 have removed condition for reduction of cost of insurance so now total premum paid is considered as tax basis.


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