Reporting life settlement sales after the Tax Cuts and Jobs Act

A life settlement is the term the financial services industry uses for what the Internal Revenue Code calls the commercial transfer (i.e., sale) of a life insurance policy (term or permanent) to a third party, an acquirer, who has no insurable interest in the insured’s life; specifically, the acquirer “has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such life insurance contract . . .” (Sec. 101(a)(3)(B)).

The life settlement market gained notoriety during the AIDS crisis, as people with AIDS sold their life insurance policies to pay medical costs. Since that time life settlement has become much more widely used. In this period of low interest rates, it has attracted investors looking for higher returns than those available in traditional fixed income securities. (The value of an existing policy is heavily dependent on the medical condition of the insured.) Because a life settlement house might be willing to pay substantially more for a policy than its cash surrender value, sellers who no longer need the coverage or who need the money for other purposes are attracted to the possibility of selling their policy.   

As the market has grown, there have been continuing questions and opinions about how the first seller of a life insurance policy, typically the insured or a member of the insured’s family, should report the sale. Rev. Rul. 2009-13 was the IRS’s guidance on how the original owner of the policy should report the sale. Rev. Rul. 2009-14 explained how the life settlement house should report subsequent sales of life insurance contracts.

Under Rev. Rul. 2009-13, when an insured sold a policy, to determine the gain on a sale, the first seller had to reduce the cost basis in the policy by the expired cost of the insurance. The financial services industry was not happy with that provision. In what might be considered the result of good lobbying, Section 13521(a) of P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), amended Sec. 1016(a)(1)(B), which now states that the basis of a life insurance or annuity contract does not have to be adjusted for the expired cost of insurance.  

Probably in the hope of improving sellers’ compliance with reporting sales of life insurance policies, TCJA Section 13520(a) added an information return requirement, new Sec. 6050Y, for life settlement transactions.

Sec. 6050Y(a) requires the buyer, the life settlement house, to file an information return with the IRS reporting the sale, the proceeds, and the policy number and written statements containing the information required to be reported on the return to the life insurance company issuing the policy and the seller. However, reporting the proceeds of the sale to the insurance company in the statement is optional. Insurance companies track premiums paid on life insurance contacts. The notice triggered by Sec. 6050Y(a) will let them know to track premiums paid by the new owner.   

Section 6050Y(b) goes further than Sec. 6050Y(a). It requires the insurance company, when it receives the information return, to file an information return with the IRS including the amount of investment in the contract, as defined in Sec. 72(e)(6), and to provide the seller a written statement containing the information required to be in the return.

Last, Sec. 6050Y(c) deals with the payment of the death claim. Sec. 6050Y(c) requires the insurance company to file an information return with the IRS, including the amount of the death benefit paid and the company’s estimate of the last owner’s basis in the contract as determined under Sec. 72(e)(6). The insurance company must also provide the death benefit recipient a written statement with the information required to be reported in the return. Again, since the last owner’s basis will be the sum of what it paid for the policy, plus whatever it paid in premiums, insurance companies will have to modify their data systems to allow for accumulation of premiums paid as ownership changes.

Notice 2018-41, issued April 26, provides details on the reporting requirements under Sec. 6050Y and says the IRS intends to issue regulations implementing the reporting requirements. The IRS says the regulations will also clarify which parties are subject to the reporting requirements and provide definitions of terms such as “acquirer,” “payment,” and “issuer.”

Through the IRS’s information return matching programs, Sec. 6050Y should strengthen the reporting of life settlement transactions, both as policies are sold and as death benefits are paid. On the other hand, Secs. 6050Y(b) and (c) will impose substantial, new recordkeeping requirements on life insurers, the cost of which will be significant.

David K. Smucker, CPA, MSM, CLU, ChFC, is Advanced Consulting Group’s technical director with Nationwide Insurance in Columbus, Ohio. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.