Tax and Other Considerations of Life Insurance Policy Sales

Question:        I own a policy of insurance on my life that I am selling to a third party at a profit.  What tax consequences and other concerns do I have?

Answer:          Any gain from the sale of a life insurance policy you own will be subject to income tax.  Like the sale of most other assets, the difference between the amount realized or the amount you receive from the sale and your tax basis in the policy will be subject to tax.  Based on recent legislative changes, your tax basis in the policy will generally be the aggregate amount of premiums you have paid for the policy.

A more complicated tax issue is the nature of the gain you must report on the policy sale.  The gain you realize on the policy sale could be ordinary income, capital gain or both, the determination of which is primarily dependent on the cash surrender value of the policy.  In the case of a pure term insurance policy, the gain will be taxed as a capital gain as term insurance policies do not have cash surrender values.  The rules differ for a policy with a cash surrender value. The amount of the sale proceeds in excess of your basis in the policy will be treated as ordinary income up to the policy’s cash surrender value; any sale proceeds in excess of the policy’s cash surrender value will be treated as capital gain. 

Consider, for example, an individual who sells a policy of insurance on his life with a face value of $100,000 and a cash surrender value of $40,000 and who made aggregate premium payments of $30,000.  If the policy is sold for $75,000, the individual will report income equal to the difference between the policy sale proceeds of $75,000 and the individual’s policy basis of $30,000 or $45,000.  Of that $45,000 of income, the difference between the policy cash surrender value of $40,000 and the policy basis of $30,000 or $10,000 must be reported as ordinary income. The balance of the income of $35,000 will be taxed as a capital gain.

You might contrast the results of a policy sale to a third party with the results of a surrender of a policy to the insurance company.  Insurance companies will typically accept a surrender of a whole life insurance policy and remit the cash surrender value to the policy owner after the reduction of any charges that may be required to be paid under the terms of the policy.  In this case, the difference between the amount received from the insurance company and the policy owner’s basis in the policy will be taxable as ordinary income.

There are other factors to consider in choosing to sell a policy of insurance on your life to a third party. Third party purchasers of insurance policies are typically investment groups purchasing policies as investments for profit. Policy purchasers will usually conduct extensive due diligence delving into your medical history to determine your probable life expectancy. You of course will likely have to make your medical records available to third parties. Like many other policy sellers, you may be uncomfortable with the thought that someone you do not know owns a policy of insurance on your life and stands to benefit financially from your death.  

Assuming you are comfortable with a third party owning an insurance policy on your life, you should also recognize that as long as the policy remains in effect, your ability to obtain new insurance on your life could be impacted. Insurance companies consider all of an insured’s outstanding policies to determine if a new policy can be issued.  If your income and assets are insufficient to warrant an insurance company issuing more insurance on your life, you may be unable to obtain new coverage.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.