Take-Away: Last Friday the IRS published Final Regulations with regard to the transfer and sale of life insurance policies. Those Regulations include a description of the 2017 Tax Act’s new IRC Sections 101(a)(3) and 6050Y that relate to the sale of life insurance policies, the reporting of that sale of the insurance policy to the IRS, and the taxation of the death benefit paid with respect to a transferred policy purchased by a third party.

Background: The 2017 Tax Act added several new sections to the Tax Code. Two new sections expressly deal with the sale of life insurance policies in the rapidly growing ‘life settlement’ marketplace.

  • IRC 101(a)(3) deals with ‘reportable policy sales.’
  • IRC 6050Y imposes the reporting requirement, i.e. who reports the sale and purchase; what they report; and to whom they report the policy sale.

Regulations: These Final Regulations describe these new Tax Code sections in great detail (specifically 120 pages of detail!) TD 9879, October 25, 2019

Reasons for the Code Sections: Behind all these new Tax Code sections is the unique taxation associated with life insurance death benefits. As a general rule, the death benefit paid on the death of the insured is income tax-free. [IRC 101(a).] There exists, however,  a major exception to this income tax-free treatment of the death benefit proceeds, when there exists a transfer-for-value with regard to the insurance policy- the purchase price or ‘basis’ in the policy is a tax-free return of capital, but the insurance proceeds above that amount is taxable as ordinary income in a policy ‘transfer-for-value’ transaction.

With the growing market in the sale of existing life insurance policies to third parties for value, questions arise as to how the policy owner is taxed on the sale of the existing policy and how the purchaser reports the taxation of the death benefit when the insured dies. Hence, all these new reporting obligations on the policy owner, the purchaser of the policy, and the issuing insurance company whose policy is the subject of the sale.

ILITs: Finally, it should be noted that these Final Regulations also purport to cover the transfer of a life insurance policy to an irrevocable trust like an ILIT, so the scope of the Regulations covers more conventional estate planning strategies like trust ownership of life insurance to avoid including the death benefit in the insured’s taxable estate.