Although, generally, the additional proceeds of a life settlement should more than offset the additional taxes, there are situations where it will not. In those situations, the ruling has created a lose/lose situation. The seller loses by getting less for a policy; and the government loses tax revenue because the policy is surrendered, rather than sold for a higher amount, which would usually generate additional tax.
A hidden danger of the revenue ruling: It could also apply to non-life settlement transfers or sales (e.g., a business that sells or bonuses a policy to a key employee at retirement). Under the IRS's artificial distinction between sale and surrender, such a transaction, because it is not a surrender, could require the business to recognize significant additional taxable income.
Since we have to live with these rules for now, clients should be instructed to request the cumulative COI charges from the insurance company (assuming it has them) before closing the life settlement transaction. They should not wait until afterwards because the insurer may be unwilling to deal with them once they are no longer listed as the owner of the policy.
Although the increased value brought by a life settlement will usually more than offset the tax consequences, there are situations where it will not. Among them: those involving older policies that only sell for a small premium over the surrender value.
Knowing the COI charges will help the client estimate the tax consequences of the transaction. (We have a created a worksheet for this that is available upon request.)
Another murky situation is a retained death benefit, which providers are offering as an alternative to a cash-only life settlement. These transactions allow the policy owner to retain some portion of the death benefit, free of additional cost, as part of the selling price in lieu of some or all cash, while the buyer is responsible to pay all future premiums to maintain the policy. Unfortunately, from a tax standpoint, this feature only compounds the ambiguities facing life settlement transactions.
In addition to the previously discussed tax questions, there has been no guidance on how to determine the value to the seller, for tax purposes, of the retained death benefit the buyer is paying for. While the transaction clearly has tax implications to the seller, there are many theories under which the retained death benefit can be taxed.