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Should a Life Settlement be on Your Client’s Year-End Planning List?

Capital gains rates will likely rise in 2021, making this option less attractive unless completed before year end.

Many high-net-worth, high-income individuals are assessing whether to take any significant capital gains in 2020 in case their gains are taxed at ordinary income rates in 2021, as proposed by President-elect Biden. 

Why Now?

A life settlement is the sale of a life insurance policy for a lump sum that’s more than its cash surrender value, but less than the death benefit. Under current law, a life settlement is generally taxed in a tiered fashion: basis (premiums paid to date) is recovered tax-free, sale proceeds up the gain in the policy (excess of cash value over basis) is ordinary income and sale proceeds above the cash value are treated as capital gains. The possibility that the capital gains portion of a life settlement by HNW/high-income individuals or their irrevocable life insurance trusts (ILITs) could be taxed at 39.6% (plus the 3.8% tax on net investment income) suggests that affected taxpayers who are seriously considering a life settlement might want to complete it in 2020. (Note that the ordinary income portion of the life settlement would also be taxed at a higher marginal rate of 39.6% versus the current 37%.)

Problematic Split-Dollar Arrangements

Aside from the usual reasons for individuals to consider a life settlement, these HNW/high-income individuals are more likely than others to be involved in split-dollar or other arrangements that might now problematic because of low credited interest rates, among other reasons. Many of those arrangements, which involve the individuals’ ILITs, are at a point where: (1) other than a significant taxable gift of cash  or a loan to the ILIT,  which the individual is reluctant to make, there’s no viable exit strategy for the foreseeable future, (2) the policy itself is no longer needed because of good planning or other circumstances or (3) the individual/insured has just decided to call it a day and stop supporting it. 

If feasible, given the status of the insured and the policy, respectively, a life settlement could provide the cash to repay the party that advanced the premiums under the split-dollar arrangement or other transaction. In some of these situations, there are two or more policies subject to the arrangement. A life settlement of one of the policies may inject enough liquidity into the ILIT to roll out the remaining coverage and support it for the duration without further cash gifts from the individual, which, along with capital gains, could be decidedly more taxes in 2021 than 2020. Of course, in some cases, the life settlement could even leave the ILIT with a residual of cash post-roll out that won’t be included in the individual's estate. 

If there’s a life settlement in progress, then, needless to say, the parties should consider getting it done get it done quickly or, at least, getting it to the point where the applicable party can have enough real-time information to make a decision and conclude the transaction this year. 

Three Steps

But what about those situations in which the life settlement will be a matter of the first impression for the individual/insured (let alone the ILIT trustee)? The process will have to start from scratch. However, there may still be time left on the 2020 clock to get it done. Assemble the planning team and proceed apace with these steps:

  • The insured, the trustee, the life insurance professional who’s servicing the policy and any other parties who will be involved in the process and the decision should provide the life settlement company with all the information and documents it needs to quickly determine the marketability of the policy and the feasibility of completing the transaction by the end of the year. The more “textbook” the fact pattern as to the condition of the insured and the type and condition of the policy, and the more lead time given to the life settlement company, the easier it will be to get it done. Some buyers will bid on guaranteed universal life policies or certain term and universal life policies without requiring medical records or life expectancy assessments. But everyone will need to understand that there’s no slack in the schedule. Time is of the essence! 
  • The tax professionals on the planning team will need to review a lot of information about the policy, the ILIT and the arrangement that would be terminated by the funds from the sale, to confirm and explain the economic/cash flow implications of the entire transaction as well as the applicable income, gift and generation-skipping transfer tax implications. One can only envision some of these conversations with the individuals, starting with, “You remember that grantor trust concept we talked about a few years ago where the ILIT keeps the cash but you get the tax bill? Well…” 
  • Get the life settlement offer, do a final, comprehensive stress test of the economic and tax implications of the transaction(s) and make the decision!

The to-do list for a life settlement by year-end may appear daunting. However, daunting doesn’t mean impossible. Close, timely collaboration among all involved could possibly result in some truly significant tax savings. 

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