Purchase of Life Insurance Policy

[WhiteOleander]

Have a client who purchased an insurance policy belonging to another person. The person they purchaed it from has HIV/AIDS. He sold it to get money now. I have heard of this practice. But, not sure of the tax consequences, if any.

If this person should pass away, would the life insurance proceeds be taxable to my client? Would my client have a basis in the payoff? Their purchase price along with the premiums they are paying?

Any guidance is appreciated.

[Bees Knees]

TTB, page 3-18, "Proceeds paid because of the death of the insured are not taxable unless the policy was turned over to the taxpayer for a price."

In other words, if the person who gets the benefits is not the person who died, or the decedent's beneficiary, it is taxable to the one who receives the benefit. Such as in your case where the taxpayer is looking to profit off the transaction. Basis would be what they paid for the policy, and gain is any excess benefits over that basis.

TTB, page 3-18 goes on to say, "Amounts paid to a terminally ill insured under a life insurance contract or viatical settlemen are not taxable."

Thus, the person who sells their insurance policy due to terminal illness, such as the person your client bought the policy from, that person pays no tax on the transaction.

[Bees Knees]

TTB does not say, but I would also take the position that your client's net gain would be a capital gain, since an insurance policy is not listed on page 6-7 under the list of noncapital assets.

[jainen]

noncapital assets

>>an insurance policy is not listed on page 6-7 under the list of noncapital assets<<

Unless the client is in the business of buying out life insurance policies, which some people are.

[Unregistered]

I'm not sure I agree with Bees on whether the proceeds are tax free to the person who sold the policy to W.O.'s client. I don't believe its an absolute. The IRC provides that a viatical service provider is a person who REGULARLY engages in the practice of purchasing life insurance contracts. Perhaps, I mis-read this but it appears in the original post this is a casual sale of the contract and may result in taxable income to the seller since the provisions of §101(g) may not be met..

This is a snip from Rev Ruling 2002-82

"If the person making the payments to the owner of the life insurance contract is the issuing insurance company, the availability of the exclusion depends solely upon whether the insured meets the definition of either a terminally or chronically ill person. If a life insurance contract insuring a terminally or chronically ill individual is sold or assigned, however, the buyer/assignee must qualify as a viatical settlement provider under § 101(g)(2)(B) in order for the owner of the life insurance contract to exclude all or a portion of the amounts received from the sale or assignment."

New York Enrolled Agent

[Bees Knees]

I'm not sure I agree with Bees on whether the proceeds are tax free to the person who sold the policy to W.O.'s client. I don't believe its an absolute.

Your are correct. I stand corrected. It is not a absolute. IRS Pub 525 says the following:

"Accelerated Death Benefits
Certain amounts paid as accelerated death ben-
efits under a life insurance contract or viatical
settlement before the insured’s death are ex-
cluded from income if the insured is terminally or
chronically ill.

Viatical settlement. This is the sale or assign-
ment of any part of the death benefit under a life
insurance contract to a viatical settlement pro-
vider. A viatical settlement provider is a person
who regularly engages in the business of buying
or taking assignment of life insurance contracts
on the lives of insured individuals who are termi-
nally or chronically ill and who meets the require-
ments of section 101(g)(2)(B) of the Internal
Revenue Code."

[JoshinNC]

the client should have bought a policy with a terminal illness rider,

and all of this could have been avoided. At least, that is what I tell my clients. And, most policies I sell include this rider free of charge!

Just one more reason you have to make sure that your agent is knowledgable in all aspects of the policy (which is why my clients enjoy using my firm as their primary source for insurance/retirement solutions) and looking out for your best interest.

[WhiteOleander]

Thank you all so much.

My clients are the ones who bought the policy from the terminally ill person. They are definately not in the business of doing this.

I will be able to advise them from this info.

[Unregistered]

I've been thinking about Bees comment that W.O. client's net gain would be a capital gain. I'm more inclined to believe the gain would be ordinary. Doesn't mean I'm correct but its worth the discussion.

The fact that this gain is not included on the exclusion list for noncapital assets in the TB or the code is not determinative to reach the conclusion that there would be capital gain. I believe the Courts have held the list to be non-exclusive. In a TC case, Davis 119 TC No 1, the court addresses the issue of the sale of lottery winnings. While obviously, not the same issue as the sale of this insurance policy, it seems much of the argument is applicable here - the lump sale of the future lottery payments was found to be ordinary to the seller. While W.O.'s client is the buyer in this instance, I don't think that's controlling.

In the Davis decision, the TC quoted the Supreme Court (in a case prior to the 1956 Code)

"While a capital asset is defined in § 117(a)(1) [of the Internal Revenue Code of 1939] as "property held by the taxpayer," it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset. * * *"

As I said - its worth the discussion.

New York Enrolled Agent

[Unregistered]

RIA has posted a case today in its Newstand that leads me to further believe that W.O's client has ordinary income. It's a case from the 10th Circuit CA that discusses the "substitute-for-ordinary income" doctrine. An interesting read.
Watkins v Cmmr 97 AFTR 2d 2006-2444

New York Enrolled Agent