The taxation on life insurance sales is something that requires careful calculation. In previous blog posts, we discussed what trustees should know about selling a life insurance policy. In this blog entry, we want to talk about the taxation of a life insurance policy sale for the seller.
A life insurance held in trust receives a death benefit free of both an estate and income taxation on life insurance sales. However, if a trustee sells a TOLI life insurance policy, taxes may be due. When a trustee taxes a life insurance policy, it is similar to, but not as simple as, a policy surrender for cash value, though the Tax Cuts and Jobs Act – did simplify the process.
A Three Step Process For Calculating The Taxation on Life Insurance Sales
First, determine total gain by subtracting the cost basis of the policy, typically the total premium paid, from the amount received from the sale by the policy owner.
Second, determine that amount which will be taxed as ordinary income, which is the difference between the cash value in the policy and the cost basis. This is the same process by which trustees calculate the taxable amount of a policy surrender. Clients receive the cost basis in both transactions free of income tax – it is the return of premium paid. Before the new tax law, a policy seller would have to reduce the cost basis by the mortality charges paid in the policy. This was an arduous, and sometimes impossible process, that increases the taxation of a policy sale.
Third, calculate that portion of the sale that will be taxed at capital gains rates by subtracting the amount taxed as ordinary income (second step) from the total gain (step one). The amount above the cash value is taxed as capital gains.
As can be seen from the chart, if a policy with a cost basis of $250,000, and a cash value of $400,000 was sold for $800,000, the total gain for the seller would be $550,000 ($800,000 sale price minus $250,000 cost basis received tax-free). $150,000 of that amount ($400,000 cash value minus $250,000 cost basis) would be taxed as ordinary income and $400,000 ($550,000 total gain minus $150,000 taxed as ordinary income) would be taxed at capital gains rates. Note that if there is no cash value in the policy, the total amount a client receives above cost basis is taxed at capital gains rates.
The TOLI Handbook
A TOLI trustee will need to increasingly understand trust settlements over the coming years. For more information, review chapter 14 of the TOLI Handbook, available as a free download at http://www.TOLIHandbook.com.