The tax changes enacted by Congress at the close of 2017 were sweeping and affected nearly every area of taxation for U.S. Persons. This tax legislation is commonly known as the Tax Cuts and Jobs Act (TCJA). One of the major changes was to the individual exemption for the estate and gift tax. The exemption was doubled from $5.49M in 2017 (which would have increased to nearly $5.6M for 2018) to $11.18M per individual for 2018. This increase is currently set to phase-out in 2025, but it is still inflation-adjusted and it can be made permanent before 2025.
The impact of this change on many current estate plans is that life insurance is often employed to reduce the financial impact that the estate tax would have on a taxable estate. Thanks to the increased exemption, estates that have a value between $5.49M and $11.18M (for individuals, or $10.98M and $22.36M for couples) that already had life insurance in place for the anticipated estate tax that would be due, no longer need that insurance. Certainly, there is nothing preventing an individual from maintaining the life insurance policy and simply having additional assets when they pass. However, some may view the life insurance policy as an unnecessary expense. Luckily, the tax changes also reversed a Revenue Ruling from 2009 that was unfavorable to the basis calculation for purposes of selling a life insurance policy.
Section 13521(a) of the TCJA allows the seller of a life insurance policy to include all premiums paid in determining the cost basis for purposes of calculating the taxes due on a settlement transaction. It provides a “clarification of tax basis of life insurance contracts” (from Sec. 1016(a)(1)(B)) stating that when determining the basis of property, no adjustment is made “for mortality, expense, or other reasonable charges incurred under an annuity or life insurance contract.”
This means that sellers of life insurance are now afforded similar tax treatment as they would be given in the event of a surrender of the policy. This change now makes a sale of the life insurance policy more attractive than surrendering the policy. For the past several years, because of the difference in tax treatment, it was often, unfortunately, better to just surrender an unwanted life insurance policy than to sell the policy. It is important to note that this change is a retroactive provision as well that applies to any transactions entered into since August 25, 2009.
This change will streamline the process of calculating cost basis as it will simply include the amount of all premiums paid by the owner. Additionally, there is the potential for this change to fuel increased growth in the life settlement market (which had been struggling). Thousands of life insurance policies made unnecessary by the increased estate tax exemption may now be sold. The owners of such policies can recoup their premiums and not be concerned about a huge capital gains tax hit.