You are usually the first professional to see a lapsing policy, because the premium shows up as a recurring outflow on a cash-flow review or as a line on a trust’s fiduciary return long before anyone else questions it. By the time an attorney or advisor looks at the same policy, the client has often already surrendered it — capturing cash surrender value and nothing more.
The tax picture is better than it was. Rev. Rul. 2020-05 conformed IRS guidance to the 2017 Tax Cuts and Jobs Act change: a seller’s basis is no longer reduced by cost-of-insurance charges, so basis is generally total premiums paid. That is a material improvement over the old Rev. Rul. 2009-13 treatment and directly increases the after-tax result on a sale.
Colorado governs these transactions under the viatical settlement provisions in C.R.S. Title 10, Article 7, regulated by the Colorado Division of Insurance. Send a redacted policy cover page for a free review — typically one to two business days for a first read, no obligation for you or your client. Call (305) 209-7183.
In This Article
Basis After Rev. Rul. 2020-05
Under Rev. Rul. 2009-13, a seller’s basis in a life insurance contract was reduced by the cost-of-insurance charges embedded in premiums paid — a reduction that could be substantial on an older policy and that produced a larger taxable gain. The 2017 Tax Cuts and Jobs Act eliminated that basis reduction, and Rev. Rul. 2020-05 conformed the Service’s published guidance accordingly.
The practical result is that basis is generally total premiums paid. That is easier to substantiate and larger than the old figure, which is why reconstructing the premium history is now the highest-value piece of work you can do on one of these files. Carrier premium histories, cancelled checks, and prior returns all contribute.
The Two-Tier Gain Characterization
On a sale, gain up to the cash surrender value over basis is generally ordinary income. Gain above the cash surrender value is generally capital gain. That split is why cash surrender value matters to your calculation even when the client never surrenders the policy — it is the dividing line between the two buckets, not just an alternative outcome.
Three figures drive the entire computation: total premiums paid, cash surrender value at the time of sale, and gross proceeds. Get all three in writing before the return is prepared, and the rest is arithmetic. The cash surrender value explainer is a client-readable reference for the middle figure.
IRC Sec. 6050Y and the Forms Your Client Will Bring You
A reportable policy sale triggers information reporting under IRC Sec. 6050Y. Form 1099-LS reports the payment to the seller and goes to the seller and the issuer. Form 1099-SB is furnished by the issuer and reports the seller’s investment in the contract and the surrender amount. Buyer, issuer and seller each have a role.
Two practical consequences. First, the client will receive forms and will call you about them, often months after the transaction closed. Second, the figures reported by the issuer are the starting point — not automatically the correct basis for the client’s return. Reconcile them against the premium history rather than accepting them without review.
| Computation input | Treatment | Where to substantiate it |
|---|---|---|
| Basis in the contract | Generally total premiums paid; no longer reduced by cost-of-insurance charges after TCJA and Rev. Rul. 2020-05 | Carrier premium history, cancelled checks, prior returns |
| Gain up to cash surrender value over basis | Generally ordinary income | Carrier statement showing CSV at the time of sale |
| Gain above cash surrender value | Generally capital gain | Settlement contract and closing statement |
| Gross proceeds | Reported on Form 1099-LS | Escrow disbursement record |
| Issuer-reported investment in the contract | Reported on Form 1099-SB; reconcile, do not simply accept | Compare against the reconstructed premium history |
| Viatical qualification | Different federal framework where the insured is terminally or chronically ill | Physician certification and provider qualification documentation |
Viatical Files Are Taxed Differently
Where the insured meets the terminally ill or chronically ill definitions and the transaction runs through a qualified viatical settlement provider, federal law provides favorable treatment that can differ substantially from the ordinary settlement analysis. On a hospice or serious-illness file, that distinction changes the answer, not just the paperwork.
Establish the facts before you compute anything: the insured’s status, the physician certification if one exists, and whether the provider met the qualification requirements. Those elements determine which framework applies, and they need to be documented contemporaneously rather than asserted at filing time.
Where the Policy Surfaces in Your Practice
On a personal cash-flow review, the premium is a recurring outflow with no corresponding asset appreciation. On a fiduciary return for an ILIT, premiums paid out of trust corpus with declining grantor contributions are a live signal that the trust design has drifted. On a business return, key-person or buy-sell coverage on a retired or departed principal is a classic orphaned policy.
In each case the question is the same and takes ten seconds to ask: does anyone still need this death benefit? A no on a policy with a face amount of $100,000 or more is worth a free valuation before the client’s next surrender or lapse decision.
Colorado Context Worth Knowing
Colorado does not change the federal tax analysis, but two state facts frequently sit alongside it in a client file. Long-term care Medicaid here runs through Health First Colorado’s Elderly, Blind and Disabled program and long-term care waivers with a $2,000 individual countable-asset limit. And Colorado processes those applications through county departments of human services, so timelines vary noticeably from county to county.
That matters for the timing of a receipt. A large payment landing in the wrong month can create an eligibility problem the client’s elder law counsel then has to unwind. Coordinate the closing month where Medicaid is in the picture — see the Colorado asset and income limits page and the Colorado tax treatment page for the two sides of that question.
How a Referral Works
Send the policy cover page, with the client’s permission, redacted as you prefer. Carrier, product type, face amount and issue date are enough for a preliminary read on whether the policy has secondary-market value. No fee, no engagement, no obligation for you or your client.
If it looks viable, three more documents produce an indicative range: a current in-force illustration, the latest carrier statement, and a signed HIPAA authorization. From complete documentation through funding, a standard file runs roughly 60 to 120 days. If the timing has tax-year consequences for your client, say so early — a closing that slips across December 31 changes which return the gain lands on.
Your client stays in control throughout and can stop before closing. Send the cover page or call (305) 209-7183 for a free review.
This page is educational only and is not legal, tax, or investment advice for you or your client. Pine Lake Life Solutions does not provide legal or tax counsel; the tax treatment of any specific transaction should be determined by the client’s own tax professional.
Frequently Asked Questions
What changed about basis after the 2017 tax act?
Basis in a life insurance contract is no longer reduced by the cost-of-insurance charges embedded in premiums, so it is generally total premiums paid. Rev. Rul. 2020-05 conformed IRS guidance to that statutory change, superseding the less favorable approach in Rev. Rul. 2009-13.
How is gain on a life settlement characterized?
Gain up to the cash surrender value over basis is generally ordinary income, and any gain above the cash surrender value is generally capital gain. You need three figures to compute it: total premiums paid, cash surrender value at sale, and gross proceeds.
What are Forms 1099-LS and 1099-SB?
They are the information returns required for a reportable policy sale under IRC Sec. 6050Y. Form 1099-LS reports the payment to the seller; Form 1099-SB is furnished by the issuer and reports the seller’s investment in the contract and the surrender amount. Both should be reconciled against your own premium reconstruction.
Is a viatical settlement taxed the same way?
No. Where the insured meets the terminally ill or chronically ill definitions and a qualified viatical settlement provider is involved, federal law provides different and generally more favorable treatment. Document the qualifying facts contemporaneously rather than asserting them at filing.
Does Colorado impose any additional tax on settlement proceeds?
The analysis described here is federal. Colorado state treatment generally follows federal taxable income as the starting point for individual returns, but confirm the current Colorado Department of Revenue position for your client’s facts rather than assuming conformity.
How do I reconstruct basis on a thirty-year-old policy?
Start by requesting a full premium history from the carrier, then supplement with cancelled checks, bank records and prior-year returns. Because basis is now generally total premiums paid, this reconstruction has a larger effect on the client’s result than it did under the old rule.
Does the closing date matter for tax planning?
Yes. A closing that slips across a year end changes which return the gain lands on, and it can also affect Medicaid resource timing if the client is heading toward Health First Colorado long-term care coverage. Flag timing constraints early rather than after the contract is signed.
Is there a cost for a policy review?
No. The review is free, there is no engagement, and there is no obligation for the CPA or the client at any point before closing.
Find out what your policy is worth — free, confidential, no obligation.
A 15-minute educational review covers your eligibility, every alternative, and a realistic view of what each path would net you.
Related Reading
- Cash Surrender Value Life Insurance
- Life Settlement Vs Surrender
- Life Settlement Taxes Colorado
- Life Settlement Licensing Colorado
- Colorado Medicaid Asset Income Limits
- Education Center
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.