Since Rev. Rul. 2020-05, a policy seller’s basis is no longer reduced by cost-of-insurance charges — basis is generally total premiums paid, which changed the after-tax math on every older policy your clients own. That ruling conformed IRS guidance to the 2017 Tax Cuts and Jobs Act and superseded the less favorable treatment under Rev. Rul. 2009-13 for sales in the relevant periods. If your workpapers still carry the old COI-reduction step, they are producing the wrong number.
The practical consequence is that a life settlement now compares more favorably against a surrender than it did a decade ago. On a surrender, all gain over basis is ordinary income. On a sale, the amount above cash surrender value is generally capital gain — a tier that a surrender cannot produce at all.
If a client is holding a policy they no longer need. With their permission, a redacted policy cover page supports a free preliminary read, typically returned in one to two business days, with no fee and no obligation to you or the client. Call (305) 209-7183.
In This Article
The Three-Tier Calculation
Lay the computation out in three tiers. Tier one: proceeds up to basis are a tax-free return of premium. Tier two: proceeds between basis and cash surrender value are ordinary income — the same character the client would have realized on a surrender. Tier three: proceeds above cash surrender value are generally long-term capital gain, assuming the policy was held long enough.
Two inputs drive the whole schedule and both come from the carrier: total premiums paid since issue, and the cash surrender value at the sale date. Request both in writing. Client recollection of premiums paid over thirty years is not a workpaper, and carriers will generally produce a premium history on request.
Basis After Rev. Rul. 2020-05
Under Rev. Rul. 2009-13, a seller reduced basis by the cost-of-insurance charges embedded in the policy, which inflated taxable gain on a sale. The 2017 Act eliminated that adjustment, and Rev. Rul. 2020-05 conformed the Service’s published position. Basis is now generally total premiums paid, without the COI subtraction.
Two workpaper notes. First, confirm which ruling governs the client’s specific transaction period rather than assuming — the effective-date question is where errors show up on amended returns. Second, adjustments still matter for other reasons: outstanding policy loans, prior partial surrenders, and dividends taken in cash all affect the computation. Verify current IRS guidance in 2026 before finalizing a position.
IRC Section 101(g): When the Whole Thing Is Excluded
A terminally or chronically ill insured may receive proceeds income-tax-free under IRC § 101(g) when the certification requirements are met — generally a physician’s certification of a life expectancy of 24 months or less for terminal illness, with separate and more restrictive conditions for chronic illness including use of proceeds for qualified long-term care services subject to per-diem limits.
This is the single highest-value screening question in the engagement. Where 101(g) applies, the entire three-tier analysis is displaced and the transaction can be tax-free. Where it does not, or where the certification is not properly documented, it is fully taxable under the ordinary rules. Get the certification into the file contemporaneously, not at filing.
IRC Section 6050Y Information Reporting
A reportable policy sale triggers information reporting under IRC § 6050Y. In broad terms, the acquirer reports the sale and the payment to the seller, and the issuer reports the seller’s basis and the policy’s cash surrender value. Your client should receive forms, and those forms are the reconciliation point for the return.
Two things go wrong routinely. The issuer-reported basis can differ from the basis your workpapers support, particularly where premium history is incomplete — document your position and be ready to explain the difference. And clients frequently do not recognize the forms when they arrive, so flag them in the closing memo before they show up in January.
| Proceeds tier | Amount | Character | Authority to cite |
|---|---|---|---|
| Tier 1 | Up to basis (generally total premiums paid) | Tax-free return of premium | Rev. Rul. 2020-05; TCJA 2017 |
| Tier 2 | Basis up to cash surrender value | Ordinary income | Same character as gain on surrender |
| Tier 3 | Above cash surrender value | Generally long-term capital gain | Tier a surrender cannot produce |
| Terminal illness | Entire proceeds | Generally excluded from income | IRC 101(g), 24-month physician certification |
| Chronic illness | Proceeds used for qualified LTC services | Generally excluded, subject to per-diem limits | IRC 101(g) chronic illness conditions |
| Any reportable policy sale | n/a | Information reporting | IRC 6050Y |
Surrender Versus Sale, After Tax
The comparison your client needs is after-tax, not gross. A surrender produces exactly the cash surrender value, with all gain over basis taxed as ordinary income. A sale can produce more, with the excess over cash surrender value taxed at capital rates — commonly cited market ranges run roughly 10% to 35% of face value, and the GAO’s 2010 study (GAO-10-775) found settlement proceeds substantially exceeded cash surrender value on the policies examined.
Run both columns before the client acts. Where the client is also planning for long-term care in Washington, note that Apple Health long-term services and supports, including the COPES waiver, carry a $2,000 individual countable-asset limit as of 2026, so a policy’s cash value is generally a countable resource regardless of which path is taken. Comparison: settlement vs. surrender.
State-Level Items in Washington
Washington has no personal income tax, so the seller-level analysis is federal in most engagements — but that is not the end of the state conversation. Washington imposes a capital gains excise tax on certain long-term capital gains above a statutory threshold, with statutory exemptions and a deduction structure that has been litigated and amended; verify the current 2026 threshold, rates, and exemption list with the Department of Revenue before concluding it does or does not reach a particular sale.
Washington also has its own estate tax, which is why some clients genuinely still need coverage that would otherwise look expendable. And on the regulatory side, settlements are governed by RCW Chapter 48.102 under the Washington State Office of the Insurance Commissioner, with Washington among the states addressing settlement as an alternative to lapse or surrender. Detail: Washington tax overview and licensing.
Entity-Owned and Business Policies
When the seller is a business entity rather than an individual, three additional questions arise. Whether employer-owned life insurance notice and consent requirements under IRC § 101(j) were satisfied at issue, which affects the death benefit exclusion and is worth knowing before advising on disposition. Whether the transfer-for-value rules affect any related-party movement of the policy. And how the gain flows through to owners under the entity’s structure.
Orphaned buy-sell coverage on a bought-out partner and key-person policies that survived a business sale are the two most common findings. Both are usually still being funded out of habit, and neither is typically priced before someone decides to surrender.
How a Referral Works
With the client’s permission you send one document: the policy cover page, showing carrier, product type, face amount, and issue date. That supports a free preliminary read, typically returned within one to two business days, at no cost and with no obligation to you or the client.
If the policy is worth pursuing, three additional documents produce an indicative range: a current in-force illustration, the most recent carrier statement, and a signed HIPAA authorization. A standard file then runs roughly 60 to 120 days from complete documentation through funding — which means a sale contemplated for a given tax year needs to start well before year end.
The client stays in control throughout, can stop before closing, and can have any offer reviewed by you and by the client’s attorney before acceptance. (305) 209-7183.
This page is educational only and is not legal, tax, or investment advice for you or your clients. Pine Lake Life Solutions does not provide legal or tax counsel, and nothing here is an offer to purchase a policy; independent professional review should precede any transaction.
Frequently Asked Questions
What exactly did Rev. Rul. 2020-05 change?
It conformed IRS guidance to the 2017 Tax Cuts and Jobs Act so that a policy seller’s basis is no longer reduced by cost-of-insurance charges. Basis is generally total premiums paid. That is more favorable than the prior treatment under Rev. Rul. 2009-13 and it materially reduces taxable gain on older, heavily funded policies.
How do I compute the three tiers?
Proceeds up to basis are a tax-free return of premium, proceeds between basis and cash surrender value are ordinary income, and proceeds above cash surrender value are generally long-term capital gain. You need two carrier-supplied inputs: total premiums paid and cash surrender value at the sale date.
When are proceeds entirely income-tax-free?
Under IRC Section 101(g), a terminally ill insured may exclude proceeds where a physician certifies a life expectancy of generally 24 months or less. Chronically ill insureds may exclude proceeds used for qualified long-term care services, subject to per-diem limits and additional conditions. Get the certification into the file contemporaneously.
What forms should the client expect?
A reportable policy sale triggers IRC Section 6050Y information reporting, with the acquirer reporting the sale and payment and the issuer reporting basis and cash surrender value. Flag the forms in the closing memo so the client does not misfile them in January.
What if the issuer-reported basis differs from mine?
That happens, usually where premium history is incomplete. Document your basis computation with the carrier’s premium history, note any policy loans, partial surrenders, and dividends taken in cash, and be prepared to explain the difference on examination.
Does Washington tax the gain at the state level?
Washington has no personal income tax, but it imposes a capital gains excise tax on certain long-term capital gains above a statutory threshold. The threshold, rates, exemptions, and deductions have been amended and litigated, so verify the current 2026 rules with the Department of Revenue before concluding it does or does not reach a particular transaction.
How does this differ for an entity-owned policy?
Check whether the employer-owned life insurance notice and consent requirements under IRC Section 101(j) were satisfied at issue, whether transfer-for-value rules affect any related-party movement, and how gain flows through under the entity’s structure. Orphaned buy-sell and key-person policies are the most common findings.
How long does a sale take, for year-end planning?
A standard file typically runs about 60 to 120 days from complete documentation through funding. A sale intended to land in a specific tax year should start well before year end, and the initial free read on a cover page usually comes back in one to two business days.
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Related Reading
- Life Settlement Taxes Washington
- Cash Surrender Value Life Insurance
- Life Settlement Vs Surrender
- Life Settlement Licensing Washington
- Washington Medicaid Asset Income Limits
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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.