Life Settlements for CPAs: Key Tax Considerations

The Three-Tier Framework, Precisely Stated

When a policyowner sells a life insurance policy to a third party, the gain computation splits proceeds into three tranches under Revenue Ruling 2009-13:

• Tier 1 — return of basis. Proceeds up to the seller’s adjusted basis in the contract are a tax-free recovery of capital. Post-TCJA, basis equals aggregate premiums paid, with no reduction for the cost-of-insurance charges the ruling originally required — Congress reversed that basis haircut retroactively in 2017 for sales after August 25, 2009.
• Tier 2 — ordinary income. The amount by which cash surrender value exceeds basis is ordinary income. The logic: this slice represents inside buildup that would have been ordinary income on surrender, and a sale should not convert it. For policies whose CSV is below basis — common in stressed universal life — this tier is zero.
• Tier 3 — capital gain. Proceeds above the greater of basis or CSV are capital gain, long-term where the policy was held over a year (nearly always).

A quick worked example: premiums paid $180,000; CSV $110,000; sale price $310,000. Tier 1 returns $180,000 tax-free. Tier 2 is zero (CSV below basis). Tier 3 is $130,000 of long-term capital gain. Contrast a surrender of the same policy: $110,000 received, no gain (below basis) — but $200,000 less cash. The comparison logic, and why the sale can be dramatically better after tax, is developed for a client audience in the life settlement tax treatment guide; the ruling’s full history, including the companion surrender holding, is in Revenue Ruling 2009-13 explained.

Basis: The Number That Decides the Return

Every tier boundary depends on basis, and basis is where engagements go sideways. Aggregate premiums paid is simple to state and tedious to prove on a 25-year-old contract, especially one that has been exchanged, restructured, or partially surrendered along the way. Practical points:

• Order the carrier’s premium ledger immediately. Carriers can produce complete premium histories, but retrieval takes weeks and the request should predate the closing, not the filing deadline. Form 1099-SB (below) reports the carrier’s view of the seller’s “investment in the contract,” but preparers should verify rather than adopt it.
• 1035 exchange chains. Basis carries over from exchanged contracts; a policy acquired via exchange in 2004 carries the prior contract’s premium history. Trace the chain.
• Dividends and withdrawals. Dividends taken in cash or used to reduce premiums lower basis; paid-up additions complicate it; prior withdrawals were basis-first recoveries that reduce what remains. Loans do not reduce basis, but outstanding loans at sale are treated as amounts realized — a policy sold “subject to” a $90,000 loan produces $90,000 of additional proceeds the client never saw in cash.
• Term policies. For a term policy sold after conversion — or the occasional direct term sale — basis questions get thin: premiums paid for expired term coverage are still basis under the post-TCJA rule, a taxpayer-favorable result worth computing carefully.

Where records genuinely cannot be reconstructed, document the methodology and the carrier correspondence; a reasonable, contemporaneous reconstruction defended in the workpapers beats a silent number. Authoritative guidance lives at IRS.gov, including the 2009-13 ruling itself and the §1016 regulations on contract adjustments.

Information Reporting: Forms 1099-LS and 1099-SB

The TCJA created a reporting regime for “reportable policy sales” that makes every settlement visible to the Service, and reconciliation is now a standard part of the sale-year return:

• Form 1099-LS comes from the acquirer (the settlement provider or its assignee) and reports the gross amount paid to the seller. Expect one per policy; the payment date drives the tax year.
• Form 1099-SB comes from the issuing carrier after it receives notice of the transfer, reporting the seller’s investment in the contract and the surrender value — effectively the carrier’s inputs for Tiers 1 and 2.

Preparer notes from the field: the two forms frequently arrive in different months, and 1099-SB’s investment-in-contract figure sometimes disagrees with the client’s records — resolve the discrepancy in workpapers rather than importing it. Gross proceeds on 1099-LS will not match cash received when broker compensation was netted at escrow or a policy loan was extinguished at closing; build the reconciliation from the closing statement. Report the sale on Form 8949/Schedule D for the capital gain tier and as ordinary income for the Tier 2 slice, with the allocation schedule retained. Sellers who are terminally ill viators (next section) may receive a 1099-LS even where §101(g) excludes the income — the exclusion is claimed on the return, not by the payer’s silence, so attach the support.

State returns follow federal characterization in most states, but a handful tax capital gains as ordinary income or lack preferential rates entirely, which changes the settle-versus-surrender arithmetic your projection should capture. Multi-state clients — sale-year movers especially — need a residency-sourcing look before closing, not after.

Scenario	Tier 1 (Tax-Free)	Tier 2 (Ordinary Income)	Tier 3 (Capital Gain)	Key Preparer Note
Sale: premiums $180k, CSV $110k, price $310k	$180,000	$0 (CSV below basis)	$130,000 LTCG	Stressed UL policies often zero out Tier 2
Sale: premiums $100k, CSV $150k, price $260k	$100,000	$50,000	$110,000 LTCG	Inside buildup keeps ordinary character on sale
Surrender: premiums $100k, CSV $150k	$100,000	$50,000 (all gain ordinary)	None	No capital tier on surrender — sale can beat it after tax
Viatical sale, terminal illness (LE < 24 months)	Generally 100% excluded under IRC §101(g)			Requires physician certification + licensed provider; employer-relationship bar
Sale with $90k loan outstanding, cash price $150k	Tiers computed on $240k amount realized			Loan extinguishment is proceeds the client never saw in cash
Grantor trust (ILIT) sale	Same tiers, reported on grantor’s Form 1040			Cash stays in trust — flag the tax/cash mismatch

The Viatical Exclusion: IRC §101(g) for Terminally and Chronically Ill Sellers

The single largest tax swing in this practice area is the viatical exclusion. Under IRC §101(g), amounts received from the sale or assignment of a policy to a licensed viatical settlement provider are treated as amounts paid by reason of the insured’s death — that is, excluded from gross income — when the insured is:

• Terminally ill: certified by a physician as having an illness or condition reasonably expected to result in death within 24 months. The exclusion is complete regardless of how proceeds are used.
• Chronically ill: certified as unable to perform at least two activities of daily living without substantial assistance (or requiring supervision due to cognitive impairment). Here the exclusion is narrower — generally limited to amounts used for qualified long-term care costs not otherwise reimbursed, or within per-diem limits.

The CPA’s diligence points: obtain and retain the physician certification; confirm the purchaser’s licensure status as a viatical provider in the applicable state (the licensing regimes, generally following the NAIC model framework, are surveyed in life settlement regulation by state); and mind the statutory carve-out — the exclusion does not apply where the insured is a director, officer, or employee of the seller, or has a financial interest in the seller’s business, a trap for key-person and buy-sell policies. The same §101(g) architecture governs accelerated death benefits paid by carriers directly, so a terminally ill client should compare the rider against a viatical sale on both price and tax before choosing; the decision framework is in the viatical settlement guide and the accelerated death benefit guide.

Trust, Entity, and Fiduciary Sellers

A large share of settlement volume involves sellers that are not individuals, and the preparer’s analysis shifts accordingly:

• Grantor trusts (most funded ILITs). The sale is reported on the grantor’s Form 1040 under the grantor trust rules, even though proceeds remain in trust — flag the cash-flow mismatch for the client, and check the instrument for tax reimbursement provisions. Basis is the trust’s premium history, which frequently spans decades of gifted premiums.
• Non-grantor trusts. The tiers land on Form 1041 at compressed brackets — the top federal rate arrives around $15,000 of trust income — so sale-year DNI distribution planning can shift the capital gain and ordinary tranches to beneficiaries in lower brackets where the instrument and state law permit capital gains to carry out. Model both postures before closing; the fiduciary-side duty context is covered in life settlements for trustees.
• Business-owned policies. Key-person and buy-sell coverage sold by a C corporation prices the tiers at corporate rates and raises corporate AMT and accumulated earnings considerations for large gains; pass-throughs push the character out to owners. Watch §101(g)’s employer-relationship exclusion bar, and consider transfer-for-value history on any policy that moved between the entity and owners over its life.
• Estates. An executor selling a decedent’s policy on another life (a surviving spouse, a co-shareholder) computes basis under the estate’s acquisition rules and coordinates fiduciary income tax with administration timelines — the executor-facing walkthrough is the life settlement guide for executors.

In every fiduciary posture, insist on seeing the closing statement, the compensation disclosures, and the trust instrument or governing documents — the return cannot be right if the seller’s identity and basis history are assumed rather than verified.

Pre-Sale Projections: The Work Clients Should Buy Before Closing

The highest-value CPA engagement in this area happens before the client signs, not at filing time. A pre-sale projection letter should quantify:

• The tier allocation under realistic offer scenarios — because the ordinary/capital split changes the after-tax ranking of offers that look similar gross. An offer $10,000 higher can be worth less after tax if a competing structure extinguishes a loan differently.
• Settle versus surrender versus hold. The GAO found settlements typically pay several multiples of surrender value — commonly 4–8× — but the after-tax comparison is the honest one, and occasionally surrender’s simpler treatment narrows the gap. See life settlement vs. surrender for the framework.
• Rate interactions. A six-figure Tier 3 gain can trigger net investment income tax, push the client through capital gains brackets, phase out deductions and credits, and — two years later — raise Medicare premiums through IRMAA. For clients near those cliffs, timing the closing across a year boundary, or harvesting capital losses in the sale year, has real dollar value.
• Charitable overlays. A client with charitable intent can donate the policy before sale (deduction generally limited to the lesser of basis or FMV, with a qualified appraisal) or donate cash proceeds after — the comparison is client-specific and worth running.
• Benefit interactions. Proceeds are countable for means-tested programs; a client on or near Medicaid needs elder law coordination before funds move, per life settlement Medicaid spend-down rules.

Deliver the projection in writing with the assumptions stated. It becomes both the client’s decision document and the preparer’s file support when the 1099s arrive the following January.

Preparer’s Checklist and Common Errors

A condensed working checklist for the sale-year engagement — the expanded version is maintained in the tax professional’s life settlement checklist:

• Closing statement, purchase agreement, and all compensation disclosures obtained.
• Carrier premium ledger and 1099-SB investment-in-contract figure reconciled; 1035 chains traced.
• Loan balances at closing added to amounts realized.
• Tier allocation schedule prepared: basis recovery / ordinary (CSV minus basis, if positive) / capital gain.
• §101(g) eligibility screened for any seriously ill insured: physician certification, provider licensure, employer-relationship bar.
• Seller identity verified — individual, grantor trust, non-grantor trust, entity, estate — and the right return charged with the income.
• 1099-LS and 1099-SB tied to the return; discrepancies memorialized.
• State characterization and residency sourcing checked.
• Estimated tax adjusted for the sale year — the ordinary tier and a large capital gain routinely create underpayment exposure for retirees on safe harbors keyed to prior-year liability.

The recurring errors, in rough frequency order: treating the entire proceeds as capital gain (missing Tier 2); using the 1099-SB basis figure without verification; missing loan extinguishment in amounts realized; failing to claim §101(g) for a qualifying viator because a 1099-LS arrived; and reporting a grantor trust’s sale on the 1041. Each is avoidable with the checklist, and each is expensive to amend. CPAs who build this competence also become the professional their advisor and attorney referral network calls first when a client asks the question every aging policyowner eventually asks — the one answered in what is a life settlement.

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Frequently Asked Questions

How is a life settlement taxed under Revenue Ruling 2009-13?

In three tiers. Proceeds up to the seller’s basis — total premiums paid, with no cost-of-insurance reduction after the TCJA’s retroactive fix — are tax-free return of capital. The amount by which cash surrender value exceeds basis is ordinary income, preserving the character the inside buildup would have had on surrender. Everything above the greater of basis or CSV is capital gain, long-term for policies held over a year. For stressed universal life contracts whose CSV sits below cumulative premiums, the ordinary tier is frequently zero and the sale is basis recovery plus capital gain.

What is the difference between Form 1099-LS and Form 1099-SB?

Form 1099-LS comes from the buyer (the settlement provider or acquirer) and reports the gross amount paid for the policy — it establishes proceeds and the tax year. Form 1099-SB comes from the insurance carrier after it learns of the transfer and reports the seller’s investment in the contract and the surrender value — effectively the carrier’s inputs for the basis and ordinary-income tiers. They arrive separately, sometimes months apart, and the 1099-SB basis figure should be verified against the carrier’s premium ledger rather than adopted, since discrepancies are common on older or exchanged contracts.

Are viatical settlement proceeds really tax-free for terminally ill clients?

Generally yes. Under IRC §101(g), amounts received from selling a policy to a licensed viatical settlement provider are treated as death benefits — excluded from gross income — when a physician certifies the insured is terminally ill with a life expectancy of 24 months or less. Chronically ill insureds get a narrower exclusion tied to qualified long-term care costs and per-diem limits. Retain the certification and verify the buyer’s license. Note the carve-out: the exclusion fails where the insured is a director, officer, employee of, or has a financial interest in, the seller — a trap for business-owned policies.

How do I calculate basis in a life insurance policy that was sold?

Start with aggregate premiums paid over the contract’s life — post-TCJA, no reduction for cost-of-insurance charges. Then adjust: subtract dividends received in cash or applied against premiums, subtract prior withdrawals (basis-first recoveries), and trace basis carryover through any 1035 exchange chain. Outstanding loans do not reduce basis, but loan balances extinguished at closing are added to the amount realized. Order the carrier’s premium ledger early — retrieval takes weeks — and reconcile it against the Form 1099-SB figure, documenting any reconstruction methodology in the workpapers.

Is selling a life insurance policy taxed better than surrendering it?

Often, on two counts. First, magnitude: settlements typically pay several times surrender value — the GAO found multiples of four to eight — so there is simply more after-tax cash even at higher tax. Second, character: surrender gain is entirely ordinary income, while a sale caps the ordinary tier at CSV-minus-basis and converts the excess to long-term capital gain. A projection should still be run: state tax treatment, NIIT, bracket effects, and IRMAA can narrow the gap, and policies without secondary-market value make surrender the only realistic exit.

Who reports the income when an irrevocable trust sells a life insurance policy?

Grantor trust status controls. Most funded ILITs are grantor trusts while the insured-grantor lives, so the three tiers land on the grantor’s personal Form 1040 even though the trust keeps the cash — a mismatch worth flagging in advance, along with any reimbursement clause in the instrument. Non-grantor trusts report on Form 1041 at compressed brackets, where the top rate arrives near $15,000 of income, making sale-year distribution planning to carry income out to lower-bracket beneficiaries a genuinely valuable exercise where the instrument and state law allow.

Does a life settlement trigger the net investment income tax or higher Medicare premiums?

It can do both. The capital gain tier is net investment income for the 3.8% NIIT where MAGI exceeds the thresholds, and both taxable tiers raise MAGI, which feeds the IRMAA calculation that sets Medicare Part B and D premiums two years later — a surprise retirees particularly resent. Large gains can also breach capital gains brackets and phase-outs. Mitigation is timing and offsets: close in a deliberately chosen tax year, harvest capital losses against the Tier 3 gain, and adjust estimated payments so safe harbors keyed to prior-year liability do not leave an underpayment penalty.

What documents should a CPA request from a client who sold a life insurance policy?

The closing statement and purchase agreement; every compensation disclosure (broker fees are sometimes netted at escrow, so gross 1099-LS proceeds will not match cash received); the carrier’s full premium ledger and any 1035 exchange history; loan payoff figures at closing; Forms 1099-LS and 1099-SB; for viators, the physician certification and evidence of the buyer’s viatical license; and for fiduciary or entity sellers, the trust instrument or governing documents establishing who reports the income. With that package, the tier allocation schedule and the return reconcile cleanly.

Related Reading

• Tax Professional Checklist Life Settlement
• Revenue Ruling 2009 13 Explained
• Life Settlement Tax Treatment Guide
• Viatical Settlement Complete Guide

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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.