Recent Guidance on Life Insurance Payments in the Form of Viaticals

Recent Guidance on Life Insurance Payments in the Form of Viaticals

The Background

A "viatical" is a contractual arrangement in which an investor buys a life insurance policy from an insured (or, perhaps, another) for a negotiated purchase price. The investor generally continues to pay the premiums on the policy and is paid the proceeds from the insurance company upon the death of the insured. The investor may be either domestic or foreign.

The Problem

When the insured dies and the insurance company pays the policy amount, the investor is faced with a question of what the tax result of his investment payoff is. Certainly, he has a return of capital (his capital being the amount paid to the insured and the subsequently paid premiums) but, hopefully, he also has a profit from his investment. Part of that profit might be interest, depending on the circumstances, and the rest is gain on the investment.

Looking only at the gain, the question is whether the gain is ordinary or capital. When the investor is a foreign person (generally, a nonresident alien) he is looking at an additional question of how much of the amount received, if any, is subject to withholding. That answer might vary, depending on whether the foreign investor is a resident of a treaty country.

Rulings

In May 2009, the Service issued twin revenue rulings (Rev. Rul. 2009-13 (I.R.S. 2009) and Rev. Rul. 2009-14 (I.R.S. 2009)) (twin in a sense that they both were issued on the same date and addressed a U.S. tax treatment of certain transactions involving viaticals)...

  1. The Domestic Ruling. Rev. Rul. 2009-13 (I.R.S. 2009) focused on the tax consequences to the insureds (individuals) who either sold or surrendered their insurance policies. Specifically, the ruling analyzed three scenarios, two of which involve policies with a cash surrender value (typically, a return on a portion of the premium payment on the permanent insurance policy), with the third scenario dealing with a term insurance policy (the term life insurance policy is issued for a specified term and typically does not have the cash surrender value)... <Analysis>
  2. The Foreign Ruling. In Rev. Rul. 2009-14 (I.R.S. 2009), the Service took a look at an investor who had purchased and held a term insurance policy on an unrelated insured. Under the facgts of the ruling, the insured is a U.S. citizen with the policy originally issued by a U.S. corporation. Similar to its domestic twin ruling, the Service analyzed three scnearios...  <Analysis>

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Significance

Although the rulings provide some certainty in the area, the certainty is misguided. ...[T]he Service is probably in error on the issues of FDAP characterization, withholding, and whether the income is ordinary or capital in the hands of a foreign person.

From a tax planning standpoint, foreign investors should consider the availability of treaty relief and determine whether they qualify for treaty benefits under the applicable U.S. income tax treaty. To the extent a treaty relief is sought by foreign investors in life insurance contracts, one other important issue is the characterization of death benefits for the purposes of the applicable U.S. income tax treaty (i.e., as "other income" or "business profits"). ...
Rev. Rul. 2009-14 (I.R.S. 2009) is silent on that issue.

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This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

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