Tax Rules for Settlement Purchases
The tax results for the seller depend upon whether you are selling a court ordered structured settlement, lottery winnings, or a life insurance policy (life settlement). In all situations you should consult a professional tax advisor. This site only provides general information and not tax or legal advice.
Life Settlements
For a Life Settlement transaction, the taxation rules can be complicated. You start with understanding the terminology, as follows: CSV = Cash Surrender Value. Cost Basis = Total dollar amount of premiums paid into the policy. Settlement Amount = Purchase price paid to policy owner/seller for the sale of the policy. Depending on these amounts, you could pay capital gains tax, ordinary income tax, or no taxes at all. Of course, your own situation may be different than these general guidelines.
Capital Gain
If there is no CSV or if the CSV is less than the Cost Basis of the policy, then there is a capital gain equal to the dollar difference between the settlement amount minus the cost basis of the policy. Here is that calculation: Capital Gains = Settlement Amount - Cost Basis
Ordinary Income
If the CSV is greater than the Cost Basis, then that excess
is ordinary income and taxed according to the policy owner’s
tax bracket. In addition, the difference between the settlement
amount and the CSV is treated as a capital gain. Here is
the calculation: Ordinary Income Tax = CSV
- Cost Basis
Capital Gains Tax = Settlement
Amount - CSV
No Taxes
If the Cost Basis of the policy is higher than the settlement amount, then there should not be any taxable income from the transaction. This would only result where you have paid in more for the policy in the past than you are receiving now for the settlement.
Please remember that these are general guidelines and cannot be relied upon as fact. The tax implications of a settlement should be considered prior to the transaction.
Purchase of Structured Settlements from Personal Injury Claims
The federal tax law was esablished by the bill passed by Congress in 2001 ( HR 2884), and signed into law by the President in 2002 and effective July 1, 2002, codified at Internal Revenue Code § 5891. In effect, this tax law imposes a punitive excise tax penalty on all structured settlement factoring transactions unless the proscribed requirements are met. This has created the de facto regulatory paradigm for the factoring industry for purchasing structured settlements. Under IRC 5891, all structured settlement factoring transactions must be approved by a state court, in accordance with a qualified state statute. The state statute must make certain basic findings. Among other determinations, the state court must conclude that the transfer is in the best interest of the seller, taking into account the welfare and support of any dependents. Following this federal mandate, nearly all states have enacted statutes regulating structured settlement transfers. Source: Wikipedia, Structured Settlement Factoring Transaction.
We cannot stress enough that each case can be treated differently by the IRS. Professional tax advice must be sought. Also, your state laws may impact overall taxes.