Life Settlements in a Retirement Account? Think Again.
By Jordan Sheppherd
Most of you who subscribe to our newsletter understand that life insurance is prohibited to retirement accounts as an investment. Its hard to forget, given that there are only two investment classes prohibited to IRAs and 401(k)s – life insurance and collectibles. There is an exception for 401(k)s, but that’s not relevant to the subject at hand.
Recently I’ve had a number of clients and prospective clients ask about investing in life settlement contracts, or as they’re called by the purveyors of these products – viatical settlements or just viaticals. If you don’t know what a viatical settlement is, its essentially where someone sells their life insurance policy to a third party. Say I have cancer and want to cash out my life insurance before I die; maybe to pay off my house or pay for my medical expenses. I can sell my life insurance policy to Joe Smith who will pay me more than if I surrendered the policy, but less than the net death benefit or what you might call the full benefit or face value of the policy. When I die, Joe Smith collects the full value of my life insurance policy.
I’ll state this as clearly as I can – life settlements or viaticals are life insurance contracts.
This seems self-evident, but there are a number of companies out there that have come up with a tricky way of structuring these life settlements into, what they consider to be a permissible investment to be held by a retirement account.
Generally it goes like this: the viatical settlement contracts are bundled or pooled into a Trust; lets call it the American Viatical Holdings Trust, or AVHT for short. Annie Smith then takes her IRA and makes a loan to AVHT and receives as collateral a fractional interest of AVHT’s viatical settlements. Voila! Annie’s retirement account doesn’t “own” the life settlement, her account has simply made a loan to a Trust holding the life settlement or viatical. Annie’s IRA holds a promissory note and nothing more. Nothing to see here, say the companies who push these products.
What poor Annie doesn’t know, and what the sales team at AVHT won’t tell her, is that she’s almost certainly blown up her IRA. Were the IRS to ever look at that transaction, they would likely rule her IRA to have engaged in a prohibited transaction by investing in life insurance.
Without going into an enormous amount of detail, this particular structuring of the viatical or life settlement would not be considered a debt due to the Annie’s IRA. Instead, Annie’s IRA would be seen as holding an equity position in the life settlement. The court case A. Finkenberg’s Sons, Inc. v Commissioner, 17 T.C 973 established “The essence of a debt is an unconditional, legally enforceable obligation to repay a sum certain on demand or on a specified date.” Loaning money and taking a life settlement as collateral doesn’t meet that standard based on 11 additional factors the 9th Circuit has used to determine whether an asset is to be considered debt or equity. In this case, out of the 11 factors, 8 favor an equity position, 1 is neutral, and 2 favor a debt position.
In plain English, that means that according to the tax courts, Annie’s IRA will be seen to have actually bought the life settlement. Translation: prohibited transaction.
Now comes the real kick in the teeth. Here’s a quote from a court case brought by the Securities and Exchange Commission against a certain company that was structuring their transactions like the above example. For liability reasons, I’ve redacted the company name, and I’m only going to give the docket number, but type that into Google and you’ll get the case.
“In order to circumvent the Internal Revenue Code prohibition upon IRAs investing in life insurance contracts [REDACTED] structures the purchase through a separate trust established for that purpose. The IRA lends money to the trust, for which it receives a non-recourse note; the trust then uses the loan proceeds to purchase an interest in a life insurance policy, the death benefits of which collateralize the note. When the insured dies and the benefits are paid, the proceeds go to pay off the note held by the IRA.”
“The note is used in these transaction, as the SEC itself affirms in its brief, merely in order to navigate around certain restrictions in the tax code that preclude IRAs from investing in life insurance contracts. If the individual who owns the IRA wants to invest the IRA’s capital in a viatical settlement, then the note is nothing more than a device by which to make that investment in a form that complies with the tax code; use of the note does not alter the substance of the transaction in any manner…”
Source: 87 F. 3d 536
I hope nothing else need be said on the subject, but just a friendly reminder – don’t let anyone tell you life settlements are permissible in a retirement account. And just for clarity, this goes for 401(k)s as well.
As a final and somewhat related note – 401(k)s are actually allowed to purchase life insurance and use some of the employee’s and employer’s contributions to pay for premiums, though the plan documents have to allow for it, and the particulars are somewhat restrictive. That’s a different subject. Maybe for my next newsletter article, I’ll do an overview of how that sort of thing can be done.