Tax Implications of Viatical or Life Settlement (Sale of an Unwanted Life Insurance Policy)

To The Seller

As a general rule, anytime a life insurance policy is sold to an unrelated third-party investor, the proceeds are taxed according to guidance issued by the IRS in 2009. This guidance will generally govern the taxation of life settlement proceeds. However, as is discussed later in this section, a couple of major exclusions apply that may exempt part or all of the proceeds from taxation, and these exclusions will typically apply to the proceeds of viatical settlements. The 2009 IRS guidance indicates that the sale of a life insurance policy may produce both ordinary income and capital gains taxes. The total amount of taxable income is the difference between the sale proceeds and the policyholder’s adjusted basis in the policy.

Ordinary income portion – the difference between the cash surrender value and the cumulative premiums paid (i.e., the gain in the policy at the time of the sale).

Capital gain portion – the difference between the sale price of the policy and the adjusted basis in the policy minus any amounts subject to ordinary income tax. Note that the adjusted basis is aggregate premiums paid by the seller minus the cost of insurance charges. So unlike policy surrenders, where the basis is equal to the cumulative premiums paid, for sales to unrelated third parties where the proceeds are not covered by the terminal or chronic illness exclusions, the cumulative premiums must be reduced by the cumulative cost of insurance to arrive at the adjusted basis.

Example. If a policyholder sells a $500,000 life insurance policy with a cash surrender value of $78,000 to an unrelated third party for $150,000 and has paid premiums totaling $64,000 with insurance charges of $10,000, then he or she must recognize ordinary income in the amount of $14,000 ($78,000 − $64,000, which equals the gain in the policy) and capital gain in the amount of $82,000 [$150,000 − ($64,000 − $10,000) − $14,000].

As mentioned above, there are two major exclusions which may override the general rule and exempt some or all of the living proceeds from life insurance from taxation. These exclusions were contained in The Health Insurance Portability and Accountability Act of 1996 (HIPAA 96), which added Code section 101(g). Specifically, the insured in a viatical or life settlement transaction must either be a terminally ill individual or a chronically ill individual in order for amounts received to be potentially tax-free.

Terminally ill individual – A person is deemed to be terminally ill if he has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within twenty-four months of the date of certification. If the terminal illness exclusion applies, it applies to the entire amount of the living proceeds paid (i.e., there is no upper limit on the amount that can be excluded) and there is no restriction on the use of the proceeds by the recipient. Most viatical settlements will qualify for this exclusion, with the exception of viatical settlements for insureds with a life expectancy of greater than two years (who may qualify for the chronic illness exception discussed below). The terminal illness exclusion should not be applicable to life settlements, as they are for insureds with life expectancies typically much longer than two years.

Once the insured obtains the certification based upon the doctor’s reasonable medical opinion, the reality of what later happens does not matter. In other words, the statute does not contain a look-back rule.7 If the insured actually lives months, years, or decades longer than expected, the viatical settlement proceeds continue to be excluded from income.8

Chronically ill individual – A person qualifies as chronically ill if he has been certified within the previous twelve months by a licensed health care practitioner as meeting one of three criteria: (1) he is unable to perform without substantial assistance at least two activities of daily living (bathing, dressing, eating, transferring, continence, or toileting) for at least ninety days due to a loss of functional capacity; (2) he has a level of disability similar to the level of disability described in clause (1); or (3) he requires substantial supervision to protect him from threats to health and safety due to severe cognitive impairment. People who are terminally ill are not included within the class of people who qualify as chronically ill.9 This exclusion may apply to viatical settlements that don’t qualify for the terminal illness exclusion, and in some situations may apply to life settlements where the insured qualifies as chronically ill. However, unlike the terminal illness exclusion, the amount excluded from income pursuant to this exclusion may be limited.

In order to qualify for the income exclusion, payments to chronically ill individuals must be reimbursements for the costs of qualified long-term care services provided for the insured that are not compensated for by insurance or otherwise.10 Qualified long-term care services include “… necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services which: (A) are required by a chronically ill individual; and (B) are provided pursuant to a plan of care prescribed by a licensed health care practitioner.” 

In other words, unlike terminally ill insureds, chronically ill individuals do not have the discretion to use viatical or life settlement proceeds in whatever manner they desire. Despite the limitation to long-term care costs, the Internal Revenue Code protects periodic payments by providing that a payment will not fail to qualify “… by reason of being made on a per diem or other periodic basis without regard to the expenses incurred during the period to which the payment relates.” The amount of periodic payments that may be excluded is subject to a dollar limit that is adjusted annually. In 2015, the per diem limitation amount is $330 ($120,450 per year).

Also, to qualify for the favorable tax treatment, the viatical or life settlement contract may not “… pay or reimburse expenses incurred for services or items to the extent that such expenses are reimbursable under the title XVIII of the Social Security Act [Medicare] or would be so reimbursable but for the application of a deductible or coinsurance amount.” 

Finally, the chronic illness income tax exclusion does not apply to amounts paid to any taxpayer other than the insured in certain circumstances. If the payee has an insurable interest in the insured’s life because the insured is a director, officer or employee of the payee, or because the insured is financially interested in any trade or business carried on by the payee, the exclusion does not apply. Viatical settlements must comply with additional requirements for the proceeds of the sale or assignment in order to be excluded from income tax. First, the payments must be made by a viatical settlement provider. To qualify as a viatical settlement provider, the purchaser must be “… regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of insureds…” who are terminally or chronically ill.

Second, the provider must either be licensed to provide viatical settlements under the laws of the state in which the insured resides, or if the insured’s state does not require licensing of viatical settlement providers, the provider must meet the requirements specified in the Internal Revenue Code. With regard to terminally ill individuals, the viatical settlement provider must meet the requirement of: (1) Sections 8 and 9 of the Viatical Settlements Model Act prepared by the National Association of Insurance Commissioners; and (2) the Model Regulations of the National Association of Insurance Commissioners relating to standards for evaluation of reasonable payments in determining amounts paid by the viatical settlement provider in connection with the purchase or assignment of life insurance contracts.

With respect to chronically ill insureds, the provider must meet requirements similar to those contained in Sections 8 and 9 of the Viatical Settlements Model Act along with the standards of the National Association of Insurance Commissioners, if any exist at the time of the settlement, for evaluating the reasonableness of the amounts paid by the provider in connection with viatical settlements for chronically ill individuals.

To The Buyer

Guidance issued by the IRS in 20097 clarifies that when a third party that has no insurable interest in the life of the insured (e.g., a viatical or life settlement company) purchases a policy from the insured, the transfer-for-value rule causes the purchaser to have ordinary income equal to the amount by which the death benefit proceeds exceed the amount that the purchaser paid to purchase the policy plus any premiums paid by the purchaser to the carrier subsequent to the purchase.

The transfer for value rule, contained in Code ­section 101(a)(2), provides:

In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income …. shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts, subsequently paid by the transferee.

Since viatical and life settlement providers make their profit in the transaction on the difference between what they pay and what they receive, the taxation of the differential requires them to pay less for the policies than they would otherwise pay if the death benefits were received tax free.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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