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Chapter 6: Taxation of Lifetime Settlements
Taxation of Lifetime Settlements
The important points addressed in this lesson are:
The general tax concepts applied to life insurance death benefits, policy loans and policy surrender.
The definition of terminally ill and chronically ill viators under HIPAA
The differences in taxation between viatical and senior settlements
Special tax rules that apply to the sale of policies owned by a business organization
Taxation affects many of the things that we do (or the way that we do them) in our lifetime. It also affects viatical and senior settlements.
In general, a life policy's death benefits received by beneficiaries are received free of federal income tax. The policy's value would be included in the insured's estate for estate tax purposes if the insured was the owner of the policy at the time of death (or held incidents of ownership within 3 years of death). If the policyholder surrendered the policy for its cash value, the amount received that exceeded the policyholder's cost basis (premiums paid less any dividends received) is taxable as ordinary income. Policy loans, secured by the policy, are received tax-free. Those loans, if outstanding at the time of the insured's death, would reduce the death benefits payable to the beneficiaries.
Let’s begin our discussion of the taxation of lifetime settlements by looking at the situation prior to the federal legislation that defined their taxability. In a word, it was confused; but there were good reasons for this confusion. A viatical settlement did not require that the insured die before it was paid, so it wasn’t really a tax free death benefit. The amount of the viatical settlement often greatly exceeded the cash value, so it wasn’t a cash value loan that could be secured by the policy. In addition, the viatical settlement wasn’t really a withdrawal against the policy that might be taxed to the extent that it exceeded the policyowner’s basis.
Despite this confusion, the viatical industry grew dramatically. It wasn’t until 1996, however, with the passage of the Health Insurance Portability and Accountability Act (HIPAA) that the tax treatment of certain viatical settlements was established. Under HIPAA, a distinction is made between an individual who is terminally ill and one who is chronically ill. The tax treatment given to viatical settlements made to these individuals depends principally on which category is applied to a given viator. HIPAA defines a terminally ill individual as someone with a life expectancy of 24 months or less and a chronically ill individual as someone who is incapable of performing at least two activities of daily living, such as eating, bathing and toileting or who requires substantial supervision.