Taxation of Viatical Settlements



A viatical settlement made to an individual considered terminally ill (under HIPAA, one who has a life expectancy of 24 months or less) is entirely tax free. To obtain this tax-free status:

the viator (policyholder)  must be individual (not a business)
the viatical settlement company is licensed by the state in which the viator resides or, if there is no licensing requirement, complies with certain requirements stated in the Health Insurance Portability and Accountability Act (HIPAA).   

This favorable tax treatment generally applies only to individual viators -- and does not apply to companies viaticating life insurance policies covering the lives of their employees.

A viatical settlement made to an individual who is considered chronically ill receives a different tax treatment. In order for money received by a chronically ill person to be tax free, the proceeds must be used for those costs incurred for long-term care services that are not compensated by insurance.  Otherwise,  benefits not used for long-term care received in excess of an annually-adjusted limit ($220 per day or $80,300 per year in 2003) are subject to taxation.


ESTATE TAXATION

Generally speacking, all property -- including life insurance -- owned or controlled by a person at the time of their death is included in that person's taxable estate.   There is a special section of the estate tax rules that applies specifically to life insurance policies.  If a person owns a life insurance policy (in the words of the tax code has an "incident of ownership", that is to say exercises control over the policy) and gives the policy away during their lifetime, it will not necessarily remove the policy's value from the taxable estate.  Under Section , the gift must occur more than 3 years before death, in order to remove the value of the policy from the taxable estate.  This rule applies to gift of a policy to another person, such as a family member, or to a trust -- as an estate planning vehicle.  The three-year rule applies to all gifts of life insurance.  A lifetime settlement, however, is not a gift -- it is a sale for value.  As such a lifetime settlement will effectively remove the policy's face value from the taxable estate, even if the sale occurs very close to the time of death.  Of course the proceeds received from the sale may be included in taxable estate -- unless they are given away, spend or otherwise disposed of before death.