Taxation of Senior Settlements

Although viatical settlements paid to individuals certainly garner the most favorable tax treatment, senior settlements also enjoy certain income tax benefits—benefits made even more attractive by the capital gains tax rate reduction provided in the Taxpayer Relief Act of 1997. Senior settlement benefits are not taxed in the manner of death benefits, however. They are taxed as living benefits received on the surrender of a policy, but with an interesting twist.

The cash value of a life insurance policy received upon surrender has long been taxed under ordinary income rules. Those rules provide that the policyowner’s cost basis is recovered tax free and only the excess of proceeds over the cost basis is subject to income taxation as ordinary income.

Cost basis represents the "net investment" the policyholder has made in the policy --  generally defined as the cumulative premiums paid for the base policy, less any dividends received.

Under the traditional income tax rules that apply to surrender proceeds, a policyowner whose cost basis is $15,000 and whose cash surrender value is $38,000 would be able to recover the $15,000 tax free from the surrender proceeds. The balance of the surrender proceeds (the remaining $23,000) must be included in the policyowner’s ordinary income for tax purposes. This rule hasn’t changed for senior settlements up to the policy’s cash value.

A senior settlement made under a life insurance policy, however, is greater than the policy’s cash value. If a proposed senior settlement were not greater than the cash value, the policyowner would simply surrender his or her policy in the usual way. The important question is: How is the senior settlement amount in excess of the policy’s cash value taxed? In general, the difference between the senior settlement received and the policy’s cash surrender value is treated as a capital gain.

Let’s return for a moment to the policyowner whose policy’s cash value is $38,000. The face amount of the policy is $1 million, and the settlement company has made an offer to buy the policy for $260,000. The difference between the settlement ($260,000) and the policy’s cash value ($38,000) is $222,000, which therefore would enjoy the generally-lower capital gains tax treatment.

face value
settlement proceeds
  capital gains
cash value
  ordinary income
cost basis
  tax-free return of     principal