Chapter 6
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.


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 speaking, 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.     


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
$1,000,000
TAXED AS:
settlement proceeds
$260,000
$222,000
  capital gains
cash value
$38,000
$23,000
  ordinary income
cost basis
$15,000
$15,000
  tax-free return of     principal



Taxation of Business Owned Policies

In this lesson on taxation, we have looked at the general rules regarding the income tax status of viatical and senior settlements. There is an exception to these general rules, however, that applies when a viatical settlement is made in a business situation. We noted earlier in this lesson that a viatical settlement made to an individual whose life expectancy is 24 months or less is received entirely tax free, regardless of the use to which he or she puts those funds. This significant tax advantage does not apply to certain business-related viatical settlements.

The HIPAA tax benefits that make a viatical settlement tax free do not apply when the taxpayer receiving the viatical settlement proceeds has an insurable interest in the insured because the insured is the taxpayer's:

director
officer
employee

Furthermore, these tax benefits do not apply when the insurable interest of the proceed recipient results from the insured's financial interest in the taxpayer's trade or business.

Despite these exceptions for viatical settlements paid in a business environment, business-related viatical settlements still receive tax breaks. Any viatical settlement subject to that business exception will, nonetheless, enjoy the same capital gains treatment that applies to senior settlements.