Viatical Settlement Taxation: The Complete Guide

The image shows a happy senior sitting on the couch.

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Viatical settlements can be a godsend for terminally ill patients who need cash immediately to pay for medical bills or other forms of managed care. It can also help insureds by removing the cost of insurance from their budgets.

However, these transactions can be complicated, and viatical settlement taxation can be difficult to compute in some cases. Nevertheless, they may be the only alternative for some people who have already spent all of their savings and other assets on healthcare just to stay alive.

What is a viatical settlement?

In a nutshell, a viatical settlement happens when a terminally or chronically ill patient sells his or her permanent life insurance policy such as a whole life policy to a third party, which is usually a life settlement company. This may be done through a life settlement broker in many cases. It works like this:

  • The patient receives the settlement proceeds, which is a substantial lump sum payment of cash upfront.
  • The buyer assumes the responsibility of paying the insurance premium payments each year until the death of the insured (the patient). The amount of the policy will partially dictate how much money the insured receives.
  • The buyer also names itself as the primary beneficiary on the policy.
  • Then the buyer (usually a life settlement company or another viator) collects the face value, or death benefit of the policy and thus recoups its premium outlay and also makes a profit.

By definition, a viatical settlement will usually pay the seller at least two to three times the amount of cash value or cash surrender value in the policy, but always less than the policy’s death benefit.

Some viators allow private investors to invest in the policies that they buy so that the investors each accrue a large portfolio of private life insurance policies. The viator uses the proceeds from these investors to buy more policies and then attract more investors. The viator also earns a commission from the sale of each life insurance contract.

Viatical settlements: A brief history

Viatical settlements first appeared in the wake of the AIDS epidemic back in the 1980s. Life insurance purchasers, known as viators, approached terminally ill AIDS patients and offered them a cash payment in return for their life insurance policies.

The patients who decided to sell their policies received an immediate substantial cash payment that they could use to pay for medical bills, and the buyers made their profit when the death benefits were paid out by the insurance company.

However, these unwieldy transactions conducted in the secondary market were almost completely unregulated, and the tax rules governing viatical settlements were largely a matter of almost completely subjective interpretation. The viatical industry at that time was rife with corruption and contradictions, and selling a life insurance policy was generally viewed as a risky (and rather morbid) venture by the public.

Fortunately, the viatical industry is considerably more regulated now than it was then, but the tax rules surrounding these transactions are still somewhat onerous at both the federal and state levels.

Viatical settlement taxation: Is my settlement taxable?

The tax implications for viatical transactions are somewhat complicated in general, but can be much more complex in certain instances, depending upon the seller’s health condition and financial circumstances.

In the most general sense, viatical settlements are usually tax-free because they are considered to be an advance on the death benefit of the insurance policy in question (and the death benefit is always tax-free).

However, the viatical transaction itself must meet several key criteria in order to enjoy a tax-free status. Failure to meet these criteria can result in adverse tax consequences. The criteria are listed as follows:

1. The purchaser must be a qualified settlement provider

The purchaser of the life insurance policy must be considered to be a qualified viatical settlement provider by the IRS and other government agencies. It must also be licensed in the state in which it buys the policy.

All states require viatical settlement companies to be licensed except for Alabama, Missouri, South Carolina, South Dakota, Wyoming, and Washington, D.C. If the seller resides in one of the states without this requirement, then they can ignore this rule.

2. The purchaser must adhere to the VSMA

Purchasers in non-regulated states are still required to adhere to the disclosure guidelines outlined in the Viatical Settlements Model Act by the National Association of Insurance Commissioners (NAIC).

3. The purchaser must follow payment guidelines

The purchaser must also obey the NAIC’s reasonable payments guidelines, which specify minimum payouts for policies based on the insured’s life expectancy. This rule applies to terminally ill insureds only.

4. The purchaser must have a viatical settlement purchase record

The purchaser has to have a track record of buying life insurance policies from terminally and chronically ill people. Your next-door neighbor cannot get a license, buy one policy, and then consider him or herself to be a qualified buyer. The intention to purchase policies has to be a regular and recurring activity.

5. The policyholder must be a living person

The policyholder must be a living person and not a corporation, trust, or other business entity in order for the transaction to be exempt from taxes. If a corporation owns the policy, then any sale to a third party will be fully taxable.

Happy grandparents and grandchild enjoying themselves on the beach.after getting a viatical settlement.

If the insured is a terminally ill policyholder, he or she must procure a statement signed by a doctor saying that the insured has two years to live at most. Failure to meet these criteria will result in the seller having to declare the settlement as taxable income on his or her income tax return.

Viatical settlement taxation for long-term terminally ill individuals

Viatical settlements for chronically ill insureds that have more than two years to live are tax-free to the extent that the viatical settlement proceeds are used to pay for qualified medical or long-term care expenses that are not covered by health insurance, long-term care insurance or Medicaid.

Any sale proceeds that are in excess of the cost basis and are used for any other purpose are taxable. The insured must also be permanently incapable of performing at least two out of the six activities of daily living (ADLs), which are:

  • Toileting
  • Grooming
  • Transferring (such as from a wheelchair to a bed)
  • Eating
  • Bathing
  • Walking

So, what happens when a terminally ill patient is estimated to have more than two years to live? Someone facing this dilemma has two choices. They can either…

  • wait until they fall into the two-year window and sell their policy then, or…
  • they can sell it immediately as a life settlement transaction.

A life settlement transaction will be fully taxable. The right choice will usually be determined by the insured’s financial condition. If they absolutely have to have money right now to pay medical bills, then the life settlement option is probably the way to go. Otherwise, they will be better off waiting until the two-year window kicks in.

Common myths about viatical settlements

There are also several common misconceptions about viatical transactions and the viatical settlement industry that have confused the public about the nature of these settlements, how they work, and who they are designed for. Four of the biggest myths about viatical settlement offers are:

1.  Viatical sales are a scam

Admittedly, some people have been fleeced by their purchasers in the past, especially in the early days of this fledgling industry. But viatical settlements today are much more regulated, and many purchasers offer convenient turnkey packages that sellers can use to streamline the sales process and maximize their sale price. If you feel uneasy about selling your policy, don’t hesitate to enlist the help of a qualified life settlement broker who can help you to find the right buyer.

2.  Viatical settlements are tax-free 100% of the time

As this article explains, this is definitely not the case. Any proposed viatical transaction must meet the criteria listed here to qualify for tax-free status in the eyes of the IRS. There are specific requirements for both buyers and sellers. For tax purposes, it is always a good idea to consult with your tax advisor about how your settlement could be taxed so that there are no surprises later.

3.  Viatical settlements are only designed for rich people

This is a flat-out lie. Viatical settlements are designed for qualified terminally or chronically ill insureds who own cash value life insurance policies that they want or need to sell.

Rich people may get a larger settlement because they can afford to pay for larger policies, but that’s the only real difference between how the rich and poor or middle-class insureds are treated. Rich people have probably also paid a higher amount of premiums than others. But they must also have a terminal illness to qualify.

4.  Viatical settlements have no downside of any kind

When an insured sells his or her policy to a viatical settlement company, he or she is effectively disinheriting the beneficiaries that were initially chosen for the policy when it was first purchased. The insured should discuss this issue at length with those beneficiaries before signing on the dotted line to make sure that there are no unpleasant surprises that will hit them after the insured dies.

Investors who invest in individual life insurance policies are also taking on a certain amount of risk. The insured may end up living longer than was expected, which lowers the rate of return that they earn on their investments.

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It should be noted that viatical settlements can only be done with a cash value life insurance policy. Term life insurance policies don’t qualify because they don’t have a cash value component. The one exception to this is a convertible term policy, where the policy can be converted at any time into a small amount of paid-up permanent coverage. Then the policy can be sold, provided that the smaller death benefit is still large enough.

Viatical settlement vs. life settlement: What’s the difference?

Life insurance settlements are the taxable cousins of viatical settlements. Although they cannot escape the tax man, they are available to a much wider group of people than viatical settlements are.

While viatical settlements can only be done for terminally or chronically insureds, life settlements are available to most anyone who is at least 65 years old and has some sort of cash value life insurance policy. The policy’s death benefit usually has to be at least $100,000. Life settlement providers generally pay the policy owner a lump sum of cash that is at least two to three times the policy’s cash value.

Anyone who is at least 65 years old and qualifies for a viatical settlement will almost automatically qualify for a life settlement. They just won’t receive the same tax treatment.

Life settlement transactions usually generate both ordinary income and capital gains taxes. Visit the IRS website at www.irs.gov for more information on the tax laws governing life settlements.

Can I sell my life insurance policy in a viatical settlement?

A quick look at the rules listed above should give you a pretty clear idea of whether you qualify for a viatical transaction or not. If you are terminally ill, and a doctor has signed a statement dictating that you have two years to live at most, then you should qualify with no problem. Or, if you are chronically ill with more than two years to live, but cannot perform at least two out of the six activities of daily living (ADLs) on a permanent basis, then you can also qualify for a viatical settlement.

However, there are many additional details that can also affect the taxation of your transaction that exist on the state level. These technical rules vary from one state to another and can also change from one year to another. For example, the rules that apply in Rhode Island may not apply in New York or Florida. The answer as to whether your viatical settlement will be taxable must always take this factor into account.

In cases where the life insurance policy in question contains accelerated death benefits, the insured would be wise to investigate the limits of these benefits and compare them to the settlement price offered by the purchaser. If the benefits are roughly equal to the sale price, then it may behoove the insured to take advantage of those instead of selling the policy. Accelerated death benefits are always tax-free regardless of all other circumstances.

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Viatical settlements are not simple transactions. And they must be considered at a time when the insured is probably deeply contemplating his or her own mortality, along with his or her family members and other loved ones. But this is the time to consider the tax ramifications of selling a life insurance policy, because failing to do so could result in a nasty surprise when the insured’s tax return is filed the following year.

Furthermore, state guidelines sometimes conflict with the federal rules for taxation of viatical settlements. For this reason, be sure to find out if the purchaser that you are working with follows the rules set forth in the Viatical Settlements Model Act. It is also a good idea to inquire about a given prospective purchaser with your state’s department of insurance to see about their regulatory history. Finally, your purchaser should also be adhering to all of the regulations set forth in the Health Insurance Portability and Accountability Act (HIPAA).

Most financial planners tell their clients that they need to meet with a qualified financial or tax advisor in order to get the skinny on any nuances that may exist in their settlements. There are many details (too many to list here) that can affect the tax status of a viatical transaction. Only a qualified professional will be able to give a seller a true, realistic idea of how their settlement will be taxed. Consult your financial advisor for more information on viatical settlements and whether they are right for you or your loved one.

Want to see how much you could sell your life insurance policy for? Try our instant life settlement calculator.

Author:
Chris Granwehr is the Founder of Dawn Life Settlements and a former senior manager with Mason Finance, an industry-leading life settlement provider in California. He's a member of the Life Insurance Settlement Association, and he has a passion for empowering customers financially through a faster, easier life settlement system.