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New Tax-Free Treatment of

Viatical Settlements

By Gary J. Gasper

In Brief

Help for the Terminally and Chronically Ill

A viatical settlement is the sale or assignment of a life insurance contract to a third party. The Health Insurance Portability and Accountability Act of 1996 provides for tax free treatment of the proceeds from such settlements. Payments to terminally ill individuals are entirely tax free. There are additional rules for those individuals classified as chronically ill. The tax free portion may be limited for payments made on a per diem or other periodic basis.

These new rules provide new opportunities for both tax and estate planning purposes. For example, because viatical settlements are now tax free for the terminally ill, there is the potential for eliminating the estate tax that would otherwise be payable on insurance proceeds.

On August 21, 1996, President Clinton signed into law the Health Insurance Portability and Accountability Act of 1996 (H.R. 3103 -- Pub. L. No. 104- 191). One of the most significant tax provisions in the bill provides that proceeds from viatical settlements will now be tax-free in the case of "terminally ill" and "chronically ill" individuals under new IRC section 101(g). This dramatic change in law will open up creative tax and estate planning opportunities that can provide significant tax benefits, causing many taxpayers to rethink their estate plans.


A viatical settlement is the sale or assignment of a life insurance contract by a taxpayer to a third party. It is similar to an "accelerated death benefit" ("ADB"). However, whereas an ADB generally takes the form of a rider to a life insurance policy and results in a transaction with the issuer of the policy, a viatical settlement is a sale or assignment transaction generally entered into with an independent third party. The ability to sell or assign a life insurance policy to a third party, other than the issuing insurance company, allows the taxpayer to take advantage of competitive forces and the free market to obtain the highest payment for his/her life insurance contract.

Prior Tax Treatment

To date, only one IRS private letter ruling has addressed the tax treatment of a viatical settlement payment. In Private Letter Ruling 9443020 (July 22, 1994), the IRS was asked whether an amount paid to a terminally ill person insured by a viatical settlement company upon the assignment of a life insurance contract was excludable from income under IRC section 101(a). That section provides an exclusion from gross income for amounts received under a life insurance contract if those amounts are paid "by reason of the death" of the insured.

The IRS found the amounts received from the viatical settlement company were not amounts received by reason of the death of the insured, even though the insured was terminally ill. Accordingly, the IRS held that the amounts were not excludable under IRC section 101(a).

The ruling went on to find that an assignment of a life insurance contract for consideration (e.g., a viatical settlement) "constitutes a sale of property." Significantly, the IRS tested the gain on the sale under IRC section 1001 and stated that "[T]o determine the gain on the sale, the amount realized (money and property received) is reduced by the adjusted basis of the contract." It held that "[E]xcept as otherwise provided in subtitle A of the code, the entire amount of the gain realized under Sec. 1001(b) must be recognized [See Sec. 1001(c)]."

By using an IRC section 1001 analysis, the IRS implicitly allows taxpayers to claim capital gains treatment for the receipt of viatical settlement proceeds, assuming the life insurance contract is a capital asset in the hands of the taxpayer under IRC section 1221. Therefore, a viatical settlement payment can, in most cases, be considered a capital gains transaction to the extent the life insurance contract is a capital asset and the taxpayer is not in the business of buying and selling life insurance contracts.

An ADB, on the other hand, is generally treated as an amount received "under" a life insurance contract. Such payments are governed by IRC section 72(e) and generally result in ordinary income treatment.

The ability to obtain capital gains (rather than ordinary income) treatment provides a significant tax advantage for viatical over accelerated death benefits, with or without the new change in law.

New Tax Treatment

H.R. 3103 adds new IRC section 101(g) that now excludes from gross income as "an amount paid by reason of death of an insured" the following:

* Amounts received under a life insurance contract (ADBs), and

* Amounts received from the sale or assignment of a life insurance contract (viatical settlements) to a "qualified viatical settlement provider."

To qualify for either exclusion, the insured under the life insurance contract must be either a terminally ill individual or a chronically ill individual.

A qualified viatical settlement provider is any person that regularly purchases or takes assignments of life insurance contracts on the lives of terminally ill individuals and either--

* is licensed for such purposes in the state in which the insured resides; or

* if the person is not required to be licensed by that state, meets the requirements of sections eight and nine of the Viatical Settlements Model Act [issued by the National Association of Insurance Commissioners (NAIC)], and also meets the section of the NAIC Viatical Settlements Model Regulations relating to standards for evaluation of reasonable payments, including discount rates, in determining amounts paid by the viatical settlement provider.

The new provision, however, does not apply in the case of an amount paid to any taxpayer, other than the insured, if such taxpayer has an insurable interest by reason of the insured being a director, officer, or employee of the taxpayer or by reason of the insured being financially interested in any trade or business carried on by the taxpayer.

Terminally Ill Individual. The definition of a terminally ill individual was expanded in the legislative process and is defined in the new law as anyone who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death in 24 months or less after the date of certification. A physician is defined in the same manner as under the new long-term care rules of H.R. 3103 and generally means a doctor of medicine or osteopathy legally authorized to practice medicine and surgery by the state. Further, the certificate is only based on a "reasonableness" test, as determined by the physician.

Importantly, the terminally ill test is made in the year of payment. Moreover, the new law does not contain a "look-back" rule. Therefore, for example, if a taxpayer obtains a physician's certificate in year one and lives for another 20 years, a viatical settlement payment received in year one will remain tax-free regardless of the taxpayer's later life expectancy. This is particularly relevant for individuals who receive a viatical settlement payment and later recover from a terminal illness.

The new law does not state who is responsible for the physician's certification, but since the tax-free treatment for a viatical settlement payment will be claimed on the tax return of the insured, it is reasonable to assume the burden of obtaining the certification will rest with the policy holder.

In the case of a terminally ill individual, there is no limit on the amount of proceeds that can be cashed-out on a tax-free basis prior to death.

Chronically Ill Individual. A viatical settlement paid to a chronically ill individual by a qualified viatical settlement provider will also be tax-free under new IRC section 101(g), subject however, to additional restrictions on the form of the viatical settlement.

The definition of a chronically ill individual for purposes of the tax-free ADB/viatical settlement provision has the same meaning as such term is given under the new long-term care rules of H.R. 3103. Under this new definition, a chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as either--

* being unable to perform (without substantial assistance) at least two activities of daily living for at least 90 days due to a loss of functional capacity;

* having a similar level of disability as determined by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services (HHS), so long as the individual has been certified within the previous 12 months as having a similar level of disability, as determined under regulations prescribed by the Secretary of the Treasury in consultation with the Secretary of HHS; or

* requiring substantial supervision to
protect such individual from threats to health and safety due to severe cognitive impairment.

Activities of daily living are eating, toileting, transferring, bathing, dressing, and continence. The number of such activities that are taken into account under the new law may not be less than five.

The Conference Report provides additional guidance and states that "[I]t is intended that an individual who is physically able but has a cognitive impairment such as Alzheimer's disease or another form of irreversible loss of mental capacity be treated similarly to an individual who is unable to perform (without substantial assistance) at least two activities of daily living."

Importantly, the Conference Report to the Balanced Budget Act of 1995 (vetoed by President Clinton), which forms part of the legislative history to the new law, states as follows:

"[t]he Treasury Department is required to provide a definition of a chronically ill individual . . . It is intended that this definition include individuals with Parkinson's disease, Alzheimer's disease, or symptomatic AIDS as chronically ill

A person who meets the definition of both a chronically ill individual and terminally ill individual will be treated as a terminally ill individual.

Additional Requirements for a Viatical Settlement with a Chronically Ill Individual. In conference, Congress also clarified somewhat the rules for chronically ill insured "so that the tax treatment of payments with respect to chronically ill individuals is reasonably similar under the long-term care rules of the bill and under this provision."

Accordingly, for a chronically ill individual to receive tax-free treatment, the viatical settlement must meet an additional requirement. Specifically, the viatical settlement must either--

* be a reimbursement (indemnity) arrangement for costs incurred by the payee (not compensated by insurance or otherwise) for "qualified long term care services," as that term is defined in H.R. 3103"; or

* be subject to the long-term care rules with respect to payments made on a per diem or other periodic basis.

In the case of a reimbursement (indemnity) viatical settlement arrangement for a chronically ill individual, the arrangement--

* must not be a payment or reimbursement of expenses reimbursable under Medicare (except where Medicare is a secondary payor under the arrangement, or the arrangement provides for per diem or other periodic payments without regard to expenses for qualified long-term care); and

* the arrangement must comply with the long-term care "consumer protection

These consumer protection provisions include provisions relating to the right of an individual to return the payment and the right to rescind the arrangement within 30 days. Other consumer protection provisions contained in the long-term care section of H.R. 3103 also apply.

The per diem/periodic payment rules apply without regard to the amount of expenses for qualified long-term care. In such cases, the new law limits the amount of a viatical settlement that can be tax-free under these arrangements to either 1) $175 per day or 2) $63,875 annually (more likely in the case of periodic or lump sum viatical settlement payments). Both amounts will be indexed for inflation. The amounts excludable are reduced by the amount of reimbursements and payments received for qualified long-term care services.

The Conference Report states that the excess payments "are fully includable in income without regard to rules relating to return of basis under IRC section 72." It is not clear whether this applies only to ADBs, since the IRS uses an IRC section 1001 analysis for viatical settlement payments. Excess viatical settlement payments to chronically ill individuals should receive capital gains treatment as they do under current law.

Finally, the new law provides reporting requirements for qualified viatical settlement providers. They must now report to the individual and the IRS the name, address, and taxpayer identification number of the chronically ill individual on account of whose condition such amounts are paid, and whether the viatical settlement arrangement is a per diem-type contract.

These new rules leave many questions unanswered, including the treatment of payments made to an individual who in one year is a chronically ill individual and the following year is a terminally ill individual; and the treatment of excess viatical settlement payments to chronically ill individuals entitled to capital gains treatment. It is expected Treasury regulations will be issued shortly to address these and other issues.

Tax and Estate Planning

Allowing certain taxpayers to access proceeds from their life insurance contract on a tax-free basis prior to death provides a host of tax and estate planning opportunities. While the full impact of the new law on the tax and estate planning area is beyond the scope of this article, a number of obvious planning opportunities can be identified.

In many cases, terminally ill individuals incur huge medical expenses in the six months prior to death that many times drain all liquid assets and leave the taxpayer with the option of either--

* paying off these debts by cashing out their life insurance policy (and paying income tax), or

* accumulating these huge debts and interest costs and leaving their estate with an unwanted liability (to the detriment of their beneficiaries).

Many times the individual's standard of living is dramatically reduced as well during this trying time.

Under the new law, a taxpayer can now access the proceeds of his or her life insurance policy tax-free and use the money to pay medical expenses, other debts, or simply increase their standard of living. Because, in most cases, there is no limit on the use of viatical settlement proceeds, cashing out life insurance proceeds prior to death can be used as a tremendous financial planning technique to reduce debts or rearrange financial assets.

Prior Tax Treatment. There are also many tax advantages to accessing life insurance proceeds prior to death. In a typical example, assume that a terminally ill taxpayer in the 55% estate tax bracket owns a life insurance policy with a face value of $100,000 (no cash value). Prior to the change in law, the taxpayer generally had the following options:

* Keep the policy in place until death. The tax result would be that $100,000 would be included in the estate and be taxed at 55%, leaving the estate with $45,000 to distribute to beneficiaries. The beneficiaries would pay no income tax on the proceeds under IRC section 101(a). (RESULT: $45,000 to distribute on death)

* Sell (or viaticate) the policy prior to death. The taxpayer would receive a discount on the proceeds from the viatical settlement company. In the case of a terminally ill individual, and assuming the company purchased the policy at a 30% discount, the individual would receive 70% of the proceeds (or $70,000). The amount received as a viatical settlement payment ($70,000) would then be subject to a Federal capital gains tax. At a capital gains tax rate of 28%, the tax on $70,000 would be $19,600; leaving the taxpayer with $50,400 in cash to distribute, gift, or spend. If the money were no longer in the estate on death, there would be no estate tax. (RESULT: $50,400 to distribute, gift, or spend)

If the taxpayer had a policy with an ADB provision he/she could also engage in an ADB transaction. However, since an ADB payment is taxed at ordinary income rates, a taxpayer in the highest bracket would pay 39.6% tax on the $70,000 payment (or $27,720 in income tax), leaving only $42,280 to distribute, gift, or spend. Moreover, most ADB provisions will not allow for full surrender of a policy. Both the tax and full surrender advantages make a viatical settlement more attractive than an ADB, with or without the new law.

New Tax Treatment. Now, with the change in law, the tax impact in the second option will change dramatically for those who are terminally ill. In those cases, the amount received upon the sale of the policy to a viatical settlement company is tax-free. Therefore, the taxpayer would receive the full $70,000 tax-free to distribute, gift, or spend. (NEW RESULT: $70,000 to distribute, gift, or spend)

Importantly, this money can be spent or distributed through gifts during the life of the taxpayer without being brought back into the estate under the three-year look-back rule of IRC section 2035. (Since most ADB provisions will not allow for surrender of a life insurance policy, an ADB transaction will not allow the life insurance proceeds to be completely removed from the gross estate for estate tax purposes). The end result is that by viaticating the policy in the example, the taxpayer has $19,600 ($70,000 less $50,400) more to now spend on medical expenses, gift, or use to increase his or her standard of living. This additional amount of money also does not take account of the present value savings earned by viaticating the policy prior to death.

In the case of a chronically ill individual, the new law imposes additional restrictions on the form of viatical settlement arrangement. The effect is to allow such individuals to cash out their life insurance policies on a tax-free basis up to at least $63,875 per year (indexed). In many cases, a viatical settlement arrangement can extend over a period of years, allowing the $63,875 tax-free amount to be met in successive years; thus, allowing additional amounts to be cashed out tax-free.

In other cases, the new law provides additional flexibility in the structure of viatical settlement payments by allowing a chronically ill individual to enter into a viatical settlement arrangement that is structured to indemnify the taxpayer for any long-term care expenses. While such arrangements may not be practical,
the full amount received under such
a reimbursement (indemnification) arrangement would be tax-free under the new law.

These examples are just the tip of the iceberg for an entirely new viatical settlement industry. Because the new law lends itself to new and creative tax and estate planning options, the use of viatical settlements as a planning tool will surely come to the forefront in the coming months and years. *

Gary J. Gasper, Esq., is an attorney with Washington Counsel, P.C. and outside tax advisor to Viaticus, Inc. (a wholly-owned subsidiary of CNA Financial Corp.). He previously served as senior tax advisor at the Department of the Treasury (1992-1993) and assistant to the IRS Commissioner (1989-1992).

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