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VIATICAL SETTLEMENTS: TAX-FREE TREATMENT UNDER IRC §101(g)
By: Stephen M. Watson, Esq.
Sales of life insurance policies are often generally referred to as
"viatical settlements." Technically, however, the term "viatical
settlement" refers only to those cases where the insured under the
policy is terminally ill. Where the insured under the policy is not
terminally ill, several names have been coined for the transaction
(e.g., "high net worth transactions" and "senior
settlements"). We will touch more on these types of transactions in
later newsletters, but for now we will concentrate on the
"pure" viatical settlement, where the insured under the policy
is terminally ill.
Effective January 1, 1997, Congress enacted The Health Insurance
Portability and Accountability Act of 1996, H.R. 3103, P.L. 104-191 (the
"Act"). The Act changed the Internal Revenue Code ("IRC")
to add §101(g). Pertaining to amounts received by terminally ill
insureds, IRC §101(g)(2)(A) reads in pertinent part: "If any
portion of the death benefit under a life insurance contract on the life
of an insured... is sold or assigned to a viatical settlement provider,
the amount paid for the sale or assignment of such portion shall be
treated as an amount paid under the life insurance contract by reason of
the death of such insured."
IRC §101(a) specifically provides that amounts received under a
life insurance contract by reason of the death of an insured are
excluded from gross income--in other words, income tax free. It is this
provision that for years has allowed beneficiaries to receive money from
the policy tax-free after the death of the insured. IRC §101(g) simply
expands the applicability of this concept to encompass viatical
settlements. Moreover, since many states have a state income tax
structure which parallels the federal Internal Revenue Code tax
guidelines, viatical settlement proceeds may receive tax-free treatment
at the state level as well.
In reading this section closely, we notice that there are generally
two tests that must be met in order to have a tax-free viatical
settlement. First, the insured must be terminally ill. Second, the
policy must be sold to a "viatical settlement provider."
For an individual to meet the definition of "terminally
ill," the individual must be "certified by a physician as
having an illness or physical condition which can reasonably be expected
to result in death in 24 months or less after the date of the
certification." IRC §101(g)(4)(A). There is no "look
back" provision. In other words, should the individual live for 25
months (or 30 years) after the date of certification, the amount paid
retains its tax-free status.
As discussed, the second step to
tax-free treatment is that the policy must be sold to a viatical
settlement provider, which is defined as "any person regularly
engaged in the trade or business of purchasing, or taking assignments
of, life insurance contracts on the lives of insureds...." IRC
§101(g)(2)(B)(1). Also, if it is required
by the state in which the insured lives, the viatical settlement
provider must be licensed.
There is one important exception to the
tax-free treatment rule for "pure" viatical settlements. In
IRC §101(g)(5), it says that the tax-free treatment "shall not
apply in the case of any amount paid to any taxpayer other than the
insured if such taxpayer has an insurable interest with respect to the
life of the insured 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." Thus, business entities will need to be aware that they
may not receive tax-free treatment on the sale of policies in key person
or buy/sell agreement arrangements. Nonetheless, as we will see in
future newsletters, there is still good tax news for these business
arrangement policies.
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