If you or someone you love is thinking about a viatical settlement, you might be wondering if you have to pay taxes for your payout.
Most people seem to believe that all income from a viatical settlement is tax-exempt. Unfortunately, this is not always true.
In some cases, viatical settlement payments are subject to state and federal taxes. This post will explain current federal laws and guidelines for the tax treatment of viatical settlement.
What is a Viatical Settlement?
As a reminder, a viatical settlement arises when an insured person with a chronic or terminal illness sells his/her life insurance policy to a third party. The agreed price is usually greater than the cash surrender value but less than the death benefit.
Summary of Federal Viatical Taxation
The taxation of viatical settlement is a complex issue.
Federal tax numbers do not always match those in individual states, and states do not always follow IRS daily rate guidelines. To this end, it is imperative to consult a personal tax consultant or financial advisor and your state government for fair and up-to-date tax policies on a viatical settlement.
At the federal level, most viatical settlement payments are treated the same as a death benefit. This means that the money you receive has no taxes. But first, you need to ensure that you meet all the requirements of the Internal Revenue Code, the law that establishes the basis for taxing viatical settlements.
Is a viatical settlement taxable?
In most cases, viatical settlements are not taxable. The liquidation income of terminally insured persons is treated as an advance on the life insurance benefit. The benefits of life insurance are tax-exempt, so even the conceivable solution would not be taxable.
But, of course, there are exceptions. It is no surprise that the IRS enforces a list of conditions for tax-free viatical settlements. Some of these conditions apply to you and others to the purchaser of your life insurance policy. All of these conditions must be met to maintain your tax-exempt status. Even if you meet the conditions on your part, the transaction will be taxed if the buyer does not comply.
State tax laws are inconsistent from state to state and can even change from year to year. Many states follow federal tax guidelines on a viatical settlement, but some don't.
The bottom line is that the viatical settlement's tax treatment may vary depending on the transaction details. We will analyze the general IRS requirements below. However, to get a definitive opinion considering your specific situation, you must have a thorough discussion with a qualified tax advisor.
Requirements for tax-free viatical settlements
The first condition is that the insured person is terminally ill, with a life expectancy of fewer than two years, or has been diagnosed with a chronic illness. Do note that company policyholders cannot benefit from tax-free viatical settlements.
The policy owner must sell the life coverage policy to a licensed life settlement provider in his/her state. If your state does not require a vendor license, you can ignore this clause.
The provider must also be a regular buyer of life insurance policies and meet the Viatical Settlements Model Act's specific requirements.
This means that providers must pay a certain amount of the policyholder's death benefit depending on the policyholder's life and meet special operating criteria. The smaller the life expectancy, the more money the provider has to offer for the policy.
Chronic patients with a life expectancy of more than two years can benefit from a tax-free viatical settlement. In this situation, the insured must not perform at least two daily living activities and must use the contract money to pay for long-term care costs not covered by the insurance disease or illness.
Tax-free Viatical Settlement requirements (summary)
If the insured's life expectancy exceeds two years, he/she will not be able to carry out two daily living activities.
The insured must be terminally ill with a life expectancy of fewer than two years OR have a diagnosis of chronic disease.
A state-licensed life settlement provider must purchase the policy.
The provider must comply with the requirements agreed in the law of the Viatical settlement model.
While most viatical settlements are exempt from federal taxes, it is essential to make sure that you are eligible. Choose a supplier licensed in your state and ask if they meet all of the requirements set out in the Viaticum Model Law on Contracts.
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Elliot Kravitz, ATP