Key Points in This Chapter
- Under HIPAA (1996), viatical settlement proceeds paid to terminally ill individuals (life expectancy 24 months or less) are generally excluded from federal income tax
- Chronically ill individuals may also exclude viatical settlement proceeds, but only to the extent the proceeds do not exceed a per-diem limit set annually by the IRS
- Accelerated death benefits received from an insurer receive the same tax treatment as viatical settlement proceeds under HIPAA — tax-free for terminally ill, per-diem limited for chronically ill
- For senior (life) settlements involving non-terminal, non-chronically-ill viators, proceeds are taxed in three tiers: return of basis (tax-free), gain up to cash value (ordinary income), and gain above cash value (capital gain or ordinary income)
- The transfer-for-value rule generally makes death benefits received by an investor taxable — with important exceptions including transfers to the insured, a partner of the insured, or a corporation in which the insured is an officer or shareholder
- Clients should always consult a qualified tax advisor before completing a settlement — this chapter provides a general framework, not specific tax advice
Part 1 — Viatical Settlements & Accelerated Death Benefits
HIPAA and the Tax Exclusion
Prior to 1996, the tax treatment of viatical settlement proceeds was uncertain — the IRS had issued limited guidance, and some advisors treated proceeds as taxable income while others argued for exclusion. Congress resolved this uncertainty with the Health Insurance Portability and Accountability Act of 1996 (HIPAA), which added specific provisions to the Internal Revenue Code addressing viatical settlements and accelerated death benefits.
Under HIPAA (IRC §101(g)), amounts received under a life insurance contract on the life of an insured who is terminally ill are treated the same as death benefits — and are therefore excluded from gross income. This exclusion applies whether the proceeds come from:
- A viatical settlement — a sale of the policy to a third-party settlement company
- An accelerated death benefit — a payment made by the insurer under a rider or policy provision allowing the insured to collect a portion of the death benefit while still living
Terminally Ill — Full Exclusion
A terminally ill individual is defined for HIPAA purposes as a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months or less. Proceeds received by a terminally ill viator are fully excluded from gross income with no dollar limit.
Chronically Ill — Per-Diem Limited Exclusion
A chronically ill individual is defined as a person who is unable to perform at least two activities of daily living (ADLs), or who requires substantial supervision due to severe cognitive impairment. Viatical settlement proceeds and accelerated death benefits received by a chronically ill individual are excludable from gross income, but only up to a per-diem limit set annually by the IRS.
The per-diem limit applies on a daily basis: the total excludable amount equals the IRS limit multiplied by the number of days in the period to which the payment relates. Proceeds in excess of this limit are generally includable in gross income as ordinary income.
Accelerated Death Benefits — Same Treatment
Accelerated death benefits — payments made by the life insurer under a living benefit or accelerated benefit rider — receive identical tax treatment to viatical settlement proceeds under HIPAA. The same rules apply: fully excludable for terminally ill insureds; per-diem limited for chronically ill insureds. This equivalence was intentional — Congress wanted to level the playing field between collecting from the insurer and selling to a third party.
One practical difference: accelerated death benefits reduce the policy’s remaining death benefit, while a viatical settlement transfers the entire policy (and future death benefit) to the buyer. For viators whose families still need some death benefit protection, an accelerated benefit arrangement may preserve a residual benefit while still providing immediate cash.
Part 2 — Senior & Life Settlement Taxation
The Three-Tier Framework
When the viator is neither terminally ill nor chronically ill — the typical senior settlement scenario — HIPAA’s exclusion does not apply. The tax treatment of proceeds is instead governed by general income tax principles and is analyzed in three tiers based on the relationship between the settlement proceeds and the policy’s cost basis and cash surrender value.
| Tier | Amount | Tax Treatment |
|---|---|---|
| Tier 1 — Return of Basis | Proceeds up to the viator’s adjusted cost basis (total premiums paid less any dividends received) | Tax-free — return of the viator’s own after-tax investment |
| Tier 2 — Gain up to Cash Value | Proceeds in excess of cost basis, up to the policy’s cash surrender value at the time of sale | Ordinary income — taxed at the viator’s marginal income tax rate |
| Tier 3 — Gain above Cash Value | Proceeds in excess of the policy’s cash surrender value | Capital gain — generally treated as long-term capital gain if the policy has been held more than one year (though the IRS has not definitively resolved this for all situations) |
Illustrative Example — Three-Tier Taxation
A healthy 72-year-old sells a whole life policy through a senior settlement. The policy details:
Tax analysis:
The Transfer-for-Value Rule — Investor Taxation
The general rule under IRC §101(a) is that life insurance death benefits are received income-tax-free. However, IRC §101(a)(2) — the transfer-for-value rule — creates an important exception: when a life insurance policy is transferred for valuable consideration (i.e., sold), the death benefit received by the new owner is taxable to the extent it exceeds the buyer’s cost basis in the policy.
In a life settlement context, the investor (settlement company or ultimate purchaser) pays consideration for the policy and therefore triggers the transfer-for-value rule. When the insured dies, the death benefit the investor receives is taxable ordinary income to the extent it exceeds the investor’s basis (purchase price plus premiums paid after acquisition).
Exceptions to the transfer-for-value rule exist where the policy is transferred to:
- The insured themselves
- A partner of the insured
- A partnership in which the insured is a partner
- A corporation in which the insured is an officer or shareholder
- A transferee whose basis is determined in whole or in part by reference to the transferor’s basis (e.g., a gift)
These exceptions are of limited practical relevance in most life settlement transactions, since the typical buyer — an institutional investor — does not qualify. Settlement investors factor the tax cost of the death benefit into their required rate of return, which in turn reduces the settlement proceeds available to the viator.
State Income Tax Considerations
Most states follow federal income tax treatment for life settlement proceeds, but there are exceptions. Some states impose income tax on settlement proceeds even when the federal exclusion applies. Viators should confirm the applicable state tax treatment with a qualified tax advisor before completing any settlement. Florida imposes no state income tax, so Florida residents are generally subject only to federal tax considerations.