Tax-free viatical settlements - a lifesaver for the seriously ill.

• Author: Moe, Robert A.

For millions of people afflicted with a life-threatening illness (e.g., cancer, heart disease, AIDS), the Health Insurance Portability and Accountability Act of 1996 (HIPAA) created an important tax benefit that will allow many of them to receive tax-free cash from their life insurance policies while they are still living. While most CPAs hope their clients will never have to face a terminal or chronic illness, there are now options to help such clients meet their financial needs and live out their lives with dignity.

Generally under HIPAA Section 331(a), which added Sec. 101 (g), terminally ill individuals can sell their life insurance policies and receive the proceeds tax free; in addition, a few states exclude such income from state income taxation. The exclusion of such "viatical settlements" from income is expected to increase their use by terminally ill individuals; such individuals have a wide range of financial needs, and there are no restrictions on how recipients can use the proceeds (e.g., for medical bills or a vacation). The excludibility of viatical settlements to chronically ill individuals is limited. The new provisions are generally effective for amounts received after 1996.

What Is a Viatical Settlement?

A viatical settlement is the sale or assignment of a life insurance policy by a "terminally ill" or "chronically ill" individual to a viatical "settlement provider" (VSP). Sec. 101 (g) (1) provides that any amount received under a life insurance contract on the life of an insured who is terminally ill or chronically ill is treated as an amount paid by reason of the insured's death and excludible under Sec. 101 (a) (1). Under Sec. 101 (g) (2), if any portion of the death benefit under a life insurance contract on the life of an insured described in Sec. 101 (g) (1) is sold or assigned to a VSP, the amount paid for the sale or assignment of such portion is treated as an amount paid under the contract by reason of the insured's death.

Prior to the HIPAA, amounts received under a life insurance contract (other than a modified endowment contract) before the insured's death were, includible in gross income to the extent they constituted cash value in excess of the investment in the contract; proposed regulations under Secs. 101, 7702 and 7702A would have excluded "qualified accelerated death benefits" paid to a terminally ill insured.

Viatical Settlement Provider

Sec. 101 (g) (2) (B) (i) (I) defines a VSP as any person regularly engaged in the trade or business of purchasing (or taking assignments of) life insurance contracts on the lives of insureds described in Sec. 101 (g) (1); the person must be licensed for such purposes in the state in which the insured resides. According to Sec. 101 (g) (2) (B) (i) (II), however, if the state in which the insured resides does not require such licensing, the person must meet additional requirements with respect to the insured.

Specifically, with regard to terminally ill insureds, a person meets the requirements if he meets the requirements of the Viatical Settlements...