Post-1996 Viatical Settlements under Section 101 of the Internal Revenue Code
Breakfield, Robert H., Alvis, Charles E., The National Public Accountant
Early life insurance payments made to terminally ill insured policy holders has become a 300 million dollar industry.(1) Presently, life insurance companies provide riders to existing policies or optional settlements for newly issued policies, whereby, the insured may elect to receive a percentage of his or her death benefits in exchange for the assignment or surrender of the insured's policy rights. Prior to the insurance industry entering into this market, private investors formed groups commonly known as Viatical settlement companies for the purpose of purchasing, or taking assignments of, policies at a discount owned by the terminally ill.(2)
The availability of accelerated death benefits for terminally ill individuals, such as AIDS/HIV patients, provided a source of needed revenue because many terminally ill policy owners did not have medical insurance or were under insured. Further, a person with medical insurance could not receive reimbursement for medical procedures that were deemed to be experimental as is often the case with terminal illnesses.
The federal income tax treatment of these accelerated death benefit payments or Viatical settlements is an issue for the insured or his or her personal representative, who is responsible for filing the decedents final income tax return. Prior to the enactment of Internal Revenue Code Section 101(g), the taxation of Viatical settlements was problematical.
However, Code Section 101 was significantly amended when President Clinton signed the Health Insurance Portability and Accountability Act on August 21, 1996. This act added Internal Revenue Code Section 101(g) which provides that in general, accelerated death benefits paid to the terminally insured are excluded from gross income.(3) The path traveled to enactment of the new law is an interesting study in the administrative and congressional treatment of insurance proceeds paid prior to the death of the insured.
The Code Section that excludes insurance proceeds payable by reason of death, section 101(a) of the code has long favored the named beneficiary of insurance proceeds. Code Section 101(a) provides that gross income does not include proceeds from life insurance policies payable by reason of death.(4) In the case of proceeds payable to the insured, the Service has had to determine the taxation of two forms of realizable events. In the first possible event, the insured irrevocably assigns his life insurance policy to a Viatical settlement company in consideration of a payment of an accelerated death benefit by the company (not the company that issued the policy). The Service ruled in Ltr. Rul. 9443020 (PLR) issued (7/22/1994) that the assignment of a life insurance contract for consideration constitutes a sale of property.(5) Under Section 1001(b) of the Code, the amount realized, i.e., the Viatical settlement amount received by the insured reduced by the insured's adjusted basis (typically the premiums paid) is gross income. The Service specifically stated that the amount received by the taxpayer insured from the assignment of his or her life insurance to the Viatical settlement company was not an amount received under a life insurance contract by reason of death of the insured.(6)
The Internal Revenue Service has taken a more enlightened position in relation to the second possible event where an insured assigns his life insurance contract to the insurance company (as contrasted with the above PLR in which the sale was to a Viatical settlement company) that issued the policy and the accelerated death benefit is paid pursuant to a contract term. In its proposed regulations filed on December 15, 1992, the Service redefined the term payable by reason of death. The following amendment to the regulations, Prop. Regs. Section 1.101.8, stated that a qualified accelerated death benefit (as defined in 1.77022(d)), received on or after the date the final regulations are published, is treated as an amount paid by reason of death of the insured. …