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

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 Model Act of the National Association of Insurance Commissioners (NAIC), Sections 8 and 9; and meets the NAIC's requirements (relating to standards for evaluation of reasonable payments) in determining amounts paid by such persons in connection with such purchases or assignments. Similarly, with regard to chronically ill insureds, a person meets the requirements if he meets the requirements of the Viatical Settlements Model Act of the NAIC, Sections 8 and 9; and meets the NAIC's standards (if any) for evaluating the reasonableness of amounts paid by such person in connection with such purchases or assignments with respect to chronically ill individuals.

The Settlement Process

Generally, in the absence of a viatical settlement, an insured pays premiums on a life insurance policy to an insurance company; on the insured's death, the death benefits are paid to the policy beneficiary.

Most types of life insurance can be sold to a VSP, including term, whole life, universal life and most employer-provided or membership-based group insurance. A viatical settlement is paid to the owner of the policy. A terminally or chronically ill individual (defined below) can apply for a viatical settlement by completing an application and authorizing the VSP to obtain his insurance and medical records. The VSP reviews the information and determines a payout. The settlement varies with the insured's life expectancy, and can range from 50% to 85% of the policy's face value. (It can be even higher for very short life expectancies.)

If the insured chooses to complete the sale, and his beneficiary agrees to it, the VSP pays the agreed amount in a lump sum to the policy owner and takes over all future premium payments under the policy. When the insured dies, the VSP receives the death benefits from the insurance company.

Eligibility for Exclusion

Terminally Ill

To qualify for a tax-free viatical settlement, the insured must be either terminally or chronically ill. Sec. 101(g)(4)(A) defines a terminally ill individual as one certified by a physician (as defined in Social Security Act Section 1861 (r) (i) [1]) as having an illness or physical condition that can reasonably be expected to result in death in no more than 24 months after the date of certification. For terminally ill individuals, a viatical settlement is completely Federally tax free, no matter what the settlement is used for.

Example: J, a wife and mother of two, was diagnosed in 1995 with ovarian cancer. She became too weak from chemotherapy to continue working. K, her husband, had consumed all of his vacation time and an unpaid leave to stay home and care for J and the children.

In 1996, J had considered selling her $1 00,000 life insurance policy to a VSP for $70,000; K is the policy beneficiary. J rejected the offer after considering the Federal and state tax consequences. In August 1997, J reconsiders and applies for a viatical settlement; she is certified as terminally ill and is offered $75,000 (a higher amount than originally offered, because J is closer to death). She accepts the offer; the $75,000 viatical settlement is Federally tax free, even if J lives more than 24 months from the date of certification. On J's death, the $1 00,000 death benefits will be paid to the VSP not to K.

Chronically Ill

Sec. 101 (g) (4) (B) defines a chronically ill individual as one who meets the definition in Sec. 7702B(c)(2) -- individual who has been certified in the past 12 months by a licensed health care practitioner (as defined in Sec. 7702B(c)(4)) as meeting one of the following: 1. Being unable to perform (without substantial assistance from another individual) at least two activities of daily living (eating, toileting, transferring, bathing, dressing, continence) for at least 90 days due to a loss of functional capacity.[2] 2. Having a level of disability similar (as determined under regulations) to the level of disability described in # 1. 3. Requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.

For chronically ill individuals, Sec. 101 (g)(3)(A) provides that a viatical settlement is excludible from income to the extent used for costs incurred by the payee (not compensated for by insurance or otherwise) for qualified long-term care services (as defined in Sec. 7702B(c)) provided for the insured. Sec. 101(g)(3)(d) states that if the insured is covered by a per diem long-term care insurance contract, the exclusion is limited to $175 per day ($63,875 per year; to be indexed).[3]

Sec. 101 (g)(5) provides that tax-free treatment does not apply to amounts paid to a taxpayer other than the insured if the taxpayer has an insurable interest by reason of the insured being (1) the taxpayer's director, officer or employee or (2) financially interested in the taxpayer's trade or business. For example, if the policy owner is the insured's business partner, the viatical settlement is includible in the owner's income.

Helping Clients Evaluate Their Options

Viatical settlements can be a blessing, but they are not for everyone. The tax practitioner needs to review a client's financial situation before making a recommendation.

For an elderly person or someone without children, the decision to sell a life insurance policy to pay medical bills and live life to its fullest may be an easy one. However, parents need to weigh their immediate needs against the future costs of supporting their families.

The decision process has recently become more complex for many people with AIDS because of new drugs that have brought significant improvements in both health and quality of life; however, it is generally believed the new drugs will be effective for only about 50% of AIDS patients. Patients for whom the drugs do not work are considered terminally ill, and should continue to be acceptable applicants for viatical settlements. When determining whether to purchase policies from AIDS patients, VSPs factor in the effect of new drug therapies.

Viatical settlement is rapidly moving into the mainstream as a viable financial option for the terminally or chronically ill. A settlement may allow a person who is no longer working to pay bills or to move with his family to a less expensive place to live, allowing the spouse to look for a new job. On the other hand, if an insured with young children keeps the policy, the death benefits may allow them, for example, to attend college after the insured's death.

New Life for Life Insurance?

The new exclusion for viatical settlements may create a market for life insurance among people who have not traditionally felt the need for it, or cause people who bought policies with the intention of dropping their coverage when their children were grown to keep them as a hedge against future illness and long-term care costs.

Evaluating VSPs

The availability of viatical settlements is still relatively new. Presented below is a checklist of questions to ask in selecting a VSP.

* What should one look for in a VSP? A company that understands the client's situation, will treat him with respect and seek to eliminate as many of the obstacles as possible. Inquiries should be made about the application and claims procedures, including turnaround time. The VSP should follow a familiar and streamlined process in underwriting and closing a viatical settlement transaction.

* How can one find a good VSP? As yet, there is no Federal regulation of VSPs, but 19 states[4] currently require VSPs to be licensed with the state insurance commissioner or have adopted other regulations for viatical settlements. Look for a VSP licensed in the state in which the client resides.

If VSPs are not required to be licensed in the state in which the client resides, check that the VSP is a member of the Viatical Association of America and has voluntarily agreed to comply with NAIC standards; this will ensure certain minimum operating standards and payout amounts.

* Is it prudent to obtain offers from different VSPs? Some clients choose to request settlement offers from several VSPs, while others work with brokers who submit multiple requests on their behalf. It is possible that one VSP will pay more than another for a policy, although the settlement amounts offered by VSPs should be similar, because they all use the same criteria in determining the payout.

If multiple offers are requested, the process will probably take longer, because all the companies will need to request medical and insurance records. If a broker will be used, the broker's commission should be subtracted from an payout amounts before comparing offers.

* How much will a VSP pay for a policy? Each situation is evaluated individually, but the NAIC provides guidelines. An insured with a life expectancy of six months or less should receive at least 80% of the policy's face value. The payment gradually drops to approximately 50% for an insured expected to live longer than 24 months.

* How is the settlement amount determined? Life expectancy and future premium payments are the primary factors used to determine the payout, which is reduced by policy loans. VSPs also consider current interest rates and the financial rating of the life insurance company that issued the policy.

* Is the settlement includible in state income? Currently, California, New York and Wisconsin exclude viatical settlements from state income[5]; other states are expected to follow this lead. In addition, Florida, Nevada, South Dakota and Texas do not impose state income taxes on individuals.

* How long does the settlement process take? Generally, a settlement check is sent (or funds are wire transferred) three to six weeks after receipt of a completed application. While most companies broker life insurance policies to outside investors or the public, some purchase policies directly, using committed funds. Using a company with committed funds ensures a more rapid payout and protects client confidentiality.

* Is there a fee to obtain a VSP? Brokers typically charge a commission of 6% of the settlement. Generally, there is no fee if the policy is sold directly to a VSP.

* How does a VSP assess an applicant's health? Generally, a physical examination of the insured should not be required. The VSP can obtain the necessary information from the insured's medical records and a brief questionnaire completed by his attending physician.

Conclusion

The HIPAA's enactment of an exclusion for viatical settlement may well be a financial lifesaver for the terminally or chronically ill. This article's guidance on the tax issues and how to select a VSP may provide a planning opportunity for taxpayers who would otherwise be financially devastated by illness.

[1]42 USC Section 1395x(r)(1).

[2]See Notice 97-31, IR-B 1997-21, 5.

[3]Other requirements, under Secs. 101(g)(3)(A)(ii), (B) and 7702B(b)(1), also apply.

[4]California, Florida, Illinois, Indiana, Kansas, Louisiana, Michigan, Minnesota, Montana, North Carolina, North Dakota, New Mexico, New York, Oregon, Texas, Utah, Vermont, Washington and Wisconsin.

[5]See Cal. Rev. and Tax Code Section 17131.5 (effective for tax years after 1990); NY Tax Law Section 612(a); Wisc. Inc. and Franch. Tax Law Section