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Chapter 26: Accelerated death benefits and viatical settlements.

WHAT IS IT?

The emotional stress of dealing with one's own impending death due to an illness such as cancer or AIDS is further compounded by the customary increase in medical bills and the additional costs of special care in conjunction with a likely reduction in earning capacity. A similar increase in stress levels is likely to afflict an individual with a seriously debilitating chronic illness as well. A person owning life insurance policies may have several options for essentially accelerating payment of death benefits to ameliorate some of these financial concerns.

Tax legislation, as discussed is detail below, and insurance industry innovation in response to growing demand has made two options much more attractive:

1. Viatical settlements with independent third parties; and

2. Accelerated death benefit payments from the insurance companies issuing the policies.

Before life insurance companies offered accelerated benefits, entrepreneurs formed viatical settlement companies to provide accelerated payments to insureds. (1) In a viatical settlement, a third party purchases the life insurance policy of an insured (the viator) who has a life-threatening disease or illness. The term "viatical settlement" originated from the Latin "viaticum" which means provision for a journey. The insured receives a one-time payment that usually ranges from 50% to 80% of the policy's face value or the insured can elect to receive periodic payments. The purchaser then becomes the owner of the policy and typically names itself as the beneficiary. The purchaser continues to pay any required premiums and receives the policy's entire face value when the insured dies.

Most purchasers require the insured to have two years or less to live. The shorter the insured's life expectancy, the greater, generally, the purchase price will be.

As the desire for accelerated benefits increased, particularly from AIDS and cancer patients, the life insurance industry quickly reacted to meet the growing demand by including accelerated death benefit provisions in their policies. These provisions require the insurer to prepay all or a portion of the death benefit to the insured when the insured has a disabling or life-threatening condition that doctors predict will cause death within a relatively short period of time. Life insurance companies and insurance regulation may use several different terms to refer to this type of provision, including:

1. accelerated death benefit;

2. living needs benefit;

3. acceleration-of-life insurance benefit; or

4. living payout option.

Accelerated benefits have been available from some insurers in the United States since 1965. (2) Today, hundreds of insurance companies offer living benefits riders in a variety of formats.

State governments have been quick to authorize insurance companies to offer policies that contain accelerated benefits. By the end of 1991, the insurance commissions of most states had authorized accelerated benefits. In addition, many states have extensive provisions regulating viatical settlements.

WHEN IS THE USE OF SUCH A DEVICE INDICATED?

Accelerating death benefits or entering into a viatical settlement generally is indicated only when a person is terminally ill or seriously and chronically ill, in need of cash, and other options to meet those cash needs are not available. In certain cases (see "Questions and Answers," below), estate and income tax planning considerations may prompt the use of these devices for terminally ill policyowners, even if they do not necessarily "need" the cash immediately.

ADVANTAGES

The principal advantage is that terminally ill or seriously chronically ill insureds can receive advance payments on policy death benefits free of income tax. If the insured is terminally ill, he can use the proceeds for virtually any purpose desired. For example, insureds may desire to use the proceeds to:

* cover out-of-pocket medical expenses;

* finance alternative treatments not covered by existing medical insurance;

* purchase a new car or finance a dream vacation before he or she cannot enjoy such things;

* personally distribute cash to loved ones;

* maintain his or her dignity by not dying destitute; and/or

* pay off loans.

DISADVANTAGES

Reduced Total Payout

Accepting accelerated benefits reduces the face amount of the insured's policy, thereby reducing or eliminating death benefits payable to the beneficiary when the insured dies. An insured may not wish to sacrifice the financial security of a spouse or children in exchange for receiving accelerated benefits. Accordingly, the type of individual who would most benefit from taking an accelerated benefit or a viatical settlement is a financially independent person without a financially dependent spouse or children who is unable to work and who has no long-term care or disability insurance.

Eligibility for Governmental Assistance Programs

If the insured's contract is designed with a voluntary election provision, it is uncertain whether a local, state, or federal government agency could force the insured to take accelerated benefits. In other words, is the availability of the benefit deemed property of or potential income to the insured when computing eligibility for benefits? Several bills introduced into Congress over the past years have expressly dealt with this issue. (3)

When life insurance proceeds are paid to the designated beneficiary, most states exempt them from the claims of the insured/deceased's creditors. Once these proceeds are paid to a living insured, however, the insured's creditors may be able to reach them, unless state law has extended creditor protection to accelerated benefits and viatical settlements.

A problem may arise even if the insured does not claim the proceeds but merely has the ability to demand the benefits. In this situation, would the benefits be within the reach of the insured's creditors? Could the creditors force the insured to accept benefits so that they could then attach them? These issues have not been resolved in many jurisdictions.

A life insurance policy containing accelerated benefits should not be considered as a replacement for comprehensive health insurance or long-term care insurance. In fact, many state regulations prohibit insurers and insurance agents from mentioning, illustrating, or referring to the accelerated benefit provision as an alternative or substitute for catastrophic major medical health insurance. Insureds must be strongly advised to obtain appropriate health and long-term care insurance because life insurance policies only benefit individuals who have terminal illnesses.

It is possible for dishonest individuals to take advantage of a terminally or chronically ill person who receives a large sum of money under stressful conditions. An insured may be vulnerable to charlatans claiming that they can cure the insured's ailment or to scam artists who claim that they can earn large returns on the insured's newly-gained wealth.

WHAT ARE THE REQUIREMENTS?

The insured must either be a terminally ill individual or a chronically ill individual in order for amounts received to be treated as tax-free death benefits. A terminally ill individual is one "who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification." (4)

Once the insured obtains this certification based upon the doctor's reasonable medical opinion, the reality of what later happens does not matter. In other words, the statute does not contain a "look-back" rule. (5) If the insured actually lives months, years, or decades longer than expected, the accelerated benefits or viatical settlement continue to be excluded from income. The statute does not place any upper limit on the amount of proceeds that a terminally ill insured may exclude from income.

A chronically ill individual is defined as a person "who has been certified by a licensed health care practitioner as (i) being unable to perform (without substantial assistance from another individual) at least 2 activities of daily living [i.e., eating, toileting, transferring, bathing, dressing, and continence] for a period of at least 90 days due to a loss of functional capacity, (ii) having a level of disability similar (as determined under regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services) to the level of disability described in clause (i), or (iii) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Such term shall not include any individual otherwise meeting the requirements of the preceding sentence unless within the preceding 12-month period a licensed health care practitioner has certified that such individual meets such requirements." (6)

Note that a person cannot be both terminally ill and chronically ill. A person cannot qualify as chronically ill if he or she can be classified as terminally ill. (7)

Types of Life Insurance Policies

Not all life insurance policies will qualify for preferred treatment of their accelerated benefits. Under IRC Section 7702, the contract must meet either a cash value accumulation test or a two-pronged test consisting of guideline premium requirements coupled with a cash value corridor requirement. The purpose of limiting the tax-favored status of accelerated benefits to distributions from these types of policies is to make certain that the contracts are true life insurance rather than some type of investment-oriented product that the insured is attempting to use to shelter income.

Also, accelerated death benefit payments made to someone other than the taxpayer under a key person and other business policies are not protected. "... any amount paid to any taxpayer other than the insured if such taxpayer has an insurable interest with respect to the life of the insured by reason of the insured being a director, officer, or employee of the taxpayer or by reason of the insured being financially interested in any trade or business carried on by the taxpayer," (8) is not treated as being paid by reason of the death of an insured.

Limitations on Payments to Chronically Ill Individuals

In order to qualify for the income exclusion, payments to chronically ill individuals must be reimbursements for the costs of qualified long-term care services provided for the insured that are not compensated for by insurance or otherwise. (9) Qualified long-term care services include "... necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services which (A) are required by a chronically ill individual, and (B) are provided pursuant to a plan of care prescribed by a licensed health care practitioner." (10)

In other words, unlike terminally ill insureds, chronically ill individuals do not have the discretion to use accelerated benefits or viatical settlements in whatever manner they desire. Despite the limitation to long-term care costs, the Internal Revenue Code protects periodic payments by providing that a payment will not fail to qualify "... by reason of being made on a per diem or other periodic basis without regard to the expenses incurred during the period to which the payment relates." (11) These payments, however, are generally subject to the cap on excludable benefits that applies under per diem type long-term care insurance contracts.

Also, to qualify for the favorable tax treatment, the life insurance or viatical settlement contract may not "... pay or reimburse expenses incurred for services or items to the extent that such expenses are reimbursable under the title XVIII of the Social Security Act [Medicare] or would be so reimbursable but for the application of a deductible or coinsurance amount." (12)

Additional Rules

In addition to the limitations on the use of the proceeds, the terms of the contract giving rise to the payments to the chronically ill individual must meet specified requirements designed to protect consumers from seeking accelerated payments or viatical settlements without first having the information necessary to make an informed decision and preserving the insured's right to rescind the arrangement within 30 days. Some of these detailed requirements are in IRC Section 101, while others are incorporated from various provisions of the Internal Revenue Code as well as standards adopted by the National Association of Insurance Commissioners that apply to chronically ill individuals. (13)

The Code limits the exclusion for certain periodic payments that are made to chronically ill individuals. For 2007, the maximum is $260 per day, which works out to $94,900 per year in periodic payments. These amounts are indexed for inflation. (14)

Viatical settlements must comply with additional requirements for the proceeds of the sale or assignment in order to be excluded from income tax. First, the payments must be made by a viatical settlement provider. To qualify as a viatical settlement provider, the purchaser must be ",.. regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of insureds ..." (15) who are terminally or chronically ill.

Second, the provider must either be licensed to provide viatical settlements under the laws of the state in which the insured resides, or if the insured's state does not require licensing of viatical settlement providers, the provider must meet the requirements specified in the Internal Revenue Code. With regard to terminally ill individuals, the viatical settlement provider must meet the requirement of: (1) Sections 8 and 9 of the Viatical Settlements Model Act prepared by the National Association of Insurance Commissioners; and (2) the Model Regulations of the National Association of Insurance Commissioners relating to standards for evaluation of reasonable payments in determining amounts paid by the viatical settlement provider in connection with the purchase or assignment of life insurance contracts. (16)

With respect to chronically ill insureds, the provider must meet requirements similar to those contained in Sections 8 and 9 of the Viatical Settlements Model Act along with the standards of the National Association of Insurance Commissioners, if any exist at the time of the settlement, for evaluating the reasonableness of the amounts paid by the provider in connection with viatical settlements for chronically ill individuals. (17)

HOW DO I SELECT THE BEST OF ITS TYPE?

"Life insurance continues to be the central source of financial security for most families in this country." (18) Because so many people place their trust and financial future in the hands of insurance companies, it is crucial that consumers ascertain the financial stability of a particular insurance company prior to purchasing any insurance policy, especially one that provides a living needs benefit.

A planner who wants to recommend that a client obtain a policy providing for accelerated benefits should first investigate prospective insurers. Information about insurance policies and insurers can be gathered from organizations such as the Health Insurance Association of America, the American Council of Life Insurers, National Council on Aging, and individual state insurance boards. It is important to deal with a company with an established track record so that the chances are good that the company will still be in existence to pay the accelerated benefits if the time comes.

Several sources are available to ascertain insurer solvency. The National Association of Insurance Commissioners (NAIC) developed a solvency-policing agenda to improve the ability of state regulators to monitor and regulate industry solvency. (19) Alternately, A.M. Best Company, Standard & Poor's Corporation (S&P), Moody's, and Fitch publish ratings of insurance companies. See Chapter 3 for more detailed information on company ratings.

Eligibility requirements for accelerated benefits vary among insurance companies. While some companies include a living needs benefits rider in both their new and existing life insurance policies, other companies add the rider only to new policies. The purchaser should inquire as to cost, if any, for an accelerated benefit provision. In many instances, there is no additional cost for including such a rider. However, the purchaser may be required to purchase a specified minimum amount of coverage. In addition, most insurance companies restrict the use of living needs benefits riders to permanent and universal life insurance policies.

Every insurance company requires that the purchaser generally be in good health and pass a physical examination at the time the policy is purchased. An accelerated benefit policy is not available to a purchaser diagnosed as terminally ill prior to the purchase. In addition, no two life benefits riders will be identical. Insurance companies can set their own requirements regarding many aspects of these plans, so it is wise to shop around.

In a similar manner, viatical settlement companies may apply different criteria in deciding whether to purchase a policy, as well as the percentage of the face value that they are willing to pay.

The insured should determine how the accelerated payments or viatical settlement will affect the policy's overall death benefit. For instance, will the accelerated payments reduce or eliminate the death benefit? If the death benefit is reduced, is the reduction based upon the amount paid to the insured, or is there an additional processing fee or other penalty that will be deducted from the death benefit? With most viatical settlements, the insured has no control over the death benefit because the policy belongs to the viatical settlement company after the transaction is completed.

Insurance companies vary as to which illnesses trigger the payment of accelerated benefits under their living benefits rider. While some insurance companies include any type of terminal illness for which the insured has only a short time to live, other companies restrict coverage to specified diseases. Generally, the following medical conditions are covered under all insurance plans: AIDS, heart attack, stroke, Alzheimer's disease, renal failure, liver transplant, life-threatening cancer, and coronary artery bypass. Most insurance companies further restrict availability of accelerated benefits to persons with 12 months or less to live.

The amount payable to the insured under a life benefits rider varies between 2% and 95% of the death benefit, depending upon the insurer. (20)

Generally, the insured may receive the accelerated benefits in one of three ways:

1. one lump sum payment;

2. regular installments; or

3. installments based on the insured's expenses.

If the installment option is selected, the insured should inquire as to whether accelerated payments can be canceled once the benefits start. It is important to remember that a benefit received during life reduces the amount payable to the beneficiary. Under certain circumstances, the insured may wish to cancel accelerated payments and retain the remaining value of the life insurance proceeds for the beneficiary. Another concern with installment payments is what happens if the benefits cease before the insured dies. If the accelerated payments are likely to be depleted prior to death, the insured should consider seeking alternative methods of financing for medical and personal expenses.

Insurance companies may also vary on the restrictive uses of benefits received by the insured. Some companies may require that the funds be used strictly for medical care while others may have no limitation on the expenditure of the funds. Though some policyholders may view accelerated benefits as a means of "making dreams come true," these riders are generally designed for health care and medical expenses.

If an installment payout option is available, the insured should ascertain what will happen to the remaining payments if he or she dies before the payments are completed. Some possible consequences may be:

1. The remaining payments are forfeited;

2. The beneficiary receives the remaining payments in installments; or

3. The beneficiary receives a death benefit after adjustment for the accelerated payments.

An insured may have a choice between electing to take accelerated payments from the insurance company or to enter into a viatical settlement with a third party. He or she should "take advantage of competitive forces and the free market to obtain the highest payment for the life insurance contract." (21) The general rule is that accelerated death benefits provide a higher payout than viatical settlements but typically impose a great number of restrictions on medical conditions.

TAX IMPLICATIONS

Income Taxation of Accelerated Death Benefits or Viatical Settlements

As a general rule, the proceeds of a life insurance policy are excluded from the recipient's gross income under IRC Section 101(a). To secure this exclusion, the proceeds must be payable "by reason of the death of the insured." Since accelerated benefits are paid when the insured individual is living, they are not payable by reason of the insured's death. Thus, when the question first arose it appeared likely that the proceeds would be subject to income tax.

The same was true for viatical settlements. In a private letter ruling, the Service indicated that the amount received by the insured under a viatical settlement, to the extent that the amount exceeded the insured's adjusted basis in the life insurance contract, was includable in the insured's gross income. (22)

In response to these questions of taxation, numerous bills were introduced into Congress to exclude accelerated benefits and viatical settlements from the insured's income. At the same time Congress was debating these bills, the Treasury proposed regulations in December of 1992 that would allow certain accelerated benefits to be considered as being paid by reason of the insured's death so that they would escape taxation. (23) Despite predictions that these regulations would be approved as early as 1993, they were not. The taxability of the payments continued to be the subject of rulings and litigation with mixed results. In 1996 the issue was finally resolved.

In 1996, the Health Insurance Portability and Accountability Act of 1996 (HIPAA 96)24 was enacted. This legislation included an express provision excluding most accelerated payments, as well as viatical settlements, from gross income by deeming them to be "paid by reason of the death" of the insured. (25) The payments must meet the requirements described below to escape taxation. (26)

A person is deemed to be terminally ill if he has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification. (27) A person qualifies as chronically ill if he has met one of three criteria: he has been certified within the previous 12 months by a licensed health care practitioner as being unable to perform without substantial assistance at least two activities of daily living (e.g., eating, toileting) for at least 90 days due to a loss of functional capacity; he has a similar level of disability; or he requires substantial supervision to protect him from threats to health and safety due to severe cognitive impairment. People who are terminally ill are not included within the class of people who qualify as chronically ill. (28)

In the case of chronically ill individuals, the income tax exclusion applies only if detailed requirements are met. (29) For example, the payment must be for costs incurred by the payee (not compensated for by insurance or otherwise) for qualified long-term care services provided for the insured for that period. Under the terms of the contract, the payment must not be a payment or reimbursement of expenses reimbursable under Medicare (except where Medicare is a secondary payor, or the arrangement provides for per diem or other periodic payments without regard to expenses for qualified long-term care services).

A payment to a chronically ill individual will not fail to qualify for the exclusion because it is made on a per diem or other periodic basis without regard to the expenses incurred during the period to which the payment relates. (30) However, the amount of periodic payments that may be excluded is subject to a dollar limit that is adjusted annually. In 2007, the per diem limitation amount is $260 ($94,900 per year). (31)

The income tax exclusion does not apply to amounts paid to any taxpayer other than the insured in certain circumstances. If the payee has an insurable interest in the insured's life because the insured is a director, officer or employee of the payee, or because the insured is financially interested in any trade or business carried on by the payee, the exclusion does not apply. (32)

Unanswered Questions

Although HIPAA 96 addressed many issues that were previously unresolved, unanswered questions still remain. For example, how will payments made to an insured who is chronically ill be treated if that person becomes terminally ill in a subsequent year? (33) If excess payments are made to a chronically ill insured, will those payments be treated as ordinary income or as capital gains? (34)

Transfer for Value Rule

The transfer for value rule, contained in IRC Section 101(a)(2), provides:
   In the case of a transfer for a valuable consideration,
   by assignment or otherwise, of a life insurance contract
   or any interest therein, the amount excluded
   from gross income .... shall not exceed an amount
   equal to the sum of the actual value of such consideration
   and the premiums and other amounts,
   subsequently paid by the transferee.


So virtually all transfers of life insurance policies to viatical settlement companies fall within the transfer for value rule. With the exceptions listed below, transferees for value of life insurance policies are taxable at ordinary income rates on receipt of the policy proceeds less the sum of (1) amounts paid by them to acquire the policy and (2) later premiums and other payments.

Since the purchasers make their profit in the transaction on the difference between what they pay and what they receive, the taxation of the differential requires them to pay less for the policies than they would otherwise pay if the death benefits were received tax free.

Planners should explore the possibility of obtaining loans from parties who qualify under one of the exceptions to the transfer for value rule. In this case, by collaterally assigning the policy, or by naming the lender as the beneficiary under the policy, they may be able to receive more than they could from a viatical settlement company, since the death proceeds would escape income taxation.

The transfers that qualify as exceptions to the transfer for value rule include transfers to:

* a partner of the insured;

* a partnership in which the insured is a partner; and

* a corporation in which the insured is a shareholder or officer. (35)

ETHICS (36)

The viatical settlement process has become controversial in recent years. It is important for insurance planners to do all they can to protect their clients who may be contemplating entering into a viatical settlement or filing for accelerated death benefits. First, however, there needs to be a decision about whether or not the policy needs to be sold and whether or not taking accelerated death benefits might be a better idea. It is generally harder to qualify for accelerated death benefits than to engage in a viatical settlement.

If the client decides to viaticate a policy, it is imperative that a reputable viatical broker is used. The broker will shop the policy to the investors who will ultimately purchase the policy. The broker will generally charge from 3 to 6% of the payout. Many states require that a viatical settlement provider have a license, so it is also important that the provider is licensed in the state of the insured. It is important that clients are asked whether they are receiving public assistance, such as Medicaid, because a viatical settlement may cause those benefits to be lost. The insured should also be provided with written assurance from both the viatical broker and the viatical settlement provider that the insured's medical records will remain confidential and will not be shared with anyone without the insured's written permission.

ALTERNATIVES

1. Borrow against cash values--

Permanent type policies such as whole life, variable life, universal life, etc., build up cash values over the years. The owner of the policy is usually able to borrow money from the insurance company, typically at favorable interest rates. When death occurs, the policy loans are subtracted from the face amount of the policy before payment is made to the beneficiary. If there is also a "waiver of premium" provision, the insured will be relieved of the monthly premium payments.

The advantages of borrowing are that, first, the policy will still pay the full face amount at death, less the amount borrowed, to the beneficiary named by the policyowner. In other words, the policyowner does not have to settle for less than the full amount of insurance. Second, generally, the policyowner will not need to repay the loans while living. In essence, borrowing is a form of advanced death benefit payment. Third, generally loan proceeds will be received free of income tax, similar to death benefits.

The major disadvantage is that the amount one can borrow, even from a fully paid-up policy, generally will be considerably less than the amount a terminally ill policyowner could get in accelerated benefits or a viatical settlement. If the owner needs more cash than is available from policy loans, he or she may enter into a viatical settlement. However, the policyowner will generally be required to use part of the viatical settlement to repay all policy loans.

2. Surrender the policy--

Policies with cash value buildup can be surrendered to the insurance company. However, this would generally not be desirable, since the face amount of the policy is usually much higher than the surrender value and the time of death is close. In addition, amounts received in excess of the policyowner's basis (paid in premiums less dividends received less amounts previously withdrawn, if any) are subject to income tax. The policyowner would almost always be better off borrowing against the policy or entering into a viatical settlement.

3. Borrow funds from a third party--

Other friends, family members, and possibly the beneficiary of the policy may be willing to lend money to the person who is terminally ill and then receive repayment from the insurance proceeds. Although insurance companies and institutional lenders generally will not lend money in excess of the cash value in the policy, friends and family may be willing to do so.

Depending on how the loan is secured, lenders run some risk in lending money to the policyowner. For example, if the policyowner issues an unsecured note, the lender runs the risk that other claimants against the policyowner's estate may have a higher priority and there may be insufficient assets to repay the note. Consequently, the note should be secured with specific collateral.

However, if the policy itself or any interest in the policy (e.g., the cash value or the death benefit) is assigned to the lender as collateral, it may trigger the transfer for value rule with potentially adverse tax consequences for the lender. (37) The best opportunities involve transactions with parties who qualify under one of the exceptions to the transfer for value rule: partners of the insured, partnerships of the insured, or a corporation in which the insured is a shareholder or officer.

QUESTIONS AND ANSWERS

Question--What factors will determine the amount of settlement?

Answer--The following factors will affect the amount of settlement received:

1. The insured's life expectancy--The shorter the period until the insured is expected to die, the more the company will pay. Some companies will accept up to a five-year life expectancy, but many prefer a shorter term of years.

2. The period in which the company can contest the existence of a valid contract must have passed--The incontestable period, as well as the "suicide provision" (typically two years), generally must have expired. This period may begin again for policies that have been reinstated after a lapse for non-payment of premium.

3. Company's financial rating--The company that issued the policy must have a high financial rating.

4. The amount of the premiums--The premium level is important, since the buyer of the policy must continue making the payments for the remainder of the insured's lifetime.

5. The size of the policy--Most settlement companies have upper and lower limits. For example, a top limit of $1,000,000 scaling down to a minimum of $10,000 is typical.

6. The current prime interest rate--The prime rate is important, since the buyer will compare the settlement agreement to other types of investments.

After examining the above factors, a settlement company will generally offer the owner of the policy between 25% and 85% of the policy's face amount. The settlement amount may be received income-tax-free under the same conditions described.

7. Time of payment--The time between applying for the settlement and having the cash is generally three to eight weeks. However, this will depend on how quickly the medical information and beneficiary release forms are in the hands of the settlement company.

Question--What other considerations are involved in deciding whether or not to enter into a viatical settlement?

Answer--Planners and those insureds who are considering viatical settlements or accelerating death benefits should also consider the following factors:

1. Potential impact on other public benefits--If the terminally ill or qualifying chronically ill person is presently receiving benefits that are contingent upon his or her "means" (income or assets), such as Medicaid, food stamps, etc., he or she must weigh the effect of a viatical settlement on these benefits which may be terminated or reduced until the settlement amount is "spent down."

2. Policy riders--If the policy has an accidental death or dismemberment rider, those rights should be specifically retained by the insured.

3. Confidentiality and beneficiaries--Most companies stress the confidential nature of the transaction but they require the named beneficiary to release any possible claim to the proceeds. If the insured does not want the beneficiary to know of the illness, he or she may change beneficiaries just prior to completing the settlement. If the estate is named as beneficiary, the insured (owner) would be the only one who would need to sign the release forms. However, if death occurred after the time the beneficiary was changed, but before the settlement was completed, the insurance proceeds would be paid to the estate and would, therefore, be subject to probate administration.

4. Group insurance--Group insurance policies can be sold in viatical settlements. Group insurance policies will usually require that one's employer is notified.

5. Resale of policies--Confidentiality may be lost if the policy is sold by the settlement company in the "secondary market" to individual investors, since a new investor would want to know the health status of the insured.

6. Escrow accounts--An escrow account is generally used to make certain that the payment of the agreed upon amount is made to the insured shortly after the insurance company notifies the escrow company that the ownership of the policy has been transferred.

7. Shop and negotiate--Several companies should be investigated in order to negotiate the best offer.

Question--Can a viatical settlement be used as a means of getting a life insurance policy out of one's estate for estate tax purposes?

Answer--For the individual who will not live more than three years, a transfer of an existing policy to an irrevocable trust or a third person will be ineffective to avoid inclusion of the policy in the gross estate at death. For example, an individual who owns a $500,000 life insurance policy on his life and whose estate is in the 55% estate tax bracket will only pass on $225,000 to the beneficiaries of the policy (.55 x $500,000 = $275,000; $500,000--$275,000 = $225,000).

A sale of the policy avoids the three-year rule because the viatication is a sale for fair market value in money or money's worth. This could provide additional value to the insured's family and reduce estate taxes because the conversion into cash converts the intangible asset into cash that can be given to family members in the form of tax-free annual exclusion gifts, "spent down" by the individual, or a combination of the two.

For example, the same individual who owns a $500,000 policy on his life will leave his beneficiaries only $225,000 if he dies owning the policy. Instead, the individual sells the policy and receives $350,000 (70% of the face amount). The individual can make annual exclusion gifts of the $350,000 to his four children, their spouses, and ten grandchildren over his remaining assumed life expectancy of two years. Under the viatical settlement, the individual has transferred $350,000 to his family tax-free, providing them an additional $125,000 ($350,000--$225,000).

(In addition, the estate can pass the after-estate tax value of the premiums not spent in maintaining the policy as well as the after-income-and-estate tax on the earnings on the declining balance of the $350,000 viatical proceeds over his remaining life.)

Getting a life insurance policy out of the insured's estate can sometimes save the estate administration costs of having to file an estate tax return.

Question--Can an owner of a policy who is not the insured enter into a viatical settlement?

Answer--Yes. Any person who owns an insurance policy, not just the insured, can viaticate an insurance policy.

Question--Why might a person who owns a policy, but is not the insured, enter into a viatical settlement?

Answer--A third party, for example, the trustee of an irrevocable trust, may sell the policy and receive the proceeds free of federal income tax. The third-party individual or trustee entering into the settlement can use the proceeds to purchase assets from the estate at a discount. This technique is especially advantageous where the insured has an ownership interest in a closely held business or partnership, as discounts for such interests (for lack of marketability, lack of control, minority interest, etc.) are typically between 30 and 40%. In addition, such transactions are not subject to the three-year rule since they are transfers for value.

For example, assume a terminally ill individual owns 100% of a closely held business valued at $2,000,000. The estate tax on the stock if included in the gross estate is $1,100,000 ($2,000,000 x .55). The trustee of an irrevocable life insurance trust owns a $1,000,000 face value policy on the life of the individual. If the trustee viaticates the policy and receives an $800,000 settlement, he can use the proceeds to purchase a portion of the closely held business from the individual. Because the trustee is purchasing a minority interest in a business that is not readily marketable, the interest may be discounted at let's say 35%. Thus, the trustee is able to buy 49% of the business for just $637,000 (49% x $2,000,000 x 0.65). As a result of this transaction, the estate includes a 51% interest in the business which, assuming it is valued with a 10% premium, equals $1,122,000 ($1,020,000 x 1.1). The estate also has $637,000 in cash. Even if the individual makes no annual exclusion gifts before dying, the estate is reduced by $241,000 ($2,000,000--$1,759,000), resulting in estate tax savings of $132,550 ($241,000 x .55).

Suppose now that the individual makes a gift of a 2% interest in the company (gift tax value of $16,000 = $2,000,000 x .02 x.0.65-$10,000 annual exclusion). As a result the estate now includes only a 49% minority interest in the company with an estate tax value of $637,000 ($2,000,000 x 0.49 x 0.65), rather than $1,122,000, a reduction in the estate tax base of $485,000 while an increase in the adjusted taxable gifts of $16,000. The net reduction of $469,000 creates an additional savings of $257,950 ($469,000 x 0.55). In all, the estate planning technique triggered by the viatical settlement reduces the estate taxes that would have been paid by $390,500 ($132,550 + $257,950). Thus, by giving up $200,000 through viatical rather than death settlement of the insurance policy, the beneficiaries in the aggregate have saved $190,500 ($390,500-$200,000).

Please note that this analysis does not take into account savings arising from: (1) the ability to make annual exclusion gifts in addition to spending down the cash received; (2) the saving of future premium payments; (3) the removal of the appreciation in the business sold to the insurance trust from that date to the date of death from the insured's gross estate; and (4) the net earnings on the declining balance of the viatical proceeds. Further, additional discounts may be available by wrapping the stock into a family limited partnership/liability company.

Question--What estate planning opportunities do viatical settlements provide for clients with chronic illnesses or for those over the age of 75?

Answer--Clients with chronic conditions or those over the age of 75 who meet certain underwriting criteria will likely have longer life expectancies (e.g. 4-10 years) than a terminally ill client. For such individuals, viatical settlements may also be an invaluable estate planning tool. In the above example involving a minority discount, an insured with a longer life expectancy would undoubtedly receive considerably less than $800,000 for the sale of a $1 million policy, due to the time value of money over the longer remaining life. However, this is offset to some extent by the greater earnings on the declining balance due to the longer survival period, the greater amount of premiums not paid, and sometimes most importantly, the greater appreciation removed from the client's gross estate in reference to the business interest sold to the life insurance trust. The viability of this option depends in large part on the current valuation of the policy on a viatical basis.

Question--Are there any charitable giving planning opportunities with viatical settlements?

Answer--It is advantageous to donate highly appreciated assets to charity because the donor receives a current income tax deduction equal to the fair market value of the asset, rather than the donor's basis in the asset. Often, however, such assets are income-producing assets (i.e., securities, real estate) and the donor may not be able or willing to part with the income generated by them. Selling an existing policy may free these highly-appreciated assets to satisfy the donor's charitable goals.

For example, X owns securities with a fair market value of $70,000, a tax basis of $20,000 and also owns a $100,000 policy. If X does nothing, the net amount passing to the beneficiaries is $76,500 ($170,000 x 0.45). Assume X can sell the policy for $70,000, which "replaces" the securities to be donated to charity. As a result of donating the appreciated securities, the individual receives a $70,000 income tax deduction, saving $27,720 in income taxes. The tax saving, plus the settlement proceeds, equals $97,720. If the donor's goal is to maximize estate tax savings, he can make annual exclusion gifts and/or spend down the $97,720. In other situations, it might make sense to sell a policy and donate the cash generated from the sale to charity. This would provide a greatly increased charitable deduction versus the donation of the policy itself, and most charities would rather have cash than a policy.

Question--What is a "Life Settlement?"

Answer--Alife settlement is also a sale of a policy to a third party, much like a viatical settlement, but the insured is not terminally or chronically ill. While the insured will generally receive less than would be received in a viatical settlement, he or she will generally receive more than the policy's surrender value. A life settlement might be appropriate if the life insurance is not needed anymore, the insured's health has changed, or the insured has a need for cash.

CHAPTER ENDNOTES

(1.) Martha Groves, "Terminally Ill Cash in on Insurance Policies; For AIDS Patients, Money Helps Buy Medications," Washington Post, October 30, 1990, at p. Z9 (discussing BGR International, Inc., of Brooklyn, New York; "BGR" is an abbreviation for "beat the grim reaper").

(2.) The first large insurance company to enter the accelerated benefits arena was the Prudential Insurance Company, which introduced the "living needs benefits" rider as an option to its life insurance policies in 1990. Connecticut Mutual Life Insurance Company entered the field shortly thereafter. See Jennifer Landes, "Pru Unveils Plan to Pay Living Benefits," National Underwriter, Life and Health/Financial Services edition, February 5, 1990, p. 1. (living needs benefit introduced in Canada in 1989 and in the United States in 1990). Smaller insurance companies offered living needs benefits as early as 1987. See Linda Koco, "Small Cos. Need Big Cos. To Help Promote Product," National Underwriter, Life and Health/Financial Services edition, May 7, 1990, p. 29; See Linda Koco, "Conn. Mut'l to Add Living Benefits to New Policies," National Underwriter, Life and Health/Financial Services edition, July 9, 1990, p. 7.

(3.) For example, the Living Benefits Act of 1991 was drafted with the assumption that it "would not be fair to force the terminally ill to choose between their own welfare and the future welfare of their survivors." The bill would have amended "the Social Security Act to ensure that policyholders are not compelled to elect prepayment of death benefits in order to become eligible or remain eligible for federal means-tested programs such as Medicaid." 137 Cong. Rec. S1294-02 (Jan. 30, 1991) (S. 284).

(4.) IRC Sec. 101(g)(4)(A). The term "physician" is broadly defined to include a medical doctor or a doctor or osteopathy who is legally authorized to practice medicine and perform surgery by the state in which the doctor practices. See IRC Sec. 101(g)(4)(D) and 42 USC Sec. 1395x(r)(1).

(5.) Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 21.

(6.) IRC Secs. 101(g)(4)(B), 7702B(c)(2). The legislative history for this provision reflects an intent to include individuals who have Alzheimer's disease, Parkinson's disease, and AIDS. See H.R. Conf. Rep. No. 104-350 (1995) and Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 21.

(7.) IRC Sec. 101(g)(4)(B).

(8.) IRC Sec. 101(g)(5).

(9.) IRC Sec. 101(g)(3)(A)(i).

(10.) IRC Secs. 101(g)(4)(C), 7702B(c)(1).

(11.) IRC Sec. 101(g)(3)(C).

(12.) IRC Secs. 101(g)(3)(A)(ii)(I), 7702B(b)(1)(B).

(13.) IRC Secs. 101(g)(3)(A)(ii)(II), 101(g)(3)(B), 7702B(g).

(14.) IRC Secs. 101(g)(3), 7702B(d); Rev. Proc. 2006-53, 2006-48 IRB 996.

(15.) IRC Sec. 101(g)(2)(B)(i).

(16.) IRC Sec. 101(g)(2)(B)(ii).

(17.) IRC Sec. 101(g)(2)(B)(iii).

(18.) "Association Leaders Speak Out; Life Insurance History," Best's Review, Life/Health edition, June, 1990, at p. 76.

(19.) "Association Leaders Speak Out; Life Insurance History," Best's Review, Life/Health edition, June, 1990, at p. 76.

(20.) See, e.g., Linda Koco, "Living Benefit Rider Has Monthly 'Graded' Benefit," National Underwriter, Life and Health/Financial Services edition, May 14, 1990, p. 15; "Principal Adds Benefits Advance Rider at No Cost," National Underwriter, Life and Health/Financial Services edition, August 13, 1990, p. 21.

(21.) Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 20.

(22.) Let. Rul. 9443020. This ruling analyzed the transaction under IRC Section 1001 and thus "implicitly allow[ed] taxpayers to claim capital gains treatment for viatical settlement proceeds, assuming that the life insurance contract [was] a capital asset under [section]1221." See Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 20.

(23.) Prop. Treas. Reg. [section][section]1.101-8, 1.7702-2, as then in effect.

(24.) Health Insurance Portability and Accountability Act of 1996 (HIPAA 96), P.L. 104-191.

(25.) IRC Sec. 101(g). This provision applies to payments made after December 31, 1996. For a discussion of this exclusion, see generally Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 20.

(26.) The requirements are presented in this section in summary form. Be certain to consult the complete text of the Internal Revenue Code section before making a definitive decision regarding whether any accelerated payment or viatical settlement will qualify for income tax exclusion.

(27.) IRC Sec. 101(g)(4)(A).

(28.) IRC Secs. 101(g)(4)(B), 7702B(c)(2)(A).

(29.) IRC Sec. 101(g)(3).

(30.) IRC Sec. 101(g)(3)(C).

(31.) Rev. Proc. 2006-53, 2007-48 IRB 996.

(32.) IRC Sec. 101(g)(5).

(33.) See Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 22.

(34.) Gary J. Gasper, "Viatical Settlements-Cashing Out Life Insurance," Probate & Property, March/April 1997, at p. 22.

(35.) For further discussion of the transfer for value rule, see Chapter 22.

(36.) See Hal Stucker, "Viatical Settlement: What's a Good Fit," National Underwriter, Life and Health/Financial Services edition, February 1, 1999.

(37.) See "Tax Implications" above and Chapter 22 for further discussion of the implications of the transfer for value rule.
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Publication:Tools & Techniques of Life Insurance Planning, 4th ed.
Date:Jan 1, 2007
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