Unresolved Tax Issues in Viatical and Life Settlements

Viatical and life1 settlements refer to the ownership transfer of a life insurance contract for valuable consideration. These settlements provide seller liquidity and investor return that has little corre- lation with other asset classes and investment markets. The pricing of life settlements, and thus the funding to individual policyholder sellers, are directly affected by the tax consequences of the proceeds subsequently paid to investors. This article explores the current tax environment for life settlements and explores possible tax contexts that would affect the sharing of the insurance proceeds among the insured seller, the investor, a life settlement company, and the various tax authorities. Alternative interpretations of the life settlement transaction are provided so policymakers can make informed choices with respect to tax, as well as social, policy involving the terminally-ill.The longstanding choices of the insured and their heirs, receiving the cash surrender value of a life insurance policy or waiting for the proceeds at death, are contrasted with life settlement options that offer returns to investors in the form of ordinary income, capital gains, or tax-free subrogation or assignment. Obviously, the option that provides the greatest current funding to the insured and the greatest return to the investor is the tax-free life settlement subrogation or assignment, which preserves the original tax-free character of life insurance transactions.OverviewThe first section of this article describes the life settlement market, its stakeholders, and individual investor perspectives. It then provides a general example of the life settlement contract and its functions. Next, the general tax treatment of life settlements for investors in these policies is investigated. Subsequently, the alternative tax treatment are considered. Finally, the comparative implications of the tax treatment are demonstrated.The Life Settlement MarketThe life settlement market began as the sale of life insurance policies by the terminally- ill to another party for less than the death benefit of the policy. The new policyholder is responsible for any premiums after the transfer and, upon death, receives the death benefit from the policy. Since transferees pay less than the face amount of the policy, they receive some return on this investment, depending on how much longer the transferor lives after the transfer.As these life settlements have grown over the past dozen years, the market has shifted from institutional investors to include individual investors as well. This form of secondary market for life insurance policies has risen from $13 billion in face amount of policies transferred in 1995 to $160 billion in 2004 (Simon and Schmitt 2006).The current life settlement market is divided into the segment for the terminally- ill insured/ policyholder and the segment for any life insurance policy sale by someone else. While institutions can participate directly with an insured, individual investors typically use an intermediary to match potential sellers and potential investors. The Life Settlement Association (2007), a trade association for companies involved in viatical and life settlements, has members from 58 brokers who negotiate sales on behalf of sellers spread across 48 states plus the District of Columbia. On average there are 11 licensed brokers who are members of the Life Settlement Association in each state.Life settlement companies provide the services that coordinate the sale and investment. The due diligence and the paperwork in the public offering of life settlements are substantial. The life settlement company verifies information about life expectancy of the insured and obtains authorization from beneficiaries. Several individual investors may participate in ownership of a single life insurance policy, and each individual investor may purchase an interest in several life insurance policies. …