How Do I Report a Viatical Settlement?

A viatical settlement is a financial transaction involving the sale of an existing life insurance policy to a third party. The policy seller, known as the viator, is an individual with a serious illness who needs immediate cash. In exchange for ownership of the policy, the viator receives a lump-sum payment that is more than the policy’s cash surrender value but less than its face value. The tax implications of these funds depend on the recipient’s circumstances, and reporting the transaction to the IRS differs for the original policyholder and the investor.

Tax Implications for the Original Policyholder

The tax treatment of proceeds for the original policyholder hinges on their certified health status. The IRS distinguishes between individuals who are “terminally ill” and those who are “chronically ill,” and this classification determines if the money is taxable.

A person is considered terminally ill if a physician certifies they have an illness or physical condition that can be reasonably expected to result in death within 24 months. For individuals who meet this definition, the proceeds from a viatical settlement are not included in gross income and are tax-free. This treatment views the settlement as an advance of the tax-free death benefit.

The rules differ for a policyholder who is chronically ill. A person is defined as chronically ill if they are unable to perform at least two activities of daily living for at least 90 days, or if they require substantial supervision due to severe cognitive impairment. For these individuals, the proceeds are tax-free only up to a certain limit indexed for inflation. Any funds received in excess of this daily limit may be considered taxable income. To claim this tax-free treatment, the policyholder must file Form 8853, Archer MSAs and Long-Term Care Insurance Contracts.

Tax Implications for the Investor

For a third-party investor, the tax consequences of a viatical settlement are unique. When the insured individual passes away and the investor receives the death benefit, the payout is not entirely tax-free. The investor must calculate their taxable gain, which is the difference between the death benefit received and their cost basis in the policy.

The cost basis includes the total amount the investor paid to acquire the policy from the original owner. It also includes all subsequent premium payments the investor made to keep the policy in force until the death of the insured.

Based on IRS guidance, this gain is reported as ordinary income, not as a capital gain. This distinction is important because ordinary income is often taxed at higher rates than long-term capital gains.

Required Information and Forms for Reporting

The original policyholder receives Form 1099-LTC, Accelerated Death Benefits, from the viatical settlement provider. Box 1 shows the “Gross accelerated death benefits paid,” which is the total amount the policyholder received. Box 2, “Amount of qualified benefits,” indicates the portion of the payment that meets the criteria for being tax-free, which is relevant for chronically ill individuals.

An investor does not receive a standard tax form for the death benefit proceeds and must self-report the transaction. They are responsible for compiling their own records, which must include the total death benefit received, the policy’s purchase price, and a complete record of all premium payments.

Step-by-Step Reporting Guide

For the policyholder, the reporting steps depend on their health status. A terminally ill individual whose Form 1099-LTC shows the entire payment as qualified does not need to report the amount on their tax return. For a chronically ill individual who received proceeds above the tax-free limit, the taxable portion must be reported on Schedule 1 (Form 1040) as “Other Income.”

The investor reports their calculated taxable gain on Schedule 1 (Form 1040) as “Other Income.”