As part of ThinkAdvisor's Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What is the income tax treatment of an accelerated death benefit payment from a life insurance contract?
Generally, any amount received under a life insurance contract on the life of a terminally ill insured or a chronically ill insured will be treated as an amount paid by reason of the death of the insured. Amounts received under a life insurance contract by reason of the death of the insured are not includable in gross income. Thus, an accelerated death benefit meeting these requirements will generally be received free of income tax.
However, amounts paid to a chronically ill individual are subject to the same limitations that apply to long-term-care benefits. Generally, this is a limitation of $330 per day in benefits. More specifically, if the total periodic long-term-care payments received from all policies and any periodic payments received that are treated as paid by reason of the death of the insured (under IRC Section 101(g)) exceed a per-diem limitation, the excess must be included in income (without regard to IRC Section 72). (If the insured is terminally ill when a payment treated under IRC Section 101(g) is received, the payment is not taken into account for this purpose.)
The per-diem limitation is equal to the greater of (1) a $330 per day limitation in 2014 or (2) the actual costs incurred for qualified long-term-care services provided for the insured less any payments received as reimbursement for qualified long-term-care services for the insured. This figure is adjusted for inflation annually. Accelerated death benefits paid to terminally ill individuals are not subject to this limit.
Example. In 2014, Mr. Heller received qualified long-term-care services for 30 days at a total cost of $7,500. A qualified long-term-care insurance contract paid him a benefit of $330 per day, $9,900 total. In addition, $500 of the cost of the qualified long-term-care services was reimbursed by another source. Thus, $500 of the $9,600 benefit is includable in income by Mr. Heller.
A terminally ill individual is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within twenty-four months following the certification.
A chronically ill individual is a person who is not terminally ill and who has been certified by a licensed health care practitioner as unable to perform, without substantial assistance, at least two activities of daily living (ADLs) for at least ninety days or a person with a similar level of disability. Further, a person may be considered chronically ill if he requires substantial supervision to protect himself from threats to his health and safety due to a severe cognitive impairment and this condition has been certified by a healthcare practitioner within the previous twelve months. The ADLs are: (1) eating; (2) toileting; (3) transferring; (4) bathing; (5) dressing; and (6) continence.
Are there any special rules that apply to chronically ill insureds?
There are several special rules that apply to chronically ill insureds. Generally, the tax treatment outlined above will not apply to any payment received for any period unless the payment is for costs incurred by the payee (who has not been compensated by insurance or otherwise) for qualified long-term-care services provided to the insured for the period. Additionally, the terms of the contract under which the payments are made must comply with: (1) the requirements of IRC Section 7702B(b)(1)(B); (2) the requirements of IRC Sections 7702B(g) and 4980C that the Secretary specifies as applying to such a purchase, assignment, or other arrangement; (3) standards adopted by the National Association of Insurance Commissioners (NAIC) that apply specifically to chronically ill insureds (if such standards are adopted, similar standards under number (2) above cease to apply); and (4) standards adopted by the state in which the policyholder resides (if such standards are adopted, the analogous requirements under number (2) and, subject to IRC Section 4980C(f), standards under number (3) above cease to apply.
"Qualified long-term-care services" are defined as "… necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services, which…" are required by a chronically ill individual and are provided under a plan of care set forth by a licensed healthcare practitioner.
Are there any exceptions to the general rule of nonincludability for accelerated death benefits?
There is one exception to this general rule of non-includability for accelerated death benefits. Accelerated death benefits paid to any taxpayer other than the insured if the taxpayer has an insurable interest in the life of the insured because the insured is a director, officer, or employee of the taxpayer or if the insured is financially interested in any trade or business of the taxpayer are received on a tax-free basis.
What is the income tax treatment of an amount received from a viatical settlement provider?
A viatical settlement provider is "any person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of insureds" who are terminally or chronically ill, provided that certain licensing and other requirements are met. To be considered a viatical settlement provider a person must be licensed for such purposes in the state in which the insured resides. The IRS has provided guidance on when viatical settlement providers will be considered licensed.
If any portion of a death benefit under a life insurance contract on the life of a terminally or chronically ill insured is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment will be treated as an amount paid under the life insurance contract by reason of the insured's death. In other words, such an amount will not be includable in income.
A terminally ill individual is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within twenty-four months following the certification.
A chronically ill individual is a person who is not terminally ill and who has been certified by a licensed healthcare practitioner as being unable to perform, without substantial assistance, at least two activities of daily living (ADLs) for at least ninety days or a person with a similar level of disability. Further, a person may be considered chronically ill if the person requires substantial supervision to protect himself or herself from threats to his or her health and safety due to severe cognitive impairment and this condition has been certified by a healthcare practitioner within the previous twelve months. The activities of daily living are:
