Tax Treatment of Life Settlements & Viatical Settlements

When a policyowner sells a life insurance policy on the secondary market, the IRS does not treat the entire payout as a single taxable event. Instead, Revenue Ruling 2009-13 introduced a structured approach that divides the sale proceeds into three distinct layers, each with its own tax consequence.

• Tier 1 — Return of Basis: The portion of the sale price that equals your cumulative premiums paid comes back to you tax-free. This is simply a return of the money you already invested in the policy.
• Tier 2 — Ordinary Income: If the policy's cash surrender value (CSV) exceeds your adjusted basis, that difference is taxed as ordinary income. This represents the "inside build-up" that accrued within the policy over time.
• Tier 3 — Capital Gains: Any remaining proceeds above the cash surrender value are classified as long-term capital gains, typically taxed at preferential rates (0%, 15%, or 20% depending on total income).

Under IRC § 1016, the adjusted basis for a life insurance policy was historically reduced by cost-of-insurance (COI) charges — meaning your "investment in the contract" could be significantly less than total premiums paid. This changed with the TCJA of 2017 (see next section).

Read Revenue Ruling 2009-13 (PDF)

Section 13521 of the Tax Cuts and Jobs Act fundamentally altered how policyowners determine their tax basis when selling a life insurance contract. The change is straightforward but significant:

• Before TCJA (pre-2018 sales): The IRS required sellers to subtract all accumulated cost-of-insurance charges from their basis. This often reduced basis far below total premiums paid, inflating the taxable portion.
• After TCJA (post-2017 sales): Basis equals total net premiums paid — full stop. Cost-of-insurance deductions are no longer required. This preserves a larger tax-free recovery for policyowners.
• Revenue Ruling 2020-05 extended this favorable treatment to term life policies, confirming that the same basis calculation applies regardless of policy type.

The practical impact is substantial: many sellers now retain tens of thousands of additional dollars tax-free because their basis is no longer artificially diminished. If your policy was sold before 2018, it may be worth reviewing whether an amended return is appropriate.

TCJA Full Text (Congress.gov)

The following hypothetical scenarios demonstrate how the three-tier framework applies to different policy types and seller circumstances. These are illustrative — your actual results will depend on your unique situation.

Key takeaway from Example C: When the seller qualifies as terminally ill under IRC § 101(g), the entire settlement amount is excluded from federal gross income — no tier analysis needed.

Congress carved out a specific exclusion for individuals facing terminal illness who sell their life insurance policies (known as viatical settlements). The rules differ based on health status:

• Terminally ill (IRC § 101(g)): If a physician certifies the insured has a life expectancy of 24 months or less, the full viatical settlement amount is excluded from gross income at the federal level. There is no dollar cap on this exclusion.
• Chronically ill (IRC § 7702B(c)(2)): Individuals unable to perform at least two activities of daily living, or who require substantial supervision due to cognitive impairment, may also qualify — but the exclusion is limited to actual long-term care expenses incurred.
• State conformity varies: While federal law provides these exclusions, not every state automatically conforms. Some states have their own eligibility thresholds or may not recognize the viatical exclusion at all.

The exclusion applies only to the insured (or policy owner in certain cases). Third-party investors who purchase viatical settlements do not benefit from this provision — they are taxed under standard investment income rules.

IRC § 101 Full Text (Cornell Law)

Federal rules set the floor, but your state of residence at the time of sale determines whether additional taxes apply and how the gain is characterized.

• No state income tax: Florida, Texas, Nevada, Wyoming, South Dakota, Alaska, and Tennessee impose no personal income tax — only federal taxes apply to settlement proceeds in these states.
• States following the federal framework: The majority of states with an income tax generally adopt the IRS three-tier treatment without significant modification.
• Pennsylvania: Still requires sellers to reduce basis by historical cost-of-insurance charges (the pre-TCJA federal rule), which can result in higher state-level taxable gain even post-2017.
• California: Taxes capital gains at ordinary income rates — currently up to 13.3% for high earners — making the state tax bite considerably larger than in states with preferential capital gains rates.
• Washington: Applies a 7% excise tax on capital gains exceeding $270,000 (indexed for inflation), which could affect larger settlement transactions.

Because state rules can diverge from federal treatment in unexpected ways, we strongly encourage sellers to work with a CPA who understands both their home state's conformity status and the nuances of insurance-related income.

Example: NY State Tax Authority

Since January 1, 2019, the IRS requires standardized reporting on all reportable policy sales. Two forms work together to give both the seller and the IRS the data needed to calculate the correct tax:

• Form 1099-LS: Filed by the buyer (acquirer) of the policy. It reports the gross amount paid to the seller. Receiving this form does not mean the full amount is taxable — it is simply the starting point for your calculation.
• Form 1099-SB: Filed by the insurance carrier. It reports the seller's investment in the contract (adjusted basis) and the policy's surrender value. This is the data you need to separate the three tiers.
• Effective date: Both reporting requirements apply to sales closed after December 31, 2018, as mandated by TCJA Section 6050Y.
• Common issues: Carriers occasionally report basis inaccurately on older policies. If your 1099-SB seems too low, gather premium payment records and request a correction before filing.

The following official sources provide authoritative guidance on the topics covered in this article: