There are two certainties in life: death and taxes. This is especially true in the viatical settlement context. A viatical settlement involves the sale of a life insurance policy by the insured during his or her lifetime. In effect, the investor will finance the insured's life insurance policy in exchange for being named beneficiary of the policy. In this way, the insured is able to extract value from the policy during his or her lifetime. When the insured dies, the investor is entitled to receive death benefits under the policy.
Although I.R.C. § 101(a) generally excludes life insurance proceeds from gross income, life insurance proceeds are includible in gross income in cases where, as in the viatical settlement context, the underlying policy was "transferred for valuable consideration." I.R.C. § 101(a)(2). In that case, the transferee of the policy must recognize income to the extent the death benefits exceed its basis in the policy. Therefore, a viatical settlement investor has income to the extent of his or her basis, which in most cases will be the cost of the investment. See generally, I.R.C. § 1001.
But when must this income be recognized for tax purposes? When the insured dies and the investor becomes entitled to the life insurance proceeds? Or when the investor actually receives payment from the insurance company? In many cases, the insured dies and the investor receives payment in the same year. But what about the case where the insured dies in one year and the investor does not receive payment from the insurance company until the following year?
Under I.R.C. § 451(a), income is included in a taxpayer's gross income in the taxable year in which it is received, unless properly accounted for in a different period. This means that cash basis investors may defer recognition of income until the year of receipt. However, under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income, and the amount thereof can be determined with reasonable accuracy. Treas. Reg. § 1.451-1(a).
Fixed Right to Income. Where a right to receive income is subject to one or more conditions precedent or other contingencies, courts have generally held that accrual of income is not required. E.g., Ringmaster, Inc. v. Commissioner, T.C. Memo. 1962-167 (accrual not required prior to purchaser's acceptance of sale conditions); Webb Press Co. Ltd. v. Commissioner, 3 B.T.A. 247 (1925) (accrual not required until acceptance after testing product). In these types of cases, the complexity of the tax laws and the potential for different interpretations of relevant statutes justifies non-accrual.
However, a "ministerial" contingency will not delay establishment of the fact of liability. Dally v. Commissioner, 227 F.2d 724 (9th Cir. 1955). In this regard, requirements of invoice certification, claim submission, and claim processing have been held to be ministerial acts which do not cause the right to income to be unfixed. Dally v. Commissioner, 227 F.2d 794 (9th Cir. 1955) (invoice certification); Rev. Rul. 98-39, 1998-2 C.B. 198 (claim submission); U.S. v. General Dynamics Corp., 481 U.S. 239 (1987) (claim processing). Therefore, the viatical settlement investor's right to receive income becomes fixed on the date of the insured's death. At that point, all conditions precedent to the investor's right to income have been satisfied. (Of course, this assumes that the insurer does not contest its obligation or otherwise have discretion to deny the claim).
Determinable with Reasonable Accuracy. Under the all events test, income must be reported in the tax year in which its collectability is assured, not in the year in which it is actually received. Clifton Manufacturing Co. v. Commissioner, 137 F.2d 290 (U.S. Tax Court 1943). However, if a taxpayer has "good reason" to believe that income cannot be collected, accrual is not required. American Fork & Hoe Co.v. Enterprise Manufacturing Co., 64 F.2d 1008 (1933).
The U.S. Tax Court has found "good reason" where there is "serious doubt as to ultimate collection." Corn Exchange Bank v. U.S., 37 F.2d 34 (U.S. Tax Court 1930). As for what constitutes "serious doubt," the law is unclear. But the law is relatively clear as to what does not constitute "serious doubt." Indeed, the Tax Court has explicitly stated that, "the fact that a lapse of time is contemplated before collection . . . does not constitute doubtful collectability." Harmont Plaza, Inc. v. Commissioner, 64 TC 632 (U.S. Tax Court 1977). Consequently, the fact that an accrual-basis investor may not receive payment of the death benefits in the year of death does not justify non-accrual. The income must be reported in the year of death, notwithstanding whether income is actually received in that year.