Typically, viatical settlements are tax exempt.  A viatical settlement is when the insured is considered terminally ill and has a life expectancy of less than two years. When this is the case,  the entire payment is tax free.

If the party who receives the viatical settlement is chronically ill then the amount spent on long-term care (LTC) and health care costs is not taxed and the remaining amount is partially taxed.  A certain amount, determined by a limitation set by law (adjusted annually), is tax free and anything in excess of this amount is taxed normally.  In 2003 this limit was $220 per day or $80,300 per year.

For example, if a policy owner had a chronic illness and sold their policy for $200,000 in 2003 and spent $100,000 on LTC then the remaining $100,000 would be considered for taxes.  The viator would be able to deduct the allowed amount of $80,300 from this  and would therefore pay taxes on the remaining $19,700.