Which of the following best describes the tax treatment of a viatical settlement?

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A viatical settlement involves the sale of a life insurance policy by a policyholder who is terminally ill to a third party for a lump sum payment that is less than the death benefit but more than the policy's cash surrender value. The tax treatment of a viatical settlement is beneficial for the policyholder, as the Internal Revenue Code generally allows for tax-exempt treatment under certain conditions. Specifically, if the policyholder is terminally ill and has a life expectancy of 24 months or less, the proceeds from the viatical settlement can be received tax-free.

This provision is designed to provide financial relief for individuals in terminal health situations, allowing them to use the funds from their policy while they are still alive for medical expenses or other needs without facing a tax liability. Therefore, the correct answer reflects the favorable tax treatment associated with viatical settlements under specific circumstances, illustrating the tax-exempt status available for those suffering from terminal illnesses.