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Life insurance is a valuable estate and business-planning tool. The biggest advantage of life insurance is the income tax-free nature of the death benefit. If there is a transfer for value, however, the life insurance proceeds become income taxable under IRC 101(a)(2).
The transfer for value rule is a tax trap that applies when a policy is transferred in return for valuable consideration. The definitions of "consideratio" and "transfer" are beyond the scope of this article. It is best to assume that the rule is broadly construed. This rule does not apply, however, to the proceeds of a policy that is bought initially by the beneficiary. Also, if the policy is collaterally assigned, the transfer for value rule does not apply.
Even if there is a transfer for value, one still can fall within several exceptions to the rule, such as:
Transferor's Basis Carryover Exception
The transferee's basis in a policy or an interest in a policy is determined in whole or in part by reference to the transferor's basis. This is often the hardest to understand exception to the transfer for value rule. For example, if there is an outright gift of a policy when consideration is not given, the transferee carries over the transferor's basis and falls safely within the protection this exception. Another example is if one spouse transfers insurance on his or her life to his current or ex-spouse. Under IRC 1041, there is no gain or loss recognized on the transfer or sale of property between spouses. For income tax purposes, the transfer is treated as a gift. Again, the carryover basis rule applies to exempt life insurance transfers between spouses (and in some cases between ex-spouses) from the threat of the transfer for value rule.
Transfer to the Insured Exception
Another exception is a transfer of a policy back to the insured. This exception keeps the income tax-free status under the transfer for value rule. Also, in Revenue Ruling 2007-13, the Service has ruled that a transfer to a grantor trust deemed owned by the insured is a transfer to the insured for purposes of the transfer for value rule.
Transfer to the Partner of the Insured Exception
A transfer of a policy to a partner of the insured also avoids transfer for value. This exception applies, for example, where individuals are partners in a partnership, and one partner owns a policy on another's life. If another partner buys the policy from the initial owner, there has been a transfer for value. Since the transfer is to a partner of the insured, however, the proceeds are received income tax free.
Transfer to Partner in which Insured is a Partner Exception
A transfer of a policy to a partnership in which the insured is a partner falls within an exception to the transfer for value rule. Similar to the previous example, the partner who owned the policy of insurance on the life of another partner instead sells the policy to the partnership itself. Because the transfer is to the partnership in which the partner is the insured, the policy avoids the transfer for value rule. It must be cautioned that an individual should not establish a partnership with no purpose or function except to avoid the transfer for value rule. It may be considered a sham transaction that would then fail as an exception to the transfer for value rule.
Transfer to a Corporation in which the Insured is a Shareholder/Officer Exception
Finally, a transfer of a policy to a corporation in which the insured is either an officer or a shareholder is an exception to transfer for value. An example would be key-employee insurance. The transfer for value rule will not apply if the insured is an officer or a shareholder in the corporation at the time when a policy is transferred to the insured's corporate employer. Again, one should not set up a corporation or make someone an officer to avoid the rule.
The transfer for value rule can spring up and create havoc if one is not careful in structuring transfers of life insurance. A practitioner needs to be aware of the rule to avoid changing the income tax free nature of life insurance.