One of the most attractive aspects of life insurance as an estate and financial planning tool is the tax treatment of the death proceeds. Generally, the proceeds of a life insurance policy received by a beneficiary are entirely free from income tax (Sec. 101(a)(1)). However, an often overlooked provision of the tax law, known as the transfer-for-value rule, can result in the loss of this advantageous tax treatment.
CPAs often advise their clients to purchase new life insurance or restructure the ownership of existing policies to serve as a valuable liquidity tool in the estate and business succession planning process. When dealing with life insurance transactions, one of the most important and challenging areas that the tax adviser must properly address is the transfer-for-value rules under Sec. 101(a)(2).
Generally, under the provisions in Sec. 101, life insurance proceeds, payable as a result of the death of the insured, are received income tax free. If properly structured, through third-party ownership of the policy, the proceeds can also be received estate tax free. However, if a life insurance policy, or interest in a policy, is transferred for valuable consideration of any form, such as in a cash transaction or to satisfy mutuality of promises, then the income tax exclusion is not available to the beneficiary and the death proceeds are subject to federal income tax. More specifically, the portion of the death proceeds equal to the consideration paid to acquire the policy or interest in the contract, plus all future premiums paid by the transferee (i.e., the transferee’s basis in the contract), are received income tax free, but the remaining death proceeds are taxed as ordinary income under Regs. Sec. 1.101-1(b)(3)(i).
While beyond the scope of this column, it should be noted that transferring an existing life insurance policy into an irrevocable life insurance trust (ILIT) can shield the entire death benefit from federal estate and generation-skipping transfer tax consequences. However, clients should be advised that, under Sec. 2035, the death proceeds of the policy transferred to an irrevocable trust are fully included in the decedent’s gross estate for transfer tax purposes if ownership of the policy was transferred by the insured to the ILIT within three years of the insured’s date of death.
Fortunately, a number of safe-harbor exceptions to the transfer-for-value rule allow a life insurance policy transfer to be made for valuable consideration without jeopardizing the income tax–free nature of the death benefit. Any one of these exceptions to the rule can effectively serve to insulate a policy’s death proceeds from adverse income tax consequences.
Safe-Harbor Exceptions to the Transfer-for-Value Rule
There are five exceptions to the transfer-for-value rule contained in Sec. 101(a)(2). Life insurance proceeds are received income tax free, even if there has been a transfer for valuable consideration of a policy or an interest in a policy, if the transfer is to:
1. Anyone whose basis is determined by reference to the original transferor’s basis;
2. The insured (or insured’s spouse or ex-spouse, if incident to a divorce under Sec. 1041);
3. A partner of the insured;
4. A partnership in which the insured is a partner; or
5. A corporation in which the insured is a shareholder or officer.
Transfer-for-Value Pitfalls and Opportunities
Gratuitous transfer: When the transferor of a life insurance policy receives consideration and is discharged from a policy loan obligation on the contract, the transfer of a policy subject to a nonrecourse loan is deemed a transfer for value. However, if the transferor’s basis in the policy is greater than the loan balance, a gratuitous transfer of the policy should qualify for the first exception to the transfer-for-value rule noted above, reflected in the basis carryover exception (Rev. Rul. 69-187; Letter Ruling 8951056).
Transfer to a partner or partnership: Since the transfer of a policy to a partner of the insured is one of the exceptions to the rule, the transfer-for-value issue does not occur in the context of a business partnership. Therefore, when restructuring business succession plans, it is possible to change from an entity-purchase or stock-redemption agreement to a cross-purchase agreement and use the same policies to fund the new transaction.
While the transfer of a life insurance policy to a partner of the insured is a protected transaction for transfer-for-value purposes, a policy transfer to a co-shareholder of the insured is not protected and results in a violation of this rule. Therefore, when a corporation owns life insurance policies on the lives of its shareholders, structured in the form of an entity purchase or stock redemption agreement, it is not possible to convert to a cross-purchase agreement and use the same policies to fund the new agreement. The resulting transaction would violate the transfer-for-value rule because a corporation’s transfer of an existing policy on the life of one stockholder to another stockholder is not one of the safe-harbor exceptions to the transfer-for-value rule.
While there does not appear to be any logical reason to exempt transfers of an interest in a life insurance policy to and among partners of the insured and not also afford this same exemption to transfers to and among closely held corporate shareholders, if the insured is a co-shareholder, unless the transferee is the insured, transfers of policies from a corporation to a shareholder and transfers among shareholders can easily violate the rule.
However, if the co-shareholders are all deemed partners in a partnership, the transaction may be exempt from the transfer-for-value rule under the partnership exception. In a private letter ruling, the IRS has approved the creation of a partnership for the purpose of receiving corporate-owned policies (Letter Ruling 199903020). Although a partnership must have a valid business purpose under state law and not be just an entity created to avoid taxes, this ruling appears to approve the creation of a partnership whose sole purpose is to “engage in the purchase and acquisition of life insurance policies on the lives of the partners.”
In Letter Ruling 9701026, three shareholders in a professional corporation were also partners in a partnership that owned and leased an office building to the professional corporation. The parties planned to enter into a cross-purchase agreement to provide the surviving shareholders with funds that might be needed to purchase a deceased shareholder’s shares in the professional corporation from his estate. Each shareholder owned insurance on the lives of the others, and the professional corporation owned a life insurance policy on one shareholder’s life that was subject to a collateral assignment split-dollar plan. The professional corporation proposed to transfer its ownership interest in the split-dollar policy to the other shareholders, who would assume the corporation’s position under the split-dollar plan. The letter ruling held that the transfer qualified for the partnership exception under Sec. 101(a)(2)(B).
Beneficiary designation: The designation of a policy beneficiary in exchange for any kind of valuable consideration constitutes a transfer for value. The consideration could be an exchange of policies or a promise to render future services and does not have to involve the exchange of money. However, the mere pledging or assignment of a life insurance policy as collateral is not deemed to be a transfer for value.
More specifically, a pledge or assignment of a life insurance policy as collateral security for a loan or other obligation owed by the policy owner is not a transfer for valuable consideration. Sec. 101(a)(2) is not applicable to amounts received by the pledgee or assignee that are treated as a repayment of capital and are therefore generally income tax free to the extent of the outstanding debt amount. However, insurance proceeds representing interest on the debt are taxed as ordinary income to the creditor (Regs. Sec. 1.101-1(b)(4)).
Term life insurance: Term life insurance policies, even though such policies do not accumulate cash value, are subject to the transfer-for-value rule (Letter Ruling 7734048). The transfer does not have to be of the policy itself. A transfer of some or all of the underlying interest in the policy (e.g., the death benefit proceeds) is sufficient to invoke the transfer-for-value rule. For example, the creation, for value, of an enforceable contractual right to receive all or part of a life insurance policy’s proceeds may constitute a transfer for valuable consideration. This can occur when an insured shareholder-owner of a corporation, which owns the policy on his life, is contractually bound under the terms of an enforceable buy-sell agreement to designate a co-shareholder as the policy beneficiary in order to fund the transaction.
Reciprocal promise transaction: A reciprocal promise can also constitute valuable consideration. For example, if several insured co-shareholders agree to “gift” their policies to one another in order to fund a cross-purchase arrangement, the reciprocal gifting constitutes valuable consideration. In addition, if the co-shareholders agree to continue paying premiums on the gifted policies (to fund the cross-purchase agreement), this too constitutes valuable consideration (Letter Ruling 199903020).
Intentionally defective grantor trust: A grantor trust that is taxed as if the underlying assets were owned by the insured grantor can purchase or obtain existing policies on the grantor’s life without adverse income tax consequences, since the transfer falls within the transfer-to-the-insured exception to the rule. More specifically, when a client wants to establish a new irrevocable trust in order to purchase an existing policy from another trust, for the purpose of changing the dispositive provisions, a transfer for value can occur. If the trust terms are no longer appropriate, then with the trustee’s consent, the insured may use the transfer-for-value exception to acquire the policy from the insurance trust and transfer the policy to a new trust with acceptable terms. Of course, the three-year rule of Sec. 2035 will begin with the new transfer.
Alternatively, the transfer could be made directly to a new insurance trust that satisfies one of the transfer-for-value safe-harbor exceptions. For example, the transfer to an intentionally defective grantor trust can be used to transfer a policy from one insurance trust to another. In Swanson, 518 F2d 59 (8th Cir. 1975), the insured retained the power to alter or amend a trust but could not vest ownership in himself. The insured was deemed the trust’s owner under Sec. 674; as a result, the sale of an insurance policy to the trust was deemed to be a transfer to the insured within the meaning of Sec. 101(a)(2)(B).
The final transfer: In a series of transfers of the same life insurance policy, if the final transfer is a transfer for value, the transfer-for-value rule will apply, and the exclusion, for income tax purposes, generally will be limited to the consideration paid for the policy by the transferee, plus any subsequent premiums paid by the transferee to keep the policy in force (Regs. Sec. 1.101-1(b)(3)(i)). However, if the final transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or an officer, the entire death proceeds of the policy will be received by the beneficiary income tax free (Regs. Sec. 1.101-1(b)(3)(ii)). If none of the stated exceptions to the transfer-for-value rule applies, but the final transferee carries over the transferor’s basis in whole or in part, the excludible amount is the amount that would have been excludible by the transferor had the transfer not taken place, plus any premiums paid by the final transferee (Regs. Sec. 1.101-1(b)(3)(iii)).
Transfer-for-value problems can occur in many unexpected circumstances. As noted above, adverse income tax consequences can be triggered by a violation of the rule in both personal and business transactions and can apply far beyond the outright sale of a life insurance policy to a third party.
Without a thorough policy review, a transfer-for-value violation is a ticking time bomb, since the problem often remains undiscovered until after the insured’s death, when it is too late to remedy potentially severe income tax consequences to the beneficiaries.
Life insurance continues to be an excellent financial planning vehicle to provide the infusion of cash—precisely when needed—to generate an instant source of liquidity in order to promptly discharge the final debts, taxes, and administrative expenses arising at a client’s death. However, whenever individuals or business owners own life insurance or are contemplating the transfer of a policy in conjunction with the review or revision of their estate or business succession plan, tax advisers must consider potential transfer-for-value implications for their clients.
Therefore, any proposed transfer of an existing life insurance policy by clients should take into account the transfer-for-value rules under Sec. 101. Failure to carefully address these rules could cause the policy proceeds to be exposed to income taxes when received by a beneficiary as a result of the insured’s death. With proper planning and foresight by the client’s team of tax, legal, and insurance advisers, this is a tax problem that can generally be completely avoided.
While life insurance continues to remain a flexible financial planning tool in the estate planner’s arsenal, both planning opportunities and tax pitfalls do exist. Since the CPA is very often the client’s most trusted adviser, he or she must have a firm grasp of the issues surrounding life insurance and the transfer-for-value rule to help guide clients through the maze of complex, and often inconsistent, tax rules. This knowledge can help the tax adviser minimize the potential tax burden and maximize the transfer of wealth to the client’s surviving family members.
Michael David Schulman is the third generation owner of Schulman CPA, An Accountancy Professional Corporation in New York, NY