Life insurance is a key business planning and wealth management tool and an important part of many individuals’ financial and estate plans — for good reason. Generally, life insurance proceeds, when payable by reason of death, aren’t subject to income tax.
What you may not be aware of is the transfer-for-value rule. Triggering a transfer-for-value (knowingly or not) can subject life insurance proceeds to income tax.
Triggering a transfer-for-value can be the most serious and costly mistake one can make with their life insurance policy. Transfer-for-value is complex, and it’s easy to violate the rule without a full understanding of the tax implications.
A transfer-for-value can be triggered with every type of life insurance — term, permanent, group coverage, etc. — and it’s wise to be clear about what transfer-for-value is, how it can be triggered, and the five safe harbor exceptions to the rule.
Transfer-for-value definition
To get technical for a moment, when a life insurance policy is transferred for consideration, the death benefit proceeds are subject to income tax to the extent they exceed the sum of the consideration and post-transfer premiums paid by the transferee, according to the Internal Revenue Code (IRC Sec. 101(a)(2); Rev. Rul. 2009-14).
If a policy is transferred multiple times, the facts associated with the final or last transfer are the ones that determine whether the death proceeds are subject to income tax.
What constitutes consideration?
The transfer-for-value tax trap isn’t necessarily triggered when a life insurance policy is transferred, unless consideration for the transfer is given. Consideration can be money or something else of value, and its presence isn’t always obvious.
A few examples of transfer-for-value consideration include:
- Selling a policy for cash.
- Relieving the debt owed by the transferee to the transferor.
- In buy/sell agreements, assigning existing corporate-owned life insurance policies to company shareholders to fund a cross-purchase agreement. (The consideration received by the corporation is the relief of its obligations to pay future premiums and to purchase stock from the estate of the deceased shareholder.)
In each of these examples, consideration has been given, and a transfer-for-value exists.
Note that a transfer-for-value can occur even if policy ownership doesn’t change. A shift in contractual interest may also trigger it. For example, if a policy owner changes the beneficiary of a policy due to the receipt of valuable consideration, a transfer for value will have occurred.
Exceptions to the transfer-for-value rule
Fortunately, five safe harbor exceptions can shelter a transfer from the income tax penalty — even if there is a transfer for consideration. Only one of the five exceptions must be met.
- The transferee’s basis in the policy is determined by reference to the basis of the policy in the hands of the transferor [transferee takes a carryover basis in the policy]. A gift is the most common, but not the only, example of this exception.
- The transfer is to the insured.
- The transfer is to a partner of the insured.
- The transfer is to a partnership in which the insured is a partner.
- The transfer is to a corporation in which the insured is a shareholder or officer.
Carefully consider the exceptions and evaluate what works best before transferring a life insurance policy.
Ask two critical questions — upfront
To determine whether a transfer-for-value has been triggered, two questions are critical to ask:
- Is there a transfer?
- Will any type of consideration be paid or received for the transfer?
If you’re considering transferring a life insurance policy, it’s wise to err on the side of caution: Assume that every policy transfer is a transfer-for-value until carefully examined.
The cost of triggering the transfer-for-value rule can be high. Consulting with your trusted financial, tax, and legal advisors is a must if you’re contemplating any transfer or change in policy interest.
