It is essential that planners understand why the rule exists: Congress wanted to discourage speculation in human life through insurance via the sale of policies to those who do not have an insurable interest in the life of the insured (essentially, a stronger preference for the continued life of the insured than for receipt of the insurance proceeds).5 The parties specified below as exempt from the transfer for value rule are those who are likely to have an insurable interest.
But it is equally important for practitioners to note that the mere fact that the beneficiary should or does have an insurable interest in the life of the insured is not sufficient. Even some parties who clearly have an insurable interest are not included in the exempt categories described below. For instance, the following individuals are not exempt from the rule:
- the policyholder’s children;
- the policyholder’s parents; and
- the policyholder’s co-shareholders.
Furthermore, even if the beneficiary can show that there is no risk or intent of speculation on the death of the insured and the only violation is a technical one, proceeds will be taxable under the transfer for value rule.
Do not try to use logic as a working guideline to this rule. Read the Internal Revenue Code and the Treasury regulations. Again, suspect a problem whenever there is:
a transfer of a policy or any interest in a policy; and
any type of valuable consideration is (or could be) given in return for that transfer.
The safe course is to consider every transfer as suspect until scrupulously examined. As noted below, even what appears to be an outright gift of life insurance may incorporate a fatal element of consideration in certain circumstances.
Five safe-harbor exceptions may shelter a transfer from the transfer for value rule penalty—even if there is a transfer for valuable consideration.
These five safe harbors consist of the following:
- the transferor’s basis (in whole or in part) exception;
- the transfer to the insured exception;
- the transfer to a partner of the insured exception;
- the transfer to a partnership in which the insured is a partner exception; and
- the transfer to a corporation in which the insured is a shareholder or officer exception.
Exception 1: The Transferor’s Basis
Code section 101(a)(2)(A) provides that the transfer for value rule does not apply if the transferee’s basis for determining gain or loss upon a subsequent sale of a policy or an interest in a policy is determined in whole or in part by reference to the transferor’s basis. In a nutshell this means that if the basis in the contract is carried over from the transferor to the recipient the death proceeds will remain income tax free.
The rule above states that the beneficiary will receive tax free proceeds if basis is determined in whole or in part by reference to the transferor’s basis. There are two common examples of the in whole portion of this exception. One is the case of outright gifts of policies that generally take the form of an absolute assignment of a policy for love and affection. Here, no consideration of any kind changes hands. The transferor merely gives the policy to the transferee.
Example. Assume an insured sells his son a $100,000 policy on his life for $100 when the policy’s gift tax value is $1,000. The son’s basis for determining gain or loss upon a subsequent sale will be the father’s basis (the net premiums he has paid) with an adjustment for any gift taxes the father may pay on the transfer. Here, the son’s basis is determined in part by his father’s basis. Even though there is a sale by the father of a policy worth $1,000 in return for $100 cash paid by the son, to the extent of the $900 balance ($1,000 value less $100 consideration paid) there is a gift from the father to the son. Tax law requires that the son carry over the father’s basis (cost) for the portion of the transfer that was a gift. The proceeds are income tax free at the father’s death because the tests of the transferor’s basis exception are met.
The other common example of a clear carryover basis situation is when a policy is transferred from one business to another in a tax-free corporate reorganization.
So where the transferee’s basis is determined by carrying over the donor’s basis (with an adjustment for any gift taxes paid), the proceeds will be income tax free even if there is a transfer and even if it is made in return for valuable consideration.
Planners must be wary of the seeming simplicity of this exception. Many think that as long as the transfer is characterized by the taxpayer as a gift or part gift-part sale, the proceeds will be exempt from the transfer for value rule. This is a very dangerous and misleading presumption.
The problem is based on the technical way the basis laws work. In some cases, the transferee’s basis is determined in whole or in part by reference to the transferor’s basis (and therefore the transfer for value rule is avoided due to this first exception).
In other cases, the transferee’s basis is not determined by reference to the transferor’s basis even though at least part of the transfer constitutes a gift and is considered so by the parties. Instead, basis is determined by the amount deemed paid by the transferee for the property.6 This falls outside the protective safe harbor.
In the example above where an insured sells his son a $100,000 policy for $100 when the policy’s gift tax value is $1,000, there is clearly a $900 gift and the son will determine his basis at least in part by carrying over his father’s basis (plus any gift tax payable). (The son can then add to his basis the $100 he paid, plus any premiums he pays after the transfer.) The entire proceeds will be received income tax free because the son’s lifetime basis in the policy is determined at least in part by referring back to the basis of the policy in his father’s hands.
Now let’s look at the result where the son’s basis may be determined by what he pays. Remember, the part gift-part sale protective rule only applies when it results in a carryover of all or a portion of the transferor’s basis.
The problem is that the transferee is considered to pay not only what he actually pays for the policy, but also any amount the transferee is deemed to pay by relieving the transferor of the obligation to pay a policy loan.
Here is where the trap lies: If the policy loan (and any cash or other property received in the exchange) is greater than the transferor’s basis, the transferee takes as his basis the higher of: (1) the amount the buyer actually pays for the policy plus the amount he is deemed to pay by reason of relieving the transferor of the obligation to repay the loan, or: (2) the transferor’s basis. Any gift tax payable is then added to the contract’s basis.7 So in this situation, the transfer is treated as if the transferee-buyer acquires the policy in a sale and not a gift!
Example. Assume a client has a $28,000 basis in a policy that he gives to his son. The basis is due to premiums he paid net of any dividends. At the time he gives the policy to his son, it is subject to a policy loan of $25,000. The client’s basis is $3,000 greater than the loan. At the date of the gift, the replacement value of the policy is $30,000. In this situation there will be no transfer for value problem. The father is deemed to “sell” his son $25,000 worth of policy (the amount of the loan debt he is relieved of) for consideration in that amount. The father is deemed to make a gift of $5,000 (the difference between the policy’s $30,000 value at the time of the transfer and its sale portion of $25,000). The son takes the policy at least partially with reference to his father’s basis. So the proceeds will be received income tax free.
Now assume the same facts as above except the father’s basis is only $22,000 rather than $28,000. The $25,000 loan against the policy exceeds the $22,000 basis by $3,000. If the father sells the policy for its loan amount rather than gives it to his son, the father will realize a $3,000 gain. Under this circumstance, the son’s basis is determined solely by the $25,000 amount he is deemed to have paid his father (i.e., the debt he is considered to have relieved his father of and assumed in the transaction). For purposes of computing the son’s basis, the father’s basis is irrelevant. Unfortunately, this means the son’s receipt of the proceeds will be subject to the transfer for value rule because the son does not determine his basis in whole or in part by reference to the transferor’s (his father’s) basis. He determines it solely on the amount paid for the policy. There is a transfer of a policy, for valuable consideration received, with none of the exceptions met, and therefore the entire proceeds are subject to ordinary income tax.
Under the transferor’s basis exception, it is generally safe to transfer life insurance to the insured’s spouse or ex-spouse (if the transfer is incident to a divorce).8 Why is such a transfer safe even if cash changes hands? Code section 1041 treats interspousal transfers as nontaxable events, so in the case where one spouse transfers a life insurance contract to another spouse, the consequences are:
No gain is recognized by either party for income tax purposes even if the policy is received in exchange for a surrender of marital rights.
The transferee spouse (or ex-spouse) takes as her basis the transferor’s basis and therefore falls within the transferor’s basis exception.
Under the transferor’s basis exception, the transferee stands in the shoes of the transferor. This means that a transfer of a policy to a transferor’s basis category of transferee carries over and retains the same tax treatment of the policy that it had in the hands of the transferor. In other words, if the proceeds were exempt before the transfer, they remain exempt after the transfer.
The opposite is also true. If the proceeds of a policy were subject to tax under the transfer for value rule before the present transfer, they continue to be tainted. A transfer to a transferor’s basis transferee is not enough to eliminate the taint. Where the last owner’s basis is determined in whole or part by reference to the prior owner’s basis, the income tax exclusion is limited to the sum of:
- the amount which the transferor could have excluded had no transfer taken place; plus
- any premiums and other amounts paid by the final transferee.
Example 1. Assume that an insured purchases a $500,000 policy on his own life and gives it to his daughter, who later sells it to the insured’s son. Here, the son must report the entire $500,000 (less the amount he pays for the policy and any premiums he later pays) as ordinary income when his father dies. Although the transfer from father to daughter is protected because of the daughter’s carryover of the father’s basis, that protection does not extend to the sale from her to the insured’s son.
Example 2. Assume an insured gives the policy on his life to his daughter, who later gives it to her own daughter. Here, the granddaughter’s basis is determined by a carryover of her mother’s basis which, in turn, is carried over from (and therefore determined by reference to) the insured’s basis. The proceeds will be income tax free.
Example 3. Assume a transfer of a policy from a corporation to X, a co-shareholder of Y, the insured. X pays the corporation an amount equal to the policy’s value at the time of transfer. Assume further that X, the new policyowner, then transfers the policy on his co-shareholder’s life to W, X’s wife, for love and affection. Although a transfer of a policy on X’s life to W, his wife, would be protected (because of the “in whole or in part” exception), the transfer of the policy on Y’s life was tainted even before X transferred it. The subsequent transfer to W from X does not cleanse the taint.
There is a solution. Make the next-to-last transfer to one of the four protected parties (the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer). At that point, the transfer for value taint is washed away.9 Proceeds will be income tax free if that party then makes an untainted gift.
Exception 2: Transfers to the Insured
Code section 101(a)(2)(B) provides that the transfer for value rule will not apply to transfers 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 officer. These protected party exceptions are obviously the safest of all the exceptions because they require the least verification and are easy to implement.
Of all of these protected party safe harbors, the most certain is the insured. The clearest, safest, most positive way to avoid the transfer for value rule is to be sure that the last transfer for valuable consideration is to the insured. No matter how little or how much money or other consideration is paid by the insured to obtain the policy, once the insured becomes the transferee, all prior transfer for value taint is eliminated and the proceeds regain (or retain) their income tax free status.
Since the transfer for value rule is an income tax provision, any transfer that is treated as made to the insured for income tax purposes should qualify for the transfer to the insured exception. Thus, a transfer to a trust for which the insured is treated as the income tax payer (e.g., an intentionally defective grantor trust) should qualify for the exception.10
Exception 3: Transfers to a Partner of the Insured
If the transfer is to someone who is the insured’s partner in a legitimate partnership, proceeds will be income tax free even if the transfer is for valuable consideration. The same is true for a transfer to a co-member of a Limited Liability Company (LLC), as long as the LLC is taxed as a partnership.
Assume two individuals are partners in a real estate development partnership and each partner owns a policy on his own life. Each partner purchases the policy on the other’s life. There is a transfer for value because there is a transfer of a policy for valuable consideration. However, because the transfer is to a partner of the insured, the proceeds will be received income tax free.
It appears that the only requirement under this safe harbor is that the transferee partner must own a legitimate (no matter how small) share of a legitimate operating or investment partnership. Even though the life insurance policy is in no way connected with the partnership or its operation, as long as the recipient partner is a partner of the insured (presumably at the date of receipt of the policy or the interest in the policy), the insurance proceeds should be income tax free.
Exception 4: Transfers to a Partnership in Which the Insured is a Partner
This exception, like the one above, has become quite popular in recent years because of its planning flexibility. It requires only that the policy be transferred to a partnership in which the insured is a partner (or to an LLC taxed as a partnership in which the insured is a member).
Example. Assume two individuals are partners in a real estate development partnership, and each partner owns a policy on his own life. Each partner sells the policy on his life to the partnership. Based on these facts there is a transfer for value, but it is exempt from the transfer for value rule because it is made to the insured’s partnership.
Practitioners often ask if a client can establish a partnership in name only to avoid the sting of the transfer for value rule. The IRS has approved a transfer of a policy to a partnership established specifically to receive and hold policies insuring the lives of its partners. However, a safer and suggested course is to transfer the policy to a partnership (or LLC electing taxation as a partnership) established for independent business or investment purposes.
Exception 5: Transfers to a Corporation in Which the Insured is a Shareholder or Officer
Under this safe harbor, the transfer for value rule does not apply to a transfer to a corporation if the insured is either: (1) an officer; or (2) a shareholder in the corporation (presumably on the date the policy is transferred).
Example. Assume an individually owned policy is transferred to the insured’s corporate employer to be used as key employee coverage or to fund a stock redemption buy-sell agreement. The insured at the time of the transfer is the treasurer of the company and owns 30 percent of the company’s stock. Thus, the transfer for value rule does not apply because the insured is both an officer (treasurer) and a shareholder.
Beware: This exemption does not protect transfers to persons who are merely:
- co-shareholders of the insured;
- key employees (no matter how important); or
- directors who are neither officers nor shareholders.
- Summary of Safe Harbors
- Transfers to the following persons are protected:
Anyone whose basis is determined by reference to transferor’s basis;
- The insured;
- The spouse of insured;
- The ex-spouse of insured, if the transfer is pursuant to a divorce or separation agreement;
- A partner of the insured;
- A partnership in which insured is a partner; and
- A corporation in which insured is a shareholder or officer.
Transfers to any of the following are not protected and may set the transfer for value trap:
- A co-stockholder of insured;
- A purchaser who takes the policy subject to a loan in excess of the transferor’s basis; and
- Any other person or entity not listed above.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM