How to Avoid Transfer for Value Problems for Business Uses of Joint Life (First to Die) LIfe Insurance

The transfer for value rule essentially says that death benefits will be subject to income tax to the extent they exceed the consideration paid for the policy if the policy has been transferred for valuable consideration. The question arises after the first death whether the increase each shareholder now has in the death benefit payable on the next to die (assuming, of course, that the trust exercises options to keep an equivalent JL coverage on the surviving shareholders) is an indirect transfer from the first deceased (upon his or her death) which violates the transfer for value rule. The value in this case would be the consideration on the part of all shareholders for entering into the agreement. If the transfer for value rule applies, the increase in the death benefit after the first death would be subject to tax to the extent it exceeds consideration paid.

Experts are divided on the question, but some have argued that a properly designed trust will avoid the problem. The key, it is argued, is to draft the trust instrument so that the shareholders only have an interest in a trust and not an interest in an insurance policy. With the trust as the owner and beneficiary and with each shareholder’s interest in the trust limited to a life interest only, there is nothing transferred at death and, consequently, no transfer for value.

Also, shareholders can avoid the transfer for value problem if each shareholder owns a JL policy insuring the other shareholders. However, after the first death, the face value on the policies owned by each survivor on the lives of the remaining survivors generally would be inadequate to buy out the second-to-die shareholder’s ownership interest (which would typically increase after the first death). Also, the value of the policy owned by the first shareholder to die on the other shareholders would be included in the deceased’s estate. Because a transfer of the deceased’s policy to the surviving shareholders would represent a transfer for value, the recommended plan of action is to transfer the policy to the corporation. The transfer of policies on the lives of shareholders to a corporation is an exception to the transfer for value rule. They could then amend the buy-sell agreement to effect a combination cross-purchase-entity-buyout plan.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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