There are a number of situations in which clients can fall into the transfer for value trap in the employee benefit planning area. One is where there is a transfer of life insurance policies to the trustee of a qualified retirement plan. The transfer may take place as a part of the corporate employer’s contribution to the plan on behalf of the participant or as a part of a participant’s voluntary contribution to the plan.
In most cases the client will succeed if the transaction is properly structured and the following no significant change of ownership rationale is employed.
- Assume an agreement between an employee, his employer, and a trust that provides for the employer to purchase an existing life insurance policy from the employee for its cash value. The employer proposes to transfer the policy to the trust as a part of the employer’s required annual contribution to the trust. The trustee will pay the premiums on the policy. At the employee’s death the trustee will pay the insurance proceeds to his designee. Assume the proceeds are in fact paid to the plan trustee, who turns them over to the insured’s designee.
There is no transfer for value problem here because there is no significant change in beneficial ownership. The proceeds retain their income tax free status because, in essence, there is no transfer and therefore the transfer for value rule cannot apply.
- Assume a successor corporation’s retirement plan buys life insurance contracts from a predecessor employer’s Keogh plan. Here, the purchase of the insurance by the new trustee from the old trustee for the policy’s cash value at the date of purchase should not be a transfer for value because no significant change in the beneficial interest of the contract occurs.
- Assume an employee-participant personally owns a life insurance contract with a cash value. The employee-participant wants to transfer that policy (as a voluntary employee contribution) to a profit sharing trust of which she is a participant. Under the plan terms, the proceeds continue to be payable to the employee’s beneficiary and the policy’s cash surrender value is payable to the participant upon her retirement or other termination of employment.
Because the proceeds are payable to the employee’s designated beneficiary upon her death and the cash surrender value is payable to the participant upon her retirement or other termination of employment, there is no significant change in the policy’s beneficial ownership. Therefore, the IRS should conclude that there is no transfer for value.
- Assume a corporation establishes an irrevocable rabbi trust with a third party trustee. Assets in the rabbi trust remain subject to creditors of the corporation if it becomes insolvent or bankrupt. Participants receive only an unsecured right to the assets in the trust. The employer transfers certain life insurance contracts to the trust. The employer or the trust will pay the premiums and the trust will become the nominal owner and beneficiary of the contracts upon their transfer to the trust.
Is there a transfer of a policy or an interest in a policy by the corporation? Here, the proceeds should be excludable from income tax of the trust and of the employer because there is never the requisite transfer. The trust should be viewed not as a trust but as an agency or alter ego of the employer. There is no change in equitable ownership of the policies, so the death benefits of the policies will retain their income tax free status.
Split-dollar life insurance arrangements are tricky and, as noted above, are potential transfer for value problem areas.
- Assume the insured’s wife owns a policy on his life. She then collaterally assigns the policy to the insured’s solely-owned corporation to fund a split-dollar arrangement. Thereafter, the wife transfers her interest in the policy, subject to the corporation’s rights under the split-dollar arrangement, to the insured.
The insured and the corporation propose to enter into a new split-dollar agreement. The insured intends to assign his interest in the policy to his wife. She will then name herself as beneficiary of the proceeds in excess of the amount due the corporation under the split-dollar plan.
Is there a problem with this arrangement? The transfer of rights in the policy to the corporation qualify for the proper party exemption provided for transfers to a corporation in which the insured is either an officer or shareholder. So any amounts received under the policy upon the death of the insured should be entirely income tax exempt. The transfer of any rights in the policy to the insured should be similarly exempt. The final transfer, a gratuitous transfer of the insured’s policy rights to his wife, should also be exempt because she takes as her basis in the contract an amount determined in whole or part by reference to the insured’s basis.
- Assume an insured owns all of the stock of a professional corporation. The firm owns a $1,000,000 life insurance policy on the shareholder’s life. The insured purchases the policy from the corporation in exchange for its cash value. The insured then gives the policy to his wife. The wife sets up a split-dollar arrangement with the insured’s corporation and collaterally assigns the policy to the corporation.
Here, the beneficiary should collect the proceeds free of income tax because the first transfer from the corporation to the insured is a transfer to the insured and the second transfer is one in which the transferee’s basis is determined in whole or in part by reference to the transferor’s.
- Assume a corporation owns several policies on the life of its shareholder, M. The corporation sells the policies on M’s life to an irrevocable trust established for his spouse and children. The trust is a partner of the insured and his son in a business venture and has been so for almost twenty years.
Here, the IRS will probably hold that because the trust is the insured’s business partner, the proceeds will be income tax free as long as the partnership itself has an independent business or investment reason for existence separate and apart from meeting the transfer for value exception.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM