Typical Personal Life Insurance Planning Problems

Transfers of life insurance policies between family members other than spouses are a quicksand pit for clients and their planners.

Assume an insured purchases a policy on his life from his corporate employer. He then immediately names his wife as beneficiary. She collects the policy proceeds upon the insured’s death. The proceeds should be exempt because the transfer is to a proper party, the insured.

Not so easy to recognize are the much more deadly part gift-part sale situations discussed above which are usually triggered by policy loans. If a transferred policy is subject to a policy loan, the amount of that loan is treated as an amount paid for the policy. In most cases the insured’s basis (net premiums paid) exceeds the amount of the loan. Therefore, the transferee’s basis is determined by reference to the transferor’s and there will be no problem.

But where the amount of the policy loan exceeds the transferor’s basis, two adverse results are likely:

  1. To the extent the loan exceeds the transferor’s net cost; ordinary income is realized just as if the policy is sold to the transferee for a payment in the amount of the loan.
  2. The transferee’s basis is determined, neither in whole nor in part by reference to the transferor’s basis but by the sale price—the amount of the loan. The result? The transferor’s basis exception is not applicable.

There is a solution to the policy loan tax trap: Limit the amount of any proposed loan to some level that is clearly less than the transferor’s basis. Then there will be no taxable sale and the transferee’s basis will clearly be determined by reference to the transferor’s basis.

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

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