H—Transfer for Value Rule

The transfer for value of a life insurance contract jeopardizes the income tax-free payment of its proceeds. Under the transfer for value rule, if a policy is transferred for a valuable consideration, the death proceeds will be taxable as ordinary income, except to the extent of the consideration, the net premiums and certain other amounts paid by the transferee.

The transfer for value rules extend far beyond outright sales of policies. The naming of a beneficiary in exchange for any kind of valuable consideration would constitute a transfer for value. Consideration does not have to be in money, but could be an exchange of policies or a promise to perform some act or service. However, the mere pledging or assignment of a policy as collateral security is not a transfer for value.

Specific exceptions to this rule allow a transfer for consideration to be made to the following, without jeopardizing the income tax-free nature of the death benefit:

1. Transfers to the insured.


2. Transfers to a partner of the insured.


3. Transfers to a partnership in which the insured is a partner.


4. Transfers to a corporation in which the insured is a stockholder or officer (but there is no exception for transfer to a co-stockholder).


5. Transfer in which the recipient’s cost basis in the policy is calculated in reference to the cost basis of the transferor (usually meaning a transfer between corporations in a tax-free reorganization if certain conditions exist).

A bona fide gift is not considered to be a transfer for value and subsequent payment of the proceeds to the grantee (donee) will be income tax-free. (Part sale/part gift transactions are also protected under the so-called “transferor’s basis exception” that provides that the transfer for value rule does not apply where the transferee’s basis in the policy is determined in whole or in part by reference to its basis in the hands of the transferor.)

The transfer for value problem does not exist with a partnership, because a transfer to a partner of the insured is one of the exceptions to the rule. Thus, it is possible to convert from an entity purchase agreement to a cross purchase agreement and use the same policies to fund the new agreement.

With respect to a corporation, once a stock redemption agreement (i.e., entity purchase agreement) has been funded with life insurance, it is not possible to change to a cross purchase agreement and use the same policies to fund the new agreement. Transfer by the corporation of an existing policy on the life of one stockholder to another stockholder would be a violation of the transfer for value rule (but transfer to a partner or a bona fide partnership of which the stockholder was a partner would fall within exceptions to the transfer for value rule). However, this problem does not exist in changing from a cross purchase agreement to a stock redemption agreement: the transfer to a corporation in which the insured is a stockholder is an exception to the rule (see 4 above).

Some planners have suggested the use of a trusteed cross purchase agreement to avoid a problem of multiple policies when there are more than just two or three stockholders. Under this arrangement, a trustee would be both owner and beneficiary of just one policy on each of the stockholders. However, it is likely that there is a prohibited transfer for value when one of the stockholders dies and the surviving stockholders then receive a greater proportional interest in the outstanding policies that continue to insure the survivors.

For example, assume A, B, C and D are equal stockholders in a corporation with a funded trusteed cross purchase agreement. Under the arrangement each stockholder is the beneficial owner of a one-third interest in the policies insuring the other three stockholders. Now assume D dies. A prohibited transfer for value could occur if D’s proportional interests in the outstanding policies insuring A, B and C pass to the surviving stockholders upon D’s death. However, the problem can be avoided by having the corporation purchase D’s interests in the policies insuring A, B and C, with the intention of funding a combined cross purchase and entity purchase agreement. Alternatively, the problem could also be avoided by simply using a stock redemption agreement.

The transfer-for-value rule does not apply to the transfer of a life insurance policy to a grantor trust, when the policy insures the life of the grantor of the trust (e.g. the policy is sold to the trust). For tax purposes the trust and the insured grantor are one and the same, and thus the sale is considered a transfer to the insured. Transfer for value problems can occur in rather unexpected circumstances. For example, the transfer of existing life insurance policies insuring stockholders to the trustee of a trusteed cross purchase agreement does not fall within one of the exceptions to the transfer for value rule. To avoid this initial ownership problem the trustee should be the original applicant, owner and beneficiary of the policies.

The sale of a life insurance policy in a viatical settlement (or similar commercial arrangement) is obviously a transfer for value. Previously, promoters and their tax council had made arguments as to why the arrangement was an exception – hence attempting to exempt the death benefit received by the investor(s). The 2017 Tax Act contains new provisions addressing what is referred to as “reportable policy sales.” These new provisions contain information reporting requirements, as well as specific language making it clear that any such “reportable policy sale” is NOT covered by an exception to the transfer for value. A prohibited transfer for value can also occur when a split-dollar agreement involving a trustee is terminated pursuant to a “rollout.”

When the agreement is between the employer and the trustee of an irrevocable trust, using endorsement split-dollar with the policy owned by the employer would require a transfer of the policy to a trustee who does not fall within any of the exceptions to the transfer for value rules. However, using collateral assignment split-dollar established under the “loan regime” will avoid this transfer for value problem.