136 / Are life insurance proceeds received by a creditor as collateral assignee or beneficiary “as interest appears” exempt from income tax?

If a creditor is collateral assignee, the creditor receives the proceeds as a recovery on the collateral and not as life insurance proceeds.¹ Consequently, if the creditor has not taken a bad debt deduction, the proceeds are received tax-free as a return of capital. They are tax-free, that is, to the extent of the unpaid debt and any premiums the creditor has paid but not deducted ( Q 132, Q 133). If the creditor, however, has received the tax benefit of a bad debt deduction, the proceeds must be reported as taxable income (except to the extent they represent a recovery of premium payments for which no deduction has been taken). If a portion of the proceeds represents interest on the debt, that portion is taxed as ordinary income to the creditor.²

If the creditor is named beneficiary as the creditor’s “interest might appear” on a policy owned by the debtor, the creditor receives the proceeds as payment of the debt and not as life insurance proceeds. Because the creditor must prove the debt to collect the proceeds, the proceeds are received because of the insured’s indebtedness rather than “by reason of the death of the insured,” and hence are not exempt under IRC Section 101(a). The proceeds, therefore, constitute taxable income to the creditor to the same extent that direct repayment of the loan would have resulted in income. This is so regardless of whether the debtor or the creditor has paid the premiums.³

A different situation arises if the creditor takes title to the insurance policy and releases the debtor from further obligation. Under these circumstances, the proceeds are received as life insurance proceeds, but a transfer for value has taken place ( Q 279). As a result, the proceeds are taxable income to the creditor to the extent that they exceed the value of the policy at the time of transfer and premiums and certain other amounts ( Q 279) paid after the transfer.⁴ There should be no tax liability under the transfer for value rule, however, if the creditor is a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or stockholder, unless the transaction qualified as a reportable policy sale (for tax years beginning after 2017).⁵