279 / Will a sale or other transfer for value of an existing life insurance policy or any interest in a policy cause loss of an income tax exemption for death proceeds?

Yes, as a general rule.

IRC Section 101(a)(2) provides that if a policy or any interest in a policy is transferred for a valuable consideration, death proceeds generally will be exempt only to the extent of the consideration paid by the transferee and net premiums, if any, paid by the transferee after the transfer. Any interest paid or accrued by the transferee on indebtedness with respect to the policy is added to the exempt amount if the interest is not deductible under IRC
Section 264(a)(4).¹ This provision regarding interest paid or accrued applies to contracts issued after June 8, 1997, in taxable years ending after this date. Further, for purposes of this provision, any material increase in a death benefit or other material change in a contract shall be treated as a new contract with certain limited exceptions.²

The balance of death proceeds is taxable as ordinary income. This is the so-called transfer for value rule. If a sale or other transfer for value comes within any of the following exceptions to the transfer for value rule, the exemption is available despite the sale or other transfer for value:

(1)     the sale or other transfer for value is to the insured ( Q 282);³

(2)     the sale or other transfer for value is to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder ( Q 285 to Q 290).⁴ Members of a limited liability company (“LLC”) taxed as a partnership are considered to be partners for this purpose; or⁵

(3)     the basis for determining gain or loss in the hands of the transferee is determined in whole or in part by reference to the basis of the transferor. This occurs, for example, where a policy is transferred from one corporation to another in a tax–free reorganization ( Q 290), where a policy is transferred between spouses ( Q 106), or where a policy is acquired in part by gift ( Q 79).⁶

The exceptions to the transfer for value rule do not apply if the transfer occurred in a reportable policy sale. A reportable policy sale means the acquisition of a life insurance contract (directly or indirectly) if the acquirer has no substantial family, business or financial relationship with the insured individual apart from the interest in the life insurance contract. This includes acquiring an interest in a partnership, trust or other entity that holds an interest in the life insurance contract.⁷ This
new rule is effective for transfers occurring after December 31, 2017.

Planning Point: Notice that the exceptions include transfers to a partner of the insured or a partnership in which the insured is a partner. But, notice that the exception only includes a transfer to a corporation in which the insured is an officer or shareholder; it does not include a transfer to another officer or shareholder.

Planning Point: Under IRC Section 1041, no gain or loss is recognized upon the transfer of property between married taxpayers. As a result, the basis in the hands of the transferor in such a transfer is equal to the basis in the hands of the transferee, i.e., carry-over basis. For this reason, a sale between such spouses or between trusts of which each spouse is a grantor, may qualify for an exception to the transfer-for-value rule under the basis exception of IRC Section 101(a)(2)(A), all other things being equal.

1.     IRC § 101(a)(2).