77 / Are death proceeds wholly tax-exempt if an existing life insurance policy is sold or otherwise transferred for valuable consideration?

Editor’s Note: The 2017 tax reform legislation restricted the availability of the exceptions to the transfer for value rule for commercial transfers (i.e., life settlement transactions or viatical settlements).

As a general rule, death benefit proceeds received by the beneficiary of the policy are wholly exempt from income tax ( Q 63, Q 65). An exception to this rule, however, is that the proceeds are not wholly exempt if the policy, or any interest in the policy, has been transferred, by assignment or otherwise, for valuable consideration.¹ This exception is known as the “transfer for value rule.” Under this rule, the proceeds will be subject to income tax to the extent that they exceed the consideration paid (and premiums subsequently paid) by the person to whom the policy is transferred. Also, for contracts issued after June 8, 1997 (in taxable years ending after this date), any interest paid or accrued by the transferee on indebtedness with respect to the policy is added to the amount exempt from tax after the transfer if the interest is not deductible under IRC Section 264(a)(4).²

This unfavorable result is avoided if the transfer for value is “to the insured, to a partner of the insured, or to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, or if the basis of the policy in the hands of the transferee must be determined (at least in part) by reference to the transferor’s basis (e.g., carryover basis). For tax years beginning after 2017, these exceptions will not apply if the policy was transferred in a reportable policy sale (see Q 279).”³ (For application of the transfer for value rule to business insurance, see Q 279 to Q 290.)

Planning Point: If a transfer is contemplated and no exception is available, it is generally accepted that creation of a partnership between the insured and the transferee at or near the time of transfer can avoid the application of the transfer for value rule. This newly created partnership, however, should have a valid purpose (other than tax avoidance) so as to not be disregarded by the IRS. Likewise, a transfer for less than adequate consideration may be considered part gift/part sale such that it qualifies as an exception under the so-called “basis exception.” Please note that the exceptions above do NOT include a transfer to a fellow shareholder of a corporation in which the insured is a shareholder. It is often (wrongly) assumed that a transfer to a fellow shareholder or officer is an exception since the transfer to a fellow partner is an exception.

The unfavorable result, however, is not avoided merely because the person to whom the policy is transferred has an insurable interest in the insured. For example, often an insured will transfer his or her policy to a son or daughter. If the transfer is a gift, the named beneficiary will receive the proceeds wholly free of income tax. But if the insured receives valuable consideration for the transfer, the proceeds will be taxable income to the beneficiary (to the extent they exceed the consideration, premiums, and other amounts subsequently paid).⁴ The fact that no money was exchanged for the policy does not necessarily mean that the transfer was a gift and therefore was not subject to the transfer for value rule. For example, when two insured individuals assign policies on their own lives to each other at about the same time, it could be argued that neither transfer was a gift. The transfer of a policy subject to a nonrecourse loan may be a transfer for value ( Q 280).