79 / Will the transfer of a life insurance policy between spouses result in loss of the tax exemption for the death proceeds?

The transfer of a life insurance policy between spouses (or former spouses if incident to a divorce, Q 106) generally will not result in the loss of exemption for the death proceeds if the transfer occurs after July 18, 1984, (unless the transfer is pursuant to an instrument in effect on or before such date), or after December 31, 1983, and both spouses (or former spouses if incident to a divorce) elect to have the nonrecognition rules of IRC Section 1041 apply.

The transferee is treated as having acquired the policy by gift and the transferor’s basis is carried over to the transferee.¹ IRC Section 101(a)(2)(A) provides that the transfer for value rule does not apply if the basis of the contract for determining gain or loss in the hands of the transferee is determined by reference to the basis of the contract in the hands of the transferor. If a life insurance policy with a loan is transferred in trust and gain is recognized by the transferor ( Q 106), the basis in the transferee’s hands is adjusted to reflect the gain, but the transfer may nonetheless come within an exception to the transfer for value rule ( Q 279).

If the transfer occurs either prior to July 19, 1984, or after July 18, 1984, but pursuant to an instrument in effect before such date and no election to have the nonrecognition rules of IRC Section 1041 apply has been made, then the nature of the transfer determines whether the transfer for value rule applies. If the transfer was made pursuant to a property settlement agreement incident to a divorce, then the policy may be considered to have been transferred for value (e.g., in exchange for the release of marital rights). If the transfer between spouses was in the nature of a gift, then no loss of the exemption would result.