In this Section:

How to Avoid Tax Disasters That Doom Finances

We all know the tragic tale of the Titanic that ended in disaster when the great ocean liner hit an iceberg that no one saw.

You might wonder what the sinking of a ship has to do with life insurance. The answer is that running into the transfer for value rule (the iceberg) can lead to disaster. Bathed in obscurity like the gloom of night, the rule looms, waiting to doom death proceeds to suffer income taxes. This is because the transfer for value rule specifies that if a life insurance policy (or any interest in that policy) is transferred for something of value (for example, money or property), a portion of the death benefit is subject to income tax.

Fortunately, there are two classes of exceptions to the rule. The first involves transfers by gift to anyone. The second includes transfers to the insured, 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 shareholder. Unfortunately, as will be seen in some of the examples below, the applicability of the rule is not always obvious and can be a dangerous trap for the unwary.

Sale of a policy
In some situations, such as the sale of a policy, the application of the rule is obvious. For example, assume that A purchases a $100,000 policy on his life and later sells it to B for $10,000. Assume further that B names himself the beneficiary and pays $10,000 in premiums before A dies. This is clearly a transfer for value situation and results in B having to declare $80,000 of income ($100,000 death proceeds less the $20,000 B paid to purchase and maintain the policy).

Naming a beneficiary
In other situations, the rule is not as clear because, according to Internal Revenue Service
(IRS) Reg.  § 1.101-1(b), there does not have to be cash consideration or a formal transfer or assignment of ownership of the policy. An example of this would be when the owner of a life insurance contract names another person the beneficiary in exchange for any kind of valuable consideration. This could happen where an elderly policy owner names someone the beneficiary of their policy in exchange for the beneficiary’s promise to take care of the policy owner. In this example, because the death proceeds would be paid to the caregiver as a bargained-for consideration, the proceeds would be taxed on the amount minus the fair market value of the services rendered.

Cross-purchase buy and sell
Going further, you should note that what makes this provision particularly hazardous is the sometimes highly obscure nature of a “valuable consideration.” For example, where a cross-purchase buy and sell agreement is used, the participants normally have to purchase multiple policies on each business owner’s life. The actual formula for the number of policies required is N x (N-1) where N is the number of business owners participating in the agreement. For example, if there are five corporate shareholders, under a cross-purchase agreement, the total number of policies they have to buy is 5 x (5-1) = 20 policies. As this is a burdensome approach to fund a buy and sell arrangement, some have suggested that the participants need only establish a trust and have the trustee purchase a single policy on each participant’s life.

The problem is that this approach probably violates the transfer for value rule. That is because when a participant dies, the participant’s interest in the policies on the other participants shifts to the survivors. For example, if A, B and C have such an arrangement and A dies, his interest in the policy on B goes to C and his interest in the policy on C goes to B. Viewing these shifts of interests in light of the transfer for value rule, each shift may be a transfer for value with the consideration being the mutuality of each participant forgoing their interest in the coverage on the others at their death.

Fortunately, there is an exception to the transfer for value rule for partners of the insured. Consequently, this allows a single-policy-per-participant approach to work when the participants to the cross-purchase buy and sell agreement are in the same partnership. In addition, it can work for the shareholders of a corporation if they are also partners in a separate business.

Gift of a policy subject to a loan
Although there is an exception to the transfer for value rule for gifts of life insurance policies, it does not clearly apply to situations where a loan on the policy exceeds the donor’s cost basis for the contract (for example, if the donor paid $15,000 in premiums on a policy with a cash value of $25,000 and a $20,000 outstanding loan).

The reason is that the exception for gifts requires that the transferee’s basis be the greater of the transferor’s basis or the amount paid, which presumably would be the amount of the loan, according to IRS Reg. 1.1015-4, which covers part gift, part sale transactions. Consequently, the transferee’s basis would seem to be the $20,000 loan and not the transferor’s basis of $15,000. It should also be noted that the transferor would have to recognize income on the gift to the extent that the loan exceeded the transferor’s basis ($20,000 loan - $15,000 premiums paid = $5,000 income).

Starting or terminating split dollar arrangements
In split dollar life insurance arrangements, care must be taken that any shift of interests in the policy fits into one of the exceptions to the transfer for value rule. For example, if an existing policy is owned by a corporation and transferred to the insured to start an IRS Section 7872 type of interest-free loan arrangement, there will be no problem since transfers to the insured are exempt from the rule. Similarly, a transfer to the corporation by the insured to begin a split dollar endorsement arrangement (governed by Internal Revenue Code [IRC] Sections 61 and 83) would be exempt if the insured were an officer or shareholder of the corporation. Likewise, when the policy is formally transferred to the insured at the termination or rollout of the endorsement arrangement, there is no problem since transfers to the insured are exempt. On the other hand, a transfer to a third party will not be exempt, unless it is covered by one of the exceptions, such as where the transferee is a partner of the insured.

Selling a business
If a business that owns life insurance policies on key employees is sold and the policies go along with the sale of other assets, it is probable that the policies will be deemed to have been transferred for value. Consequently, if they are retained by the new owner, the death proceeds will likely be subject to income tax to the extent that they exceed the prices paid for the policies and subsequent premiums paid by the new owner of the business.

Whenever there is a transfer of any interest in a life insurance policy, the parties to the arrangement should determine if the transaction constitutes a violation of the transfer for value rule of IRC § 101(a)(2). Unfortunately, as can be seen from the rather obscure applicability of the rule to some transactions, like the Titanic and the iceberg, it can be a disaster waiting to happen for those who are less than vigilant.


Louis S. Shuntich, J.D., LL.M., is director, Advanced Consulting Group, Nationwide Financial. Louis may be contacted at [email protected] [email protected].

More from InsuranceNewsNet