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Making a gift of a life insurance policy can prove to be anything but simple for clients who may not know what questions to ask in order to ascertain the potential tax consequences of the transaction. Transferring a policy that is subject to a policy loan can prove even more problematic, even if the transferee is a family member and the transfer is intended entirely as a gift.
Though the rule’s name might suggest otherwise, the transfer for value rule can create a serious tax trap for a client who transfers a life insurance policy, even if nothing tangible actually changes hands in the transaction. If the transaction is not structured properly, your client may find that the transfer for value rule has stripped the gift of life insurance of its most valuable feature—the tax-free treatment of the death proceeds.
The Transfer for Value Rule
Under the transfer for value rule, if a taxpayer transfers his interest in a life insurance policy for anything of value, the usual exclusion of the policy death benefits from gross income is limited to the sum of:
(1) the value of the consideration transferred and
(2) any policy premiums paid by the transferee.
Therefore, the rule can result in the loss of substantial tax benefits.
There are several exceptions to the rule, including transfers between the insured and himself and transfers where the basis in the hands of the transferee is measured in whole or in part by the basis in the hands of the transferor.
The Trap: Gifts of Life Insurance
Typically, when a client makes a gift of life insurance to a family member, he will not run afoul of the transfer for value rule because the basis in the hands of the transferee will carry over from the client, as transferor. However, if the policy is subject to a loan at the time of transfer, the transaction may be considered part sale and part gift, which, in some circumstances, will trigger the transfer for value rule and could cause the policy death proceeds to lose their income tax exemption.
Whether the transfer of a life insurance policy that is subject to an outstanding policy loan will trigger the transfer for value rule depends upon the transferor’s basis in the policy and the amount of the loan.
If the loan value exceeds the transferor’s basis in the policy, the amount of the loan that exceeds the basis is a transfer for value. This is because the transfer, while intended as a gift, will be treated partially as a sale—the transferee is considered to have “paid” the transferor’s debt. Conversely, if the loan value is less than the transferor’s basis, there is no transfer for value.
Structuring the Transaction
An irrevocable life insurance trust (ILIT) can allow the client to transfer a policy subject to a loan without triggering the rule. In order for the transaction to be effective, the transferor must structure the ILIT as a grantor trust so that the insured-transferor and the ILIT are taxed as a single entity. This structure allows the transfer to fall within one of the exceptions to the transfer for value rule, as it treated as a transfer from the insured to himself.
Since the client is entitled to choose the ILIT beneficiaries, he is able to effectively transfer the policy subject to the loan to the desired beneficiaries without jeopardizing the income tax exclusion of the remaining death proceeds.
Though this structure can help the client transfer the policy to his beneficiaries without triggering the transfer for value rule, the client-transferor takes the risk that he will die within three years of the transfer. If this is the case, the three-year rule (also known as the bring-back rule) operates to pull the value of the life insurance policy back into his or her taxable estate.
Conversely, if the client-transferor instead sells the policy to the ILIT for fair market value, he can avoid the three-year bring-back rule, which applies only to gifts of property made within three years of death. Unfortunately, this has its own drawback, as the IRS could characterize the dual transactions—providing the ILIT with the funds necessary to purchase the policy and the ILIT’s actual purchase of the policy—as a single transaction that is treated as a gift.
In reality, if your client is in good health and is therefore not concerned with the applicability of the three-year bring-back rule, structuring the transaction as a gift to an ILIT established for the benefit of his chosen beneficiaries can be key to avoiding the transfer for value rule trap in a situation where a life insurance policy is subject to a policy loan.