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.