295 / If an employer owns a policy on the life of an employee and sells the policy to the employee for its cash surrender value, can the sale result in taxable income to the employee or to the employer?

Transfers of property after June 30, 1969, in connection with the performance of services are governed by IRC Section 83. Effective for transfers after February 12, 2004, regulations under IRC Section 83 provide that, “In the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, or any undivided interest therein, the policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed), other than current life insurance protection, are treated as property.”

In other words, the cash surrender value may not fully reflect the value of the property transferred. Although it isn’t clear, the policy’s “interpolated terminal reserve” (for a whole life policy) or “tax reserve” (for a universal life policy) may more accurately reflect the value of a life insurance policy. For guaranteed policies, especially universal life policies with a lifetime guaranty, the policy may have a value well in excess of policy cash surrender value. Before selling a policy to the insured, it may be advisable to attain a professional independent valuation.

For a policy which is part of a split dollar arrangement entered into on or before
September 17, 2003, and which is not materially modified after that date, only the cash surrender value is considered “property.”¹ Therefore, if a policy’s actual value was more than the cash surrender value, then a sale may result in taxable income to an employee.

Under prior regulations where only the cash surrender value was considered property, the IRS concluded that where full ownership of a life insurance policy was transferred from an employer corporation to a key person, IRC Section 83 required that the employee include as income a policy’s cash surrender value, less any payments the employee made for the policy.²

If a policy is sold by an employer for its cash surrender value, which is less than the total premiums paid, the employer can exclude from gross income the amount received from the sale of the insurance policy to the employee.³ No loss deduction is allowable, however, when total premiums paid exceed the sale price ( Q 62).

If a policy is sold by an employer for the cash surrender value, which exceeds the employer’s basis in the contract, the amount realized by the employer in excess of basis is taxable income to the employer.