8778 / When will the sale of a life insurance policy cause the loss of the income tax exemption for death proceeds? What is the transfer for value rule?

Under IRC Section 101(a)(2), if a life insurance policy or any interest in a policy is transferred for a valuable consideration, the death proceeds generally will be exempt only to the extent of the consideration paid by the transferee and net premiums, if any, paid by the transferee after the transfer. Any interest paid or accrued by the transferee on indebtedness with respect to the policy is added to the exempt amount if the interest is not deductible under IRC Section 264(a)(4).¹ This provision regarding interest paid or accrued applies to contracts issued after June 8, 1997. Further, for purposes of this provision, any material increase in a death benefit or other material change in a contract shall be treated as a new contract with certain limited exceptions.²

After subtracting the permissible exclusions outlined above, the balance of the death proceeds is taxable as ordinary income. This is known as the “transfer for value rule.” If a sale or other transfer for value comes within any of the following exceptions to the transfer for value rule, the exemption is available despite the sale or other transfer for value:

(1)  The sale or other transfer for value is to the insured individual;³

(2)  The sale or other transfer for value is to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder.⁴ Members of a limited liability company (“LLC”) taxed as a partnership are considered to be partners for this purpose; or⁵

(3)  If the basis for determining gain or loss in the hands of the transferee is determined in whole or in part by reference to the basis of the transferor. This occurs, for example, where a policy is transferred from one corporation to another in a tax–free reorganization, where a policy is transferred between spouses, or where a policy is acquired in part by gift.⁶

Under the 2017 tax reforms, these exceptions do not apply if the transfer occurred in a reportable policy sale. A reportable policy sale means the acquisition of a life insurance contract (directly or indirectly) if the acquirer has no substantial family, business or financial relationship with the insured individual apart from the interest in the life insurance contract. This includes acquiring an interest in a partnership, trust or other entity that holds an interest in the life insurance contract.⁷ This new rule is effective for transfers occurring after December 31, 2017.

See Q 8779 for a more thorough discussion of when a life insurance policy is considered to have been transferred for value. See Q 8780 for a more thorough discussion of the exceptions to the transfer for value rule.