8780 / What are the exceptions to the transfer for value rule that will permit a policy to be sold or otherwise transferred for value without the loss of the income tax exemption for death proceeds?

Editor’s Note: Note that under the 2017 tax reform legislation, the generally applicable exceptions to the transfer for value rule do not apply if the transfer occurred in a reportable policy sale (see below).

Several exceptions exist to allow proceeds of a life insurance contract to maintain their tax-exempt status even if there has been a transfer for value. If a sale or other transfer for value comes within any of the following exceptions to the transfer for value rule, the exemption from gross income is available despite the sale or other transfer for value:

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

(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.² Members of a limited liability company (“LLC”) taxed as a partnership are considered to be partners for this purpose; or³

(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.⁴

For example, if a corporation purchases a policy insuring a key person and later sells it to the insured, the proceeds will be received wholly tax-exempt by the beneficiary despite the sale to the insured.⁵

Under the 2017 tax reforms, the exceptions discussed above 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.⁶ This new rule is effective for transfers occurring after December 31, 2017.

Moreover, a transfer to a trust that is treated as owned wholly or in part by the insured comes within the exception as a transfer to the insured to the extent the insured is treated as owner.⁷ An individual is treated as owner of a trust where the individual retains control over property the individual has transferred to the trust so that the income on that property is taxable to the individual under IRC Sections 671-679.

Where a policy is transferred more than once but the last transfer, or the last transfer for value, is to the insured, a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, the proceeds will be wholly tax-exempt regardless of any previous sale or other transfer for value.⁸ If the insured transfers the policy for a valuable consideration, and the transfer does not come within any of the exceptions to the transfer for value rule, the proceeds again will lose their tax-exempt status.

Example: X Corporation purchases an insurance policy for a single premium of $500 with a face amount of $1,000 upon the life of A, one of its employees, naming the X Corporation as beneficiary. The X Corporation transfers the policy to the Y Corporation in a tax-free reorganization (the policy having a basis for determining gain or loss in the hands of the Y Corporation determined by reference to its basis in the hands of the X Corporation). The Y Corporation later transfers the policy to the Z Corporation for $600. The
Z Corporation receives the proceeds of $1,000 upon the death of A. The amount which the Z Corporation can exclude from its gross income is limited to $600 plus any premiums paid by the Z Corporation subsequent to the transfer of the policy to it.

If Z Corporation, however, before A’s death, transfers the policy to the N Corporation, in which A is a shareholder, the N Corporation would receive the $1,000 proceeds upon A’s death free from income taxes.⁹