8781 / If an employer (or the employer’s qualified plan) sells or distributes a policy that insures an employee’s life to the insured’s spouse or other family member, will the transfer cause the loss of the income tax exemption for death proceeds?

Yes, generally, unless the transferee is a partner of the insured. The exceptions to the transfer for value rule will not exempt this type of transaction from the general rule. Therefore, if a sale is involved, the death proceeds will be taxable to the extent that they exceed the consideration paid by the purchaser plus net premiums, if any, paid after the sale. Any interest paid or accrued by the transferee on policy indebtedness may be added to the exempt amount under certain circumstances.

Even if a spouse or family member pays nothing for a policy, a transfer may be considered a transfer for value based on the idea that the employee’s past or promised future services constituted a valuable consideration for the transfer. The proceeds then probably would be taxable to the extent that they exceed the value of the contract at the time of transfer plus any subsequent premium payments and certain policy indebtedness.

The transfer for value rule would not cause taxation of the proceeds of a policy that is
(i) transferred to an insured, followed by a gift from the insured to the insured’s spouse or family member, or (ii) a sale to the insured’s spouse after July 18, 1984.¹ A federal appeals court refused to treat a direct transfer by an employer to the wife of an insured employee for a consideration as two transfers merged into one: a transfer to the insured employee and then a gift from him to his wife.²