The Transfer For Value Tax Trap (CC 03-29)

An important exception exists to the general rule of I.R.C. §101 that life insurance proceeds are excluded from the gross income of the beneficiary.  This is known as the “transfer for value rule.”  Thus, after the initial issuance of a life insurance policy, if it is subsequently transferred for  “valuable consideration,” the income tax exclusion under §101(a) is lost, and the beneficiary will have to include in gross income, the death proceeds received, to the extent that they exceed the consideration paid by the transferee of the policy plus any subsequent premium payments or other costs of maintaining the policy subsequent to the transfer [I.R.C. §101(a)(2)].

The exempting of life insurance proceeds from income taxation is presumably based upon a rationale that insurance functions as an alleviation of economic hardship flowing from the insured’s death.  This rationale may well be inapplicable in cases where an insurance policy has been transferred for valuable consideration. When a policy is “purchased” by one party from another the situation begins to look more like an investment or business type transaction, in which the eventual receipt of the proceeds on death of the insured is a bargained for benefit, having no strong policy rationale for exclusion from income of the recipient.

Example

John purchases a $750,000 life insurance policy on his own life, naming his brother Tom as the beneficiary.  Subsequently, John transfers the ownership of the policy to Tom for $5,000.  This is a transfer for value under I.R.C. §101(a)(2).  During the succeeding four years Tom pays annual premiums of $4,000 per year. Thereafter, John dies and Tom receives the $750,000 death benefit under the policy.  Because of the transfer for value rule, Tom realizes ordinary income in the amount of $729,000 (the $750,000 proceeds, less the $21,000 which he paid to acquire and maintain the policy).

The transfer for value rule frequently becomes a tax trap for unwary policyholders.

Neither Cash Consideration Nor Formal Transfer of Policy Ownership Are Necessary for Triggering of the Rule

The transfer for value rule can come into play under a variety of circumstances in which a party acquires an interest in life insurance policy proceeds for some form of valuable consideration.  There need not necessarily be a formal transfer or assignment of ownership of the policy [Reg. §1.101-1(b)].  

For example the naming of a beneficiary in exchange for any kind of valuable consideration could constitute a transfer for value.  The granting by separate agreement of a right to receive all or part of the death benefit would constitute a transfer for value, as long as there is consideration given for such right [see Reg. §1.101-1(b)(4)].  

Whether or not the policy has a cash value at the time of the transfer for consideration has no bearing on the applicability of the transfer for value rule.  

A transfer for value can occur even though no purchase price per se is paid for the interest in the policy, as long as the transferor receives some type of valuable consideration.

Example

In a conversation between an elderly disabled widow and her cousin, the cousin agrees to move in and care for the widow, who in return agrees to name the cousin as beneficiary as to half of her insurance policy.  Because the insurance proceeds ultimately received by the cousin were the result of bargained-for consideration in the form of providing in-home care, the proceeds will be taxable income to the cousin, but only to the extent that they exceed the fair value of the services rendered.

Pledge Of Policy As Collateral

If an insurance policy is pledged as collateral to secure a loan or other obligation, this is not deemed a transfer for valuable consideration, and will not generally trigger the transfer for value rule. Thus, if the insured dies owing a debt secured by pledge of his insurance policy, and the pledgee receives all or a portion of the insurance proceeds in satisfaction or reduction of the debt, such proceeds will not be gross income to the recipient [Reg. §1.101-1(b)(4)]. See the heading “Proceeds Received By Creditors” in Section 19.1, Subdivision B1 for discussion of the applicability of §101 to such payments.)

Common Situations Involving The Transfer For Value Tax Trap

Transfer of Policy Subject to Policy Loan

If ownership of a life insurance policy is transferred at a time when the policy is subject to a policy loan, even if no other consideration is received for the transfer, it will be deemed a transfer for value.  Under the IRS’s rationale in such a situation, the transferor realizes consideration in the form of relief from the debt represented by the policy loan [see Rev. Rul. 69-187, 1969-1 C.B. 45]. The transferor-taxpayer is considered to benefit from discharge of debt upon disposition of an asset securing the debt (the life insurance policy), even when the debt is “non-recourse,” as is the case with an insurance policy loan [see Reg. §1.1001-2(a)(4)(i)].

Buy-Sell Agreements

Since buy-sell agreements are commonly funded with life insurance, and it is sometimes determined to be advantageous to make changes in the ownership of the policies involved (e.g., ownership by the stockholder/insureds, rather than by the corporation), care must be taken to avoid the transfer for value trap in connection with any such transfers. 

Close corporations and buy-sell agreements are discussed in Section 14. 

Corporate tax issues are discussed in Section 14.1  

Partnerships and buy-sell agreements are discussed in Section 13.

Split-Dollar Plans

If a split-dollar plan is established utilizing an existing policy, or if a policy subject to a split-dollar plan is rolled out to a designee of the employee/insured, there is a potential transfer for value problem. Split-dollar is discussed in Section 15.2.

Purchases and Sales of Businesses

If a business that owns one or more life insurance policies (e.g., key man policies) is sold, or its assets transferred in liquidation, it is likely that the policies will be deemed to have been transferred for value, and if retained by the acquiring party until the death of the insured, the death benefit (in excess of the consideration paid for the policy’s acquisition and subsequent maintenance) will likely be treated as ordinary income.

Transfer for value problems can be avoided in all of the above situations, and many others, if there is a clear understanding of the statutory exceptions to the transfer for value rule, discussed immediately below.

Important Statutory Exceptions To The Transfer For Value Rule

I.R.C. §101(a)(2), which sets forth the transfer for value rule, contains two important exceptions:

·         The "Transferor’s Basis Exception"—I.R.C. §101(a)(2)(A), and

·         The "Proper Party Exception"—§101(a)(2)(B)

Transferor’s Basis Exception—I.R.C. §101(a)(2)(A)

The so-called “transferor’s basis exception” provides that the transfer for value rule does not apply where the transferee’s basis in the policy is determined in whole or in part by reference to its basis in the hands of the transferor.  This exception is of great importance in the context of policy transfers that constitute, at least in part, gifts.

Transfers That Are Part Sale and Part Gift

When property is transferred by gift, the property takes a “carryover” basis in the hands of the transferee; i.e., the transferor’s basis is carried over and becomes the basis of the property in the hands of the transferee. While this exception would eliminate all pure gifts of insurance policies from the application of the transfer for value rule, a pure gift transfer (for no consideration whatsoever) would not be subject to the rule, even absent the exception, since the rule itself only applies when the transfer involves at least some consideration.  On the other hand, the exception is important in situations where a transfer has a gift element, but the transferor receives at least something in connection with the transfer.  This is referred to as a part-gift, part-sale transfer.  Because the transferor’s basis exception to the transfer for value rule operates when the transferee’s basis is determined in whole or in part by reference to the transferor’s basis, the exception will apply in a part-gift, part-sale situation, since the gift portion of the transfer will involve a carryover basis.

Example

Bill is the owner of a $500,000 insurance policy on his life.  His basis in the policy is $10,000; the cash value of the policy is $12,000.  Bill transfers ownership of the policy to his son, Sheldon, for an agreed consideration of $2,500.  Bill has made a part-gift, part-sale of the policy, the gift being the excess of the policy’s fair market value (measured by the cash value) over the amount paid.  Under the carryover basis rule applicable when there is a gift involved, Sheldon’s basis in the policy would be $10,000, Bill’s basis at the time of the transfer, even though Sheldon paid only $2,500 for the policy.  Even though there was a transfer of the policy for valuable consideration, the transfer for value rule would not apply, because of the applicability of the transferor’s basis exception  (i.e., Sheldon`s basis is determined in whole or in part by reference to Bill`s basis).

It should be noted that in a part-gift, part-sale situation where the amount of consideration received by the transferor exceeds the transferor’s basis (even though it is  less than the market value of the policy), the carryover basis rule is not applicable, and the transferee’s basis is the amount of consideration furnished (i.e., the amount paid) [see Reg. §1.1015-4(a)(1)].  In such a situation the transfer for value rule exception would not operate, and the rule would apply. In the example above, if Sheldon had paid $11,000 for the policy, that would be his basis, and the transfer for value rule would apply (i.e., Sheldon`s basis would not be determined in whole or in part by reference to Bill`s basis but instead by reference to his cost of acquiring the policy).

Policy Transfers in Tax Free Reorganizations

Under a number of circumstances involving the transfer of property to a corporation in connection with its formation or reorganization (e.g., in a merger transaction), the transfer will not be considered a taxable transaction. In such circumstances, the property will take a carryover basis in the hands of the transferee. Thus, if a life insurance policy is transferred to a corporation in such a tax-free transaction, it’s basis in the hands of the transferee will be determined by reference to the basis in the hands of the transferor, and, thus, the transfer for value rule will not be applicable.

Policy Transfers Between Spouses or Incident to Divorce

Generally, the transfer for value rule does not apply to the transfer of life insurance policies between spouses as long as the transfer occurred after July 18, 1984, and both spouses elect to have the nonrecognition rules of Code §1041 apply [I.R.C. §§101(a)(2) and 1041]. The transferee`s basis in the policy is equal to the transferor`s adjusted basis immediately before the transfer [I.R.C. §1041(b)(2)], regardless of whether or not any consideration was paid, and thus, the transfer falls within the "transferor`s basis exception" to the transfer for value rule.

The transfer for value rule will also not apply in the case of life insurance policies transferred between spouses (or former spouses) pursuant to a divorce decree, as long as the divorce decree is entered into after July 18, 1984, and the election is made to have the Code §1041 nonrecognition rules apply.

Transfer For Value Taint Cannot Be Removed by Subsequent Transfer That Would Otherwise Qualify for the Transferor’s Basis Exception

If a policy has been the subject of a transfer for value, and neither of the exceptions to the transfer for value rule is applicable, the death benefit will be subject to taxation as ordinary income.  Once this “taint” attaches to a transferred policy it cannot be eliminated by a subsequent transfer to another party (with limited exceptions, discussed below), even if the subsequent transfer is totally gratuitous and involves no valuable consideration.  Just as the basis in the hands of the transferor will carry over to the transferee, so will the “taint” in effect carry over. See Regs. §§ 1.101(b)(2) and 1.101-1(b)(3)(iii), which provide that in the case of a transfer involving a carryover basis, the amount of death benefit which can be excluded from income by the transferee may not exceed the amount which could have been excluded by the transferor if there had been no transfer (plus consideration and other amounts paid by the transferee).

Example

Able acquires a $600,000 policy on his own life.  After having paid premiums totaling $3,000, he sells the policy to Baker for $3,500, a transfer for value.  Baker then makes premium payments totaling $4,000 more dollars, and transfers the policy for no consideration, as a gift to his daughter, Casey.  Thereafter, Casey makes premium payments totaling $8,000.  Able then dies, and Casey receives the death benefit of $600,000 dollars.  Because of the prior transfer for value from Able to Baker, the death benefit is not exempt from taxation, even though no consideration was involved in the transfer by which Casey obtained the policy.  Casey may, however, exclude from income the amount which Baker could have excluded ($3,500 purchase price, plus $4,000 in premium payments), plus the $8,000 which Casey paid in premiums, or a total exclusion of $15,500.  Accordingly, Casey realizes ordinary income of $584,500.

Transfers of Business Life Insurance Under The Proper Party Exception —§101(a)(2)(B)

This exception to the transfer for value rule operates when the transferee is either the insured party or any of the following affiliates of the insured:

·         a partner of the insured;

·         a partnership in which the insured is a partner; or

·         a corporation in which the insured is either an officer or stockholder.

As long as the transferee is one of these so-called “proper parties,” it does not matter whether or not the transfer involved any consideration flowing to the transferor.  Moreover, if the final transferee of a policy is one of these proper parties, any transfer for value taint which may have attached to the policy as a result of any prior transfer for value will be eliminated and the death benefit will be receivable tax free [see Reg. §1.101-1(b)(3)(ii)].

Partnership as Proper Party

The transfer for value rule is not applicable when the transferee is a partner of the insured or a partnership in which the insured is a partner. (However, this exception is not applicable if a policy is sold to a member of the partner/insured`s family who is not a partner.) This exception to the transfer for value rule can be vital in the design of a partnership succession plan and can help provide continuation of the business in case of the death of one or more partners.

In past private letter rulings, the IRS has held that  the extent to which transfers to partners or partnerships may qualify for this exception to the transfer for value rule includes a transfer to a partner of the insured even if the transferee has only a very small percentage interest in the partnership. See Ltr. Rul. 9045004, in which the transferee had only a 1 percent interest.  It also appears that the partnership relationship between the transferee and the insured need have no relationship whatsoever with the insurance policy or the motivation for its sale; the fact that the transferee and the insured happened to be partners in a pre-existing partnership can be totally coincidental.  In Ltr. Rul. 9235029 the exception was held to apply when the policy was sold to an irrevocable trust which happened to have been a partner of the insured in a pre-existing family partnership, even though the purchase of the policy had nothing to do with the partnership relationship. Similar results were reached in Ltr. Ruls. 9239033 and 199905010. In Ltr. Rul. 9309021 the IRS held that a retiring partner can sell an incoming partner the policy he owns on a third partner’s life without running afoul of the rule. Also in the case of a partnership which owns a key executive policy on the life of a non-partner, IRS held there was no no transfer for value as partners entered or existed the partnership, as long as the partnership is not terminated as a consequence [See Ltr. Rul. 9410039].

Despite the liberal approach taken in the foregoing rulings, it is unlikely that the proper party exception will be applicable when a policy is sold to a partnership consisting of the insured and the true purchaser, created for the purpose of taking advantage of the exception, and having no other legitimate business purpose.  See I.R.C. §7701, which in essence requires that in order for an entity to be recognized as a partnership for tax purposes, it must be formed for the carrying on of a business, financial operation or venture. In Swanson Jr. Trust v. Comm’r., 518 F2d 59 (8th Cir. 1975) the court held that a purported partnership between the insured and certain trusts which transferred life insurance policies to the partnership was not a viable partnership, and thus, the proper party exception to the transfer for value rule was not applicable.

In a 1998 private letter ruling (Ltr. Rul. 9843024) the IRS effectively served warning that partnerships created for the purpose of qualifying a transfer of an insurance policy for the proper-party exception to the transfer for value rule may not be recognized. Thus, the service might attempt to construe the transfer for value partnership exception as inapplicable when the partnership’s only assets are the insurance policies transferred and/or when the insured’s percentage interest in the partnership is de minimus (i.e., in either case, indicating that the partnership was created or utilized solely for the purpose of qualifying for the exception).

Such a position may not be supported by the language of §101(a)(2)(B), which refers simply to "a partnership in which the insured is a partner." Thus, it would seem that, technically, the statutory language would control without regard to either the purpose of the partnership or the size of the insured`s interest in the partnership. However, the caveats in Ltr. Rul. 9843024 raise red flags indicating that partnerships structured solely for purposes of §101(a)(2)(B) may be challenged. This is further indicated by Revenue Procedure 2001-3 in which the Service states that it will not issue rulings on the issue as to whether, in connection with the transfer of a life insurance policy to an unincorporated organization, (i) the organization will be treated as a partnership under I.R.C.  §§761 and 7701, or (ii) the transfer of the life insurance policy to the organization will be exempt from the transfer for value rules of §101, when substantially all of the organization`s assets consists or will consist of life insurance policies on the lives of the members.

While it is not clear whether the IRS will ultimately challenge such arrangements, or if such a challenge would ultimately stand up, the consequences of losing a fight with the Service on the issue (the death benefit being taxable as ordinary income to the beneficiary) are so severe that the risk of challenge may be too great. On the other hand, a transfer for value taint can be cleansed if, prior to the insured`s death, there is a subsequent transfer for value which does fall within the exception (e.g., to either the insured or a partnership acceptable under IRS criteria). See Regulation §1.101-1(b)(3)(ii)

Corporation as a Proper Party

Some of the same considerations discussed above with respect to partners and partnerships as proper parties are applicable in the case of a transfer to a corporation in which the insured is an officer or shareholder. For example, if a  life insurance policy is transferred to a corporation in which the insured is an officer or shareholder, the proceeds will be received tax-free. It does not appear to matter that the insured may be only a minor shareholder (see Ltr. Rul. 9054004), as long as the position as shareholder or as officer was not established as a sham for the sole purpose of qualifying for the proper party exception. In addition, even if a policy is transferred several times, the proceeds will not be subject to tax (i.e., any prior transfer for value taint is removed) if the last transferee is a corporation in which the insured is an officer or shareholder.

However, if a corporation sells or transfers a policy to a shareholder who is not the insured, the death proceeds will be subject to taxation. Similarly, if a shareholder transfers a life insurance policy to another shareholder, the policy proceeds will be taxable. In both of these situations, the transactions do not fit into any of the exceptions to the transfer for value rule.

The key to designing a business succession plan without running afoul of the transfer for value rules is in being aware of the rules and how they apply in particular situations. In most cases, a policy transfer can be structured to fit within one of the exemptions.

Indirect Transfers to the Insured as Proper Party

The case of Estate of Roth v. U.S., 77-1 USTC ¶9327 (D.C. Mich.) illustrates a situation in which a transfer to the spouse of the insured was considered as in effect a transfer to the insured (qualifying for the proper-party exception), followed by a transfer by the insured to his wife (qualifying for the transferor’s-basis exception). An insurance policy was transferred for value from the corporate policy owner to the insured shareholder`s spouse as part of a sale of the corporation. On its face, this transaction did not fit within the exceptions to the transfer for value rule. However, a stockholder`s agreement had given the insured the right to acquire the policy on his life if he ceased to be a shareholder. The wife contended that she could not have acquired the policy without the participation of the insured; in effect, there was a two-step transfer. A federal district court agreed. The transfer from the corporation to the insured fit within an exception to the transfer for value rule, and so did the transfer from the insured to the spouse, since it was partly gratuitous, and her basis was determined in part by reference to the transferor`s (insured`s) basis.

Transfers to Grantor Trusts

It appears that if the grantor of a trust is treated as its owner under the grantor trust rules, then a transfer to the trust is considered a transfer to the grantor. Therefore, the transfer for value rules will not apply when a policy on the grantor`s life is transferred to such a trust.

For example, in W. Clarke Swanson v. Comm`r, 33 T.C.M. 296 (1974), the Tax Court held that where a grantor retained extensive powers to deal with the trust property, including the right to interpret or amend the trust instruments, he should be treated as the owner of the property. The only limitation on his power was the provision that he could not become the owner of the property. However, he could add or change beneficiaries, alter trust provisions and otherwise acquire complete control over the property. According to the court, there was no transfer for value to the extent of the grantor-insured`s ownership of the trust corpus, in this case 91 percent. The remaining 9 percent of the insurance proceeds was subject to income tax under the transfer for value rule.

Transfers to Qualified Plans

A purchase of an employee`s insurance policy by a qualified retirement plan for the benefit of the employee may fall within the exception for transfers to the insured. For example, Rev. Rul. 74-76 (1974-1 C.B. 30) held that an employee`s voluntary contribution of a life insurance policy to a qualified employer profit-sharing plan was not a transfer for value. Since the proceeds were payable to the employee`s designated beneficiary and the cash value was payable to the employee at normal retirement, there was not a change in the policy`s beneficial ownership constituting a transfer for value [Reg. §1.101-1(b)(4)]. For a detailed discussion of Life Insurance In Qualified Plans, see Section 17.3. See also related discussions in the recent Current Comment: "Using Life Insurance to Reduce the Tax Bite on Retirement Plan Assets at Death (CC 03-10)."

Tabular Summary of Transfer For Value Rules

Policy Owner and Transferor

Transferee For Value

Tax Impact on Death Benefit

Anyone

Insured

Exempt

Anyone

Partner of insured

Exempt

Anyone

Partnership in which insured is a partner

Exempt

Anyone

Corporation in which insured is a shareholder or officer

Exempt

Anyone

Anyone where basis is determined by reference to transferor`s  basis

Exempt

Anyone

Co-stockholder of insured

Taxable

Anyone

Anyone else

Taxable

(December 2003 Current Comment)

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