Understanding the Insurance Transfer-for-Value Rule

One of the key benefits of any kind of life insurance is the tax-free death benefit. However, some speculators began to transfer life insurance policies between parties to reap large tax-free windfalls. To discourage this, Congress declared any life insurance policy transferred for any kind of material consideration may become partially or fully taxable when the death benefit is paid out.

This rule is known as the transfer-for-value rule, and it stands as one of the few exceptions to the general exemption from taxation accorded to all life insurance death benefit proceeds. However, the rule itself has several exceptions. We will examine these exceptions as well as the conditions under which a policy transfer may result in taxation.

The transfer-for-value rule states once the recipient of a life insurance policy transfers the benefit to another party, the tax-exempt status of the policy will be removed and the purchaser will have to pay income tax on a portion of the death benefit. The rule apples if the policy is received in return for valuable consideration of any kind. The amount of death benefit not taxed equals the value of the consideration received plus any subsequent premiums paid into the policy by the recipient after the transfer. The rest of the death benefit is fully taxable as ordinary income.

XYZ Corporation purchases a $10,000 life insurance policy on one of its key employees. It pays the premiums on this policy for five years, then transfers the policy to another employee for $8,000. The new employee pays an additional $4,000 of premiums into the policy. The original key employee passes away and the death benefit is paid to the second employee. Only $12,000 ($8000 + $4000) of the death benefit can be excluded from taxation, the remainder is taxed as ordinary income to the employee.

This rule is conceptually fairly simple. But the definition of "consideration" must be examined carefully to establish when it applies. Despite the common understanding that consideration refers to a form of monetary payments, sometimes no formal transfer of any kind needs to take place or tangible consideration be provided to violate this rule. Consideration can in this case be merely a reciprocal agreement of some sort tied to the transfer of the policy.

For example, if two shareholders in a closely held business take out life insurance policies on themselves and name each other as beneficiaries, the recipient of the death benefit proceeds from the policy of the partner who dies first will face a substantial tax bill under the transfer-for-value rule. The rule applies here because the two partners presumably agreed to name each other as beneficiaries, thereby introducing the receipt of consideration into the equation. (For related reading, see: How to Avoid Taxation on Life Insurance Policies.)

Although such rules are subject to interpretation, formal tax code is somewhat ambiguous in terms of what justifies a violation to the tax exempt status. If the IRS has reason to believe that any kind of verbal or tacit agreement was made, then the rule will be upheld. The criteria for determining this lies in the question of whether the transfer would have been made if not for the additional consideration.

In the previous example, the IRS would find an agreement had been made because each partner would most likely not have named the other as beneficiary on his or her policy without reciprocation. As mentioned previously, the transfer-for-value rule does not only apply to policy sales per se; changing or listing a beneficiary in a policy in return for consideration of any kind will trigger the rule as well.

There are several specific instances where there are exceptions made to safe-harbor the insurance proceeds. In most cases, this rule is breached unintentionally when a policy is transferred to another party with the mistaken assumption the rules are being followed. One of these happens when the owner of a policy sells it to the corporation for which he or she works or sits on the board of directors, and the insured on the policy is also either a shareholder or officer of the corporation. Other situations involve buy-sell agreements, where a privately-held corporation transfers policies between employees in a manner that does not fall under the list of qualified exceptions.

When Congress created the transfer-for-value rule, it recognized there are some valid reasons why a business would transfer a policy to one of its employees. To this end, Congress included five specific exceptions to the rule, thus allowing the death benefit of a transferred policy to be paid tax-free to the beneficiary.

1. Policy transfers to the insured on the policy
2. Policy transfers to a partner of the insured on the policy
3. Policy transfers to a partnership in which the insured on the policy is a partner
4. Policy transfers to a corporation in which the insured on the policy is an officer or shareholder
5. Policy transfers in which the recipient's cost basis in the policy being transferred is calculated in reference to the cost basis of the transferor. (This exception is usually applicable in tax-free corporate reorganizations, where the old company transfers the policy to the new one.)

As mentioned previously, this rule is often triggered when a company transfers a policy incorrectly. If a policy is transferred several times, the circumstances of the final transfer will generally determine how the death benefit proceeds are taxed. If the final transfer qualifies as an exception, the proceeds will be tax-free. If not, the rule applies. It can also apply to transfers between family members in some cases, although these transfers are usually classified at least partly as gifts.

The transfer-for-value rule limits the tax advantages of life insurance for many businesses. However, the exceptions to this rule still permit corporations and other policy owners to move their policies under certain circumstances. Policy owners who are unsure whether their policy transfer may result in taxation should consult their life insurance carrier or tax advisor. (To learn more, read: Five Life Insurance Questions You Should Ask.)