Transfer-for-value rule.

• Author: Yurkovic, Denis L.

One of the most attractive aspects of life insurance as a financial planning tool is the tax treatment of the proceeds. Generally, the proceeds a beneficiary of a life insurance policy receives by reason of the insured's death are entirely free from income tax (Sec. 101(a)(1)). However, an often overlooked provision of the tax law known as the "transfer-for-value rule" can result in the loss of that favorable tax treatment.

Under the transfer-for-value rule, if a policy (or any interest in a policy) is transferred for a valuable consideration, the death proceeds will generally be excludible from income only to the extent of the consideration paid by the transferee, plus the net premiums paid by the transferee after the transfer (Sec. 101(a)(2)). The balance of the proceeds will be taxable as ordinary income. In other words, a policy that becomes subject to the transfer-for-value rule loses the income tax exemption ordinarily permitted for life insurance proceeds, except to the extent the transferee develops basis in the policy.

Example: Small corporation M has paid premiums totaling $5,000 for a $100,000 life insurance policy on the life of shareholder A. In 1992, M transfers the policy to shareholder B (the noninsured shareholder) for $6,000. B receives the $100,000 proceeds on A's death in 1994. During the period B owned the policy (1992-1994), he paid premiums totaling $3,000. The amount B can exclude from income is limited to $9,000 (the $6,000 he paid to M for the policy + the $3,000 of premiums he paid after the transfer). The $91,000 balance is taxable to B in 1994.

The transfer-for-value rule includes, but goes beyond, outright sales of life insurance policies. For example, the naming of a beneficiary in exchange for any kind of valuable consideration is a transfer for value of an interest in the policy. On the other hand, a pledging or assignment of a policy as collateral is not a transfer for value (Regs. Sec. 1.101-1(b)(4)).

Fortunately, the tax law contains several exceptions to the transfer-for-value rule (Sec. 101(a)(2)(A) and (B)). In the following situations, the proceeds will be exempt from income tax despite a transfer for value.

* A transfer for value to the insured person.

* A transfer for value 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.

* A transfer for value in which the transferee carries over the transferor's...