Be wary of taxes sapping life insurance proceeds.

Author:Grassi, Sebastian V., Jr.


Life insurance can provide an "instant" source of liquidity to the estate of an owner of a closely held business, preferably when the policy insuring the business owner's life is held by an irrevocable life insurance trust (ILIT). Especially when business owners face succession issues, CPAs advising them can suggest life insurance as a valuable tool in estate planning. Among the points to cover are recapture rules for transfer of an existing policy to an ILIT (IRC [section] 2035) and transfer-for-value rules under IRC section 101(a)(1).

Transferring an existing policy into an ILIT can shield a death benefit from estate taxes and generation-skipping transfer taxes. Clients should be advised, however, that under section 2035 the proceeds are included in the decedent's gross estate if the ownership of the policy was transferred to the ILIT within three years of the insured's death.

Under the provisions of section 101, generally speaking, life insurance proceeds received as a result of an insured's death are income tax free. However, if a life insurance policy or interest in one is transferred for valuable consideration of any form, such as cash or mutuality of promises, then the income tax exclusion is not available, and the proceeds are taxable. The portion of the proceeds equal to consideration paid to acquire the policy or interest in it, plus any future premiums paid by the transferee (that is, the transferee's basis in the contract) are received income tax free, but the remaining proceeds are taxed as ordinary income. See Treas. Reg. [section] 1.101-1(b)(3)(i).


Even term life insurance policies that have no cash value are subject to the transfer-for-value rule. See, for example, Private Letter Ruling 7734048. The transfer does not have to be of the policy itself. A transfer of some or all of the underlying interests in the policy (such as the death benefit proceeds) is sufficient to invoke the rule, which is broadly defined. For example, the creation, for value, of an enforceable contractual right to receive all or a part of the proceeds of a life insurance policy may constitute a transfer for a valuable consideration. This would be the case when a shareholder of a company who owns a policy on his life is contractually bound under a buy-sell agreement to name a fellow shareholder as the beneficiary of the policy. Another example of a transfer for value would be to name a particular...

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