Life insurance typically is a key component of an estate plan. To keep the value of a life insurance policy you already own out of your taxable estate, or to achieve other planning goals, it may make sense to transfer the policy. But income tax traps exist. One is the transfer-for-value rule. So before making a transfer, it pays to become familiar with this rule.
Concept and exceptions
Normally, life insurance proceeds payable by reason of death (that is, death benefits) are not subject to income tax. However, when the transfer-for-value rule applies, the transferee — the person receiving the policy — will be subject to ordinary income taxes on the policy’s death proceeds, excluding the consideration paid for the policy and any premiums or other charges he or she pays after the transfer.
The transfer-for-value rule is intended to discourage speculation in insurance policies by people who lack an insurable interest. An insurable interest is a legitimate reason for someone to be insured against your death — typically, this means the person would suffer a financial hardship. Examples of people with an insurable interest on you could include your spouse, child and business partner.
Unfortunately, the rule’s design doesn’t necessarily jibe with its underlying rationale. For example, though the rule contains several exceptions, there isn’t one for transfers to children or other family members who typically do have an insurable interest.
So what are the exceptions? One is when the transfer is made to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Be aware that this exception doesn’t apply in reverse, when the transfer is to an officer or shareholder.
One reason the transfer-for-value rule is so dangerous is that the term “transfer” goes well beyond an outright sale or physical transfer of a policy. A transfer can occur, for example, when you name a beneficiary or assign someone an interest in the policy.
A transfer won’t cause the death benefits to become subject to income taxes unless the transferee provides “valuable consideration,” but this aspect of the rule can be treacherous as well. Valuable consideration isn’t limited to money. It can be virtually anything of value to the transferor — the person transferring the policy or interest.
It’s logical to assume that the transfer-for-value rule won’t apply to a gift of a policy or of an interest in a policy. In most cases, that’s true, but even gift transfers should be examined closely to avoid the transfer-for-value trap.
Plenty of thought
If you want to transfer a policy, give it plenty of thought. The transfer-for-value rule is a tax trap to which many individuals fall prey. We can help you decide whether a policy transfer is really a good idea and, if so, how to prepare for the tax impact.