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George F. Bearup, J.D. Senior Legal Trust Advisor

13-Nov-19

Life Insurance: Another Transfer-for-Value Rule

Take-Away:  The IRS published its Final Regulations that deal with the taxation and reporting of a death benefit primarily with regard to policies that were the subject of a ‘life settlement’ transaction. These Regulations could cause a substantial part of the death benefit paid under a life insurance policy to be subject to ordinary income taxation. More to the point, the Regulations create some traps, i.e. income taxation, that arise from some standard transactions that involve the transfer of a life insurance policy in a closely held business setting.

Caveat: I apologize in advance for the length of this summary. However, these Regulations are complex. Hopefully the examples will explain the new tax rule and identify some of the ‘traps’ that the Regulations present.

Basic Rule: A fundamental rule is that most life insurance death proceeds are income tax-free. [IRC 101(a) (1).] That is a big deal if the full insurance death benefit paid is income tax-free to the designated beneficiary of the life insurance policy. The obvious goal, whenever possible, is to try to fall under this basic rule, that the death benefit paid is income tax-free.

‘Transfer-for-Value’ Exception: There are a couple of well-known exceptions to the basic rule that the proceeds of a life insurance policy is an income tax-free death benefit. Upon the transfer-for-value of an existing life insurance policy, e.g., someone purchases the policy from the policy owner, the income tax-free nature of the death benefit can be tainted. In the case of a transfer of a life insurance policy for valuable consideration, by assignment or otherwise, (or even an interest in a life insurance contract) the tax-free portion of the death benefit paid cannot exceed the amount that is equal to the sum of: (i) the actual value of the actual consideration paid for the insurance policy and (ii) the premiums and other amounts that are paid by the policy transferee after the policy’s purchase. [IRC 101(a) (2).] Consequently, while normally the death benefit is income tax-free, that is not the case if the life insurance policy is purchased from the policy owner in a transfer-for-value transaction.

Exceptions to the ‘Transfer-for-Value’ Exception: The prior exception that provides for the income taxation of a life insurance death benefit has a couple of statutory exceptions, where the death benefit paid remains income tax-free. In other words, they are exceptions to the exception {if that makes any sense, which I concede I seldom do.}

  • Carryover Basis Exception to the Exception: The first exception is that if the life insurance contract (or interest in the contract) has a tax basis to determine gain or loss in the hands of the transferee that is determined in whole or in part by reference to the tax basis in the policy in the hands of the transferor, i.e. the policy owner’s basis becomes the acquirer’s basis, e.g. gift; a transfer of the policy by the insured to an ILIT; then the death benefit continues to be income tax-free. [IRC 101(a) (2) (A).]
  • Transfer to Partner or Partnership Exception to the Exception: The second exception is if the transfer of the life insurance policy is to: (i) the insured; (ii) a partner of the insured; (iii) a partnership in which the insured is a partner;  or (iv) to a corporation in which the insured is a shareholder or officer. Example: The insured transfers the insurance policy on his life to a partnership, in which the insured is a partner. This is an important exception to the general transfer-for-value taxation rule. It permits an entity in which the insured is a partner/owner to not pay income tax on the death benefit when the insured partner/owner dies. [IRC 101(a) (2) (B).] Caution: A transfer of a life insurance policy to the insured’s co-shareholder, like in a cross-purchase arrangement between shareholders, will still treated as a transfer-for-value, i.e. the death benefit will be taxable to the recipient. This is an example of the type of technical ‘trap’ the transfer-for-value rules often create.

2017 Tax Act Exception to ‘Transfer for Value’ Rule- Reportable Policy Sale: The 2017 Tax Act added a new section to the Tax Code. [IRC 101(a) (3).] It adds another exception to the valuable consideration rules generally for commercial transfers of a life insurance policy. This new Tax Code section refines, or narrows, the general ‘exception-to-the-exception’ Code provisions, curtailing income tax-free death benefits. Specifically, IRC 101 (a) (3) provides that the ‘exceptions to the exception’ will not apply to the transfer of a life insurance contract, or interest in the life insurance contract, in what is described as a reportable policy sale transaction. In short, what once might have led to an income tax-free death benefit will result in the taxation of the death benefit if the policy was the subject of a reportable policy sale.

  • 2017 Tax Act Definition of Reportable Policy Sale: The term reportable policy sale means the acquisition of an interest in a life insurance policy, directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured apart from the acquirer’s interest in the life insurance contract. Indirectly means the acquisition of an interest in a partnership, trust, or other business entity that holds an interest in the life insurance contract. Practically speaking, this definition is broadly defined in the Regulations as it is intended to cover all life settlement agreements or transactions, but that broad definition can also cover other normal business situations where a life insurance death benefit is paid to a business or the surviving owners of a business. (See examples below for how this might arise.)
  • Impact of IRC 101(a) (3): The result of IRC 101(a)(3) is that the (i) carryover basis statutory exception, or (ii) the nature of the transferee statutory exception, e.g. the transfer of the insurance policy to a partnership in which the insured is a partner, will not apply in the context of a reportable policy sale. Consequently, the death benefit from a life insurance policy that was part of a reportable policy sale will only be income tax-free with regard to an amount that is equal to the sum of the consideration the buyer paid for the policy, i.e. price paid, plus any subsequent premiums paid by the buyer to sustain the life insurance policy prior to the insured’s death. No surprise, Treasury will receive more ordinary income tax revenues with the addition of this new Tax Code section.

What is a Substantial Family, Business or Financial Relationship With the Insured?: In order to avoid the taxation of a life insurance policy’s death benefit, the policy owner’s transfer of the policy must fall outside the definition of reportable policy sale, which means that there must be a substantial family, business or financial relationship with the insured to stay within the ‘exceptions to the exception.’ Unfortunately, the definitions used in the Final Regulations are not very helpful:

  • Regulation 1.101-1(d) (1) states that: “a substantial family relationship between an individual and any family member of that individual as defined in paragraph (f) (3) of this section. In addition, a substantial family relationship exists between an individual and his or her former spouse with regard to the transfer of an interest in a life insurance contract to (or in trust for the benefit of) that former spouse incident to a divorce.”
  • Regulation 1.101-1(f) (3) states that a family member is defined to include: (i) the individual; (ii) the individual’s spouse; (iii) any parent, grandparent or great-grandparent of the individual or their spouse; (iv) an lineal descendant of the individual, their spouse, their grandparents or great-grandparents; (v) any spouse of a lineal descendant. In addition, full effect will be given to a legal adoption. A stepchild will also be deemed a descendant.

Impact on Common Life Insurance Transactions: As a gross generalization, the following transactions will not, normally, be impacted by IRC 101(a) (3):

  • ILITs: A transfer of an insurance policy to an irrevocable trust, like an ILIT, will generally not result in a reportable policy sale, but that is only so long as each beneficiary of the ILIT is a family member of the insured. Note, however, that the sale (not a gift) of a life insurance policy to a non-grantor trust will result in a transfer-for-value, even it if is not a reportable policy sale. If the sale of the life insurance policy is to a grantor trust, the insured will be treated as dealing with himself, so that sale will fall within the exception of IRC 101(a) (2) and the death benefit ultimately paid on the insured’s death will be income tax-free.
  • Transfer or Collateral Assignment of a Policy?: The Final Regulations note that naming a revocable policy beneficiary, the collateral assignment of a life insurance policy, and the issuance of a life insurance policy to the policyholders are not policy transfers for purposes of the reportable policy sale
  • Like-Kind Exchanges: Similarly, a transfer of a life insurance policy in a like-kind exchange under IRC 1035 will normally not be treated as a reportable policy sale. A reportable sale will not include: “The acquisition of a life insurance contract by a policyholder in an exchange pursuant to section 1035, if the policyholder has a substantial family, business or financial relationship with the insured, apart from its interest in the life insurance contract at the time of the exchange.” Accordingly, if there is no such defined relationship when an IRC 1035 policy exchange is completed, the IRC 1035 like-kind exchange will be classified as a reportable policy sale, and thus the death benefit will be taxable when it is ultimately paid under the policy.
  • Buy-Sell Agreements: The new Code section appears to contemplate the transfer of life insurance policies to fund a buy-sell agreement. Thus, the transfer of a life insurance policy to fund an entity redemption agreement would appear not to be a reportable policy sale. Similarly, the transfer of a life insurance policy to a co-owner to fund a business cross-purchase agreement would not appear to be a reportable policy sale, but as noted earlier, a transfer of a life insurance policy to the insured’s co-shareholder is still a transfer-for-value even it is not a reportable policy sale, as a transfer of a life insurance policy to a co-shareholder is not a statutory exception to the transfer-for-value rules.

Examples: Some examples are provided to better describe how IRC 101(a) (3) works, and some of the ‘traps’ created by the broad reportable policy sale definition.

  1. Sam is the insured. Sam owns a $100,000 life insurance policy on his life. Becky, who is unrelated to Sam, purchases the policy from Sam for the policy’s current fair market value of $6,000. Becky has no ‘substantial family, business, or financial relationship’ with Sam. Thus, the transfer of the policy from Sam to Becky is a reportable policy sale. Upon Sam’s death, Becky can only exclude from her gross income the $6,000 purchase price she paid, and any premiums Becky paid prior to Sam’s death. The balance of the death benefit received by Becky on Sam’s death will be taxed as ordinary income.
  2. Same facts as #1, except that before Sam’s death, Becky sold the same life insurance policy to Paul, who is a partner of Sam, for the policy’s fair market value of $8,000. This transfer from Becky to Sam’s partner Paul is not a reportable policy sale because Paul had a substantial business relationship with Sam. However, this transfer of the life insurance policy from Becky to Paul followed a prior reportable policy sale (the sale of the policy from Sam to Becky) so the amount of the death benefit that Paul can exclude from his gross income on Sam’s death is limited to the sum of his $8,000 purchase price paid to Becky plus any subsequent insurance premiums paid by Paul.
  3. Same facts as #1. However, instead of selling the life insurance policy to Paul, Becky sells the same life insurance policy back to Sam for $8,000. The transfer of the policy from Becky back to Sam is not a reportable policy sale. The transfer is to the insured, which is a statutory exception. Consequently, upon Sam’s death, his estate will receive the full $100,000 death benefit income tax-free.
  4. Same facts as #3, except that Becky sells the policy back to Sam for $4,000, which is one-half of the life insurance policy’s current fair market value of $8,000. Consequently, Sam did not pay fair market value for the entire life insurance policy. The transfer of the insurance policy back to Sam is bifurcated; it is treated as both a gift and a bargain-sale by Becky. Sam is treated as purchasing 50% of the policy and receiving 50% of the policy from Becky as a gift. The transfer of the interest in the policy from Becky to Sam is not a reportable policy sale; however, that ‘sale’ followed a reportable policy sale (when Becky initially purchased the policy from Sam). With respect to the 50% of the policy that was purchased by Becky for its fair market value, Sam’s estate will be able to exclude 50% of the death benefit from gross income, or $50,000. But the death benefit that is related to the 50% of the policy that was received by Sam as a gift from Becky will not be fully excluded from gross income- the amount excluded will be 50% of the $8,000 purchase price Becky initially paid for the policy, plus 50% of the premiums Becky paid when she owned the policy, plus any subsequent premiums Sam paid once he reacquired the policy. [Regulation Example 7.]
    Purging a “Taint:” This last example is very important. In the past, the ‘transfer-for-value’ taint to a life insurance policy could be completely removed by a subsequent transfer of the life insurance policy back to the insured-transferor. The Final Regulations make it clear that the transfer of the policy back to the insured to cleanse any prior transfers-for-value will be limited, as indicated by Example #4. [Final Regulation Section 1.101-1(b) (1) (ii) (B) (3) (i).] This obviously places a premium on first determining, and then paying the full fair market value, for the life insurance policy if the goal with the transfer-back of the policy is to avoid the ‘transfer-for-value’ taint.
  5. Sam contributes his life insurance policy to a corporation, ABC, Inc. in exchange for stock in ABC. Sam is an employee of ABC who materially participates in the ABC business. As the transfer of the insurance policy is a capital contribution, ABC takes Sam’s basis (carryover) in the policy equal to Sam’s basis in the life insurance policy before it was transferred to ABC. Sam’s contribution of the policy to ABC is not a reportable policy sale because ABC has a substantial business relationship with Sam.
  6. Sam contributes his life insurance policy to ABC, Inc., in exchange for stock in ABC, which represents less than 20% of the outstanding stock in ABC. Sam will not be treated as a ‘key person’ of ABC as defined in IRC 265(e) (3) [defined as an officer or 20% owner, except that the number of individuals who may be treated as ‘key persons’ shall not exceed the greater of 5 or the lesser of 5% of the total officers and employees of the employer or 20 individuals, all of which is why people hate the IRS, as no one can understand the rules it creates!] ABC will not be treated as having a substantial family, business, or financial relationship with Sam. Therefore, Sam’s transfer of the policy to ABC will be a reportable policy sale and upon Sam’s death, ABC may only exclude from its gross income the amount of the death benefit that is equal to the value of the stock exchanged for the life insurance policy, plus any premiums that ABC subsequently paid on the policy. Note, that if Sam had transferred the life insurance policy to ABC in order to fund a buy-sell agreement, ABC would have had a substantial financial relationship with Sam under Regulation 1.101-1(d)(3) and thus the death benefit paid on Sam’s death would be income tax-free.

Conclusion: While much of the literature with regard to IRC 101(a) (3) addresses the life settlement industry and the need to impose an income tax on the death benefit paid to an unrelated purchaser of the life insurance policy who benefits on the death of the insured, the examples in the Regulations show how more innocent or commonplace life insurance policy transactions can also be classified as a reportable policy sale which, in turn, will cause income taxation of the death benefit on the insured’s death.