Take-Away: The IRS recently published a new Revenue Ruling that affects the income tax basis of a life insurance policy. That change will have a positive impact on a life-settlement sale of a life insurance policy. The change may also have a modest impact on the amount of gain recognized if the death benefit received under a policy is subject to the Tax Code’s transfer-for-value rules.

Background: As a general rule, the death benefit that is received by the beneficiary when the insured dies is excluded from the beneficiary’s taxable income. [IRC 101(a)(1).] However, if the life insurance policy is subject to the transfer-for-value rules, then the death benefit received by the policy’s beneficiary is subject to income taxation. [IRC 101(a)(2).] The transfer-for-value rules provide that if the transfer of the life insurance contract is for valuable consideration, then the proceeds are included in the taxable income of the beneficiary to the extent the amount received exceeds the actual consideration paid plus subsequently paid premiums, also referred to as the investment, or basis, in the life insurance contract. This consideration paid increases the purchaser’s investment, or basis, in the life insurance contract, reducing the amount of taxable income that must be reported. [IRC 72(e)(6).]

Policy Basis: Normally, the investment in a life insurance contract reflects the aggregate premiums paid. However, in 2009,  the IRS issued a Revenue Ruling [2009-13] that said that the basis in the life insurance policy had to be reduced by the internal costs of mortality. IRC 1016 (a)(1)(B)] in the 2017 Tax Act codified this interpretation of a life insurance policy’s tax basis. That said, after strong pressure from the life insurance industry, the IRS issued a new Revenue Ruling 2020-05 on February 10, 2020 that provides that the investment, or tax basis, i.e. premiums paid or consideration paid for a life insurance contract will not to be adjusted (downward) by the mortality, policy expenses, or other reasonable charges that the insurance company assesses against the policy. The result is a higher tax basis in the life insurance contract, and the smaller the gain that will have to be recognized if the policy is sold. This change primarily has to do with the life settlement industry where policies are purchased as investments, and the capital gain when the insured dies must be calculated. It also indirectly can affect the investment in a life insurance contract that is subject to the Tax Code’s transfer-for-value rules.

Transfer-for-Value Rule: The obvious situation occurs when an individual purchases an existing life insurance policy and pays the owner of the policy money for the privilege of owning the policy on the life of the insured. However, the transfer-for-value rule does not actually require the sale of the policy itself. The concept of transfer is broadly interpreted. It only requires the transfer of a right to receive some portion of the proceeds of the policy in exchange for value. [Reg. 1.1010-1(b)(4.)] A pledge or assignment of the life insurance policy as collateral security, however, will not be considered a transfer for valuable consideration. [Reg. 1.101-(b)(4).] Similarly, the concept of consideration is also broadly construed by the Service, which includes more than money or property being exchanged. An example where the rule is implicated in the absence of an exchange of money might be where an individual promises to continue to work for the business in exchange for the transfer of a life insurance policy, or there is a  negotiated change in the policy proceeds, or a simple exchange of promises. Because both transfer and consideration are so broadly construed, it is possible to trigger the transfer-for-value rule creating possibly a very large income trap.

  • Example #1: Three shareholders, Skip, Tom and Steve, have entered into a cross-purchase agreement. That agreement requires them to purchase life insurance on the other shareholders’ lives, to facilitate a purchase of the shares of stock when one of the shareholders dies. However, the cross-purchase agreement states that at the time of one shareholder’s death, his interest in the life insurance policies on lives of the surviving shareholders will be transferred to the surviving shareholders. The valuable consideration would be the mutual agreement of Skip, Tom and Steve to transfer the policies that they own on the others’ lives. Skip dies. Skip’s estate transfers the policy on Tom’s life (owned by Skip) to Steve, and the policy owned by Skip on Steve’s life to Tom.  If the insured-shareholder Steve later dies, the policy proceeds collected by the surviving shareholder Tom will be a policy that was acquired by him for valuable consideration.
  • Example #2: The transfer-for-value trap often arises in a cross-purchase agreement among shareholders. Alex and Ben each own 50% of Biz Corp. They have a cross-purchase agreement. Each owns a $300,000 life insurance policy on the life of the other. Years later Alex decides to sell his stock to Carmen. Alex also sells his life insurance policy on Ben’s life. To Carmen. Carmen pays Alex $25,000 for the life insurance policy on Ben’s life. Carmen also pays $1,000 in policy premiums in the year following her purchase of the life insurance policy on Ben’s life. Ben dies that year, and Carmen collects $300,000 on Ben’s death. Carmen must include the insurance proceeds in her income to the extent that the proceeds exceed Carmen’s cost of the purchased policy plus premiums that she paid after the policy was purchased. In short, Carmen must report in her income for the year $274,000 [$300,000 less $25,000 purchase price less $1,000 premiums paid= $274,000.]Welcome to the transfer-for-value rule Carmen!

Obviously there is a strong incentive to avoid the transfer-for-value rules when you consider the size of many death benefits that could easily exceed a million of dollars considering the current income tax rates. In general, there are two key questions that need to be answered when a life insurance policy is exchanged: (1) will there be a transfer of a life insurance policy, or an interest in the policy, during the insured’s life?; and (2) will valuable consideration be exchanged for the transfer of the insurance policy?

Exceptions to the Transfer-for-Value Rule: The Tax Code does identify situations where the transfer-for-value rule will not be applied. Many transfers will fall within one or more of these exceptions which will cause the death benefit received to not be included in the beneficiary’s taxable income. Those exceptions include:

  • Carryover Basis In the Policy: The transfer in which the transferor’s basis in the life insurance contract is determined, in whole or in part, with reference to the transferor’s tax basis in the policy. An obvious example is where the life insurance policy is gifted to an individual, e.g. a father who owns the policy on his life gifts the policy to his children. IRC 1014 carry-over basis rules apply to a lifetime gift. [IRC 101(a)(2)(A).]
  • Transfer to the Insured: The transfer of the policy is to the insured. This would include the sale of the policy to a grantor trust for income tax reporting purposes, where the trust is ignored and treated as its grantor. If a shareholder’s interest in a corporation is terminated upon retirement e.g. the shareholder’s stock is redeemed, the policy on the shareholder/member’s life owned by the corporation can be sold to the retiring shareholder and the death benefit will not be taxed on the insured’s death. The same result occurs if the policy is sold  by the corporation to an intentionally defective grantor trust established by the retiring shareholder. [ See Revenue Ruling 2007-13, where the Service held that the sale of the life insurance policy by a third-party to a grantor trust of the insured would be exempt under the ‘sale to the insured’ exception, but the sale of the policy itself would be taxable to the policy’s seller.]
  • Transfer to a Partner of the Insured: The transfer of the policy is to a partner of the insured. [More on this below.]
  • Transfer to a Partnership of which the Insured is a Partner: The transfer of the policy is to a partnership in which the insured is a partner. This includes the insured who is a member of an LLC which elects to be taxed as a partnership.
  • Transfer Where the Insured is a Corporation’s Shareholder or Officer: The transfer of the policy is to a corporation in which the insured is a stockholder or officer. [Reg. 1.101-1(b)(1).]

The first exception is often referred to as the ‘property transaction’ exception. The remaining four exceptions are referred to as the ‘proper party’ exception.

Caution! What is critical to note is the omission from this list of exceptions to the transfer-for-value rule of a transfer of a life insurance policy from one shareholder to a fellow shareholder. In short, the transfer of a life insurance policy from one shareholder to another shareholder for value will trigger the transfer-for-value trap.

Partnership ‘Work-Around:’  One of the common ways to avoid the transfer-for-value problem for shareholders is for them to establish a partnership (or LLC taxed as a partnership). For cash-flow reasons, tax savings, and also avoidance of the transfer-for-value problem, it is common for the shareholders to form an LLC (or partnership) to hold title to real estate or equipment that is then leased to the operating corporation. Thus a later sale of a life insurance policy on a shareholder’s life will also be a sale to a partner, which is exempt from the transfer-for-value rule.

  • Example #3: Moe, Larry and Curly are equal shareholders of Slapstick, Inc. They have a cross-purchase agreement, where each purchases a life insurance policy on the life of the other shareholder(s). The three are also members in an LLC which owns the building from which Slapstick, Inc. operates. The LLC leases the building to Slapstick, Inc. On Moe’s death, the policies that he owned on the lives of Larry and Curly are sold to them by Moe’s estate. Since the life insurance policies were transferred (sold) to a partner-member of the insured, the transfers are not subject to the transfer-for-value rule, and thus the death benefits  paid under those transferred policies will be excluded from the beneficiary’s taxable income.
  • Business Purpose: The partnership (LLC) must have a valid business purpose independent of merely being a vehicle to avoid the transfer-for-value rule. [PLR 9042023.] Restated, the partnership (LLC) must be an operating entity and not one just created to own the  insurance policies.

Conclusion: As noted, the biggest change resulting from the recent revenue ruling is to reduce the capital gains tax that will have to be paid in a life settlement transaction, where existing policies are purchased for ‘investment’ by third-parties. This change will also impact the taxable income a transferee will have to report as ordinary income if they acquired a life insurance policy for valuable consideration. While the concept of policy expenses and charges seem to be a small amount, if the insured is aged, a large amount of the policy premium will be devoted to the mortality expense charged under the policy, so that might be a much larger number than would first be suspected, leading to the owner being able to report a much larger investment, or basis, in a policy that is subject to the transfer-for-value rules.