The transfer for value rule, contained in Internal Revenue Code section 101(a)(2), provides: In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by [the beneficiary of death proceeds under a life insurance contract] shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee.
So if transfers of a life insurance policy fall within the transfer for value rule, the result is a harsh penalty: with the exceptions listed below, transferees for value of life insurance policies are taxable at ordinary income rates on receipt of the policy proceeds less the sum of: (a) amounts paid by them to acquire the policy; (b) later premiums; and (c) other amounts. The term “other amounts” includes any interest paid or accrued by the transferee on indebtedness with respect to a contract, but only if the interest is not allowable as a deduction under Code section 264(a)(4).
The questions the planner must ask are:
- Is there a transfer?
- Will the transferee pay any type of consideration for that transfer?
If the answer to both questions is yes, the results are likely to be harsh. For example, if a $1,000,000 term life insurance policy on an insured’s life is transferred from the insured to his or her son for $10,000, there is a transfer of an insurance contract for valuable consideration. If the transferee, the son, then pays four $5,000 premiums before the insured’s death, the amount excludable from the owner’s gross income for amounts received under the policy will be limited to the value of the consideration paid for the policy ($10,000) plus the four $5,000 premiums paid after the transfer ($20,000), a total of $30,000. This means $970,000 ($1,000,000 less $30,000) would be subject to ordinary income tax! So instead of receiving $1,000,000 net, the son could owe a federal income tax of over $300,000 and net less than $700,000!
Planners should be aware of the following points:
- It does not matter whether the policy is term insurance or permanent insurance.
- The transfer for value rule applies to every type of life insurance contract and encompasses group as well as individually purchased coverage.
- The method by which the policy is transferred is irrelevant for purposes of this rule.
- The transfer for value rule can apply even if ownership of a policy has not been transferred. A mere shift in an interest in the contract may be sufficient to trigger the rule. So a transfer for value can occur from an absolute assignment of all the transferor’s rights, a transfer of some lesser degree of policy rights, or a different type of transfer.
- For the rule to apply there must be both a transfer of a policy or an interest in a policy and valuable consideration paid for that transfer to the transferor.
The Requirement of Transfer
The Internal Revenue Code does not define the term, transfer for valuable consideration. But the regulations provide that a transfer for valuable consideration occurs whenever any absolute transfer for value of a right to receive all or any part of the proceeds of a life insurance policy takes place. This includes, as mentioned above, the creation for value of an enforceable right to receive all or part of the proceeds of a policy, but excludes any pledge or mere assignment of a policy as collateral security.
The pledge or assignment of a policy (or an interest in a policy) as collateral security is not a transfer. A pledgee or assignee receiving the pledge or assignment of a policy as collateral for a loan will be able to recover proceeds income tax free (but as a repayment of capital, rather than as the proceeds of a life insurance policy).
The IRS defines the phrase transfer for valuable consideration broadly. The term encompasses any absolute transfer—for value—of a right to receive all or any part of a life insurance policy, including the creation for value of an enforceable contractual right to receive all or any part of the proceeds. If the insured in the above example had merely named his or her son as the policy beneficiary (for valuable consideration), that alone would constitute a transfer for purposes of the rule.
Planners should remember that any shifting of a beneficial interest in a policy is sufficient to trigger the transfer for value rule. No physical transfer of the policy or the policy’s ownership is necessary, nor does every interest in the policy have to be transferred for the trap to be set.
The Requirement of Consideration
It is impossible to fall within the trap unless there is a transfer of a policy or an interest in a policy. It is also clear that even if there is a transfer, the transfer for value trap will not be triggered if there is no consideration given for that transfer.
So even if there is a nominal promise by the transferee to pay value and even if the policy assignment says, “for one dollar,” the proceeds will be tax free—if in fact no consideration is ever paid—regardless of the formal recitation of consideration in the assignment form furnished by the insurer. Of course, the better and recommended practice is to show that a gift and only a gift is intended. To be safe, the assignment form should state that the transfer is solely “for love and affection.
If, in exchange for any kind of valuable consideration, a policy beneficiary of all or any portion of the proceeds is named or changed, there will be a transfer for value. This rule applies even if:
- there is no assignment of the policy;
- the policy has no cash surrender value at the time of the transfer; and
- the policy is term insurance, so that it never has and never will have any cash value.
Even though the transfer is found to be for a valuable consideration and none of the exceptions to the transfer for value rule apply, if the consideration paid for the transfer plus any amounts paid subsequent to the transfer by the transferee equal or exceed the policy proceeds, the entire amount of the proceeds will be excludable from gross income. But it will be rare that the transferee will pay a sum equal to the proceeds for the policy.
It is not necessary that cash change hands for the trap to be set. Any consideration sufficient to support an enforceable contract right will be sufficient. For example, in the leading case in the buy-sell area, the mutuality of shareholders’ agreements to purchase each other’s stock in the event of death and relieve the business from the burden of paying premiums was held to be enough consideration for invoking the rule.
Planners should therefore always inquire—whenever there is a transfer of either a policy or an interest in a policy—whether the transferring party will receive anything of any value in exchange for the transfer. A quid pro quo (“I’ll do this for you if you do this for me”) type transaction is consideration just as surely as if $1,000,000 changes hands. The quid pro quo does not have to be in writing, nor does it have to be explicitly stated by the parties. If it is logical to assume that the transfer of a policy or an interest in a policy would not have been made absent some consideration and that action or inaction was in fact taken, the IRS will presume that valuable consideration did pass to the transferor.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM