Is Transferring Ownership of a Life Insurance Policy Taxable?

Life insurance plays an important role in financial planning for many individuals and families. It provides a tax-advantaged way to leave an inheritance, fund estate taxes, support dependents and more.

A common strategy is transferring ownership of an existing life insurance policy to an irrevocable life insurance trust or another party. But does transferring a policy trigger taxes on the death benefit?

Below we’ll examine the potential tax implications of transferring life insurance policies. While death benefits are generally income-tax free, the transfer-for-value rule can result in taxes in certain situations.

Overview of Life Insurance Taxation

First, it helps to understand how life insurance death benefits are normally taxed.

The IRS provides an income tax exemption for life insurance death benefit payouts under Section 101(a) of the Internal Revenue Code. This states that proceeds are tax-free if paid “by reason of the death of the insured.”

Specifically, the death benefit received by beneficiaries is:

• Exempt from federal income tax
• Not included in the gross income of beneficiaries
• Exempt from estate tax when owned by an ILIT or other party

This favorable tax treatment applies to death benefits from all types of permanent and term life insurance policies. It provides families and dependents with an income-tax-free legacy.

However, the transfer-for-value rule creates an exception if ownership of the policy is transferred for “valuable consideration” prior to death. Let’s look at how this works.

What is the Transfer-for-Value Rule?

The transfer-for-value rule under Section 101(a)(2) limits the income tax exemption on life insurance death benefits after a policy has been transferred.

In general, it states that if an existing life insurance policy is sold or transferred for valuable consideration, the death benefit becomes partially taxable for the buyer.

Specifically:

• The buyer’s basis in the policy becomes the consideration they paid
• Any death benefit above the buyer’s basis is subject to ordinary income taxes

For example:

• Bob originally purchased a $1 million policy for premiums of $100,000 over 10 years
• Bob later sold the policy to Mary for $80,000
• Mary’s basis in the policy is her $80,000 purchase price
• If Mary collects a $1 million death benefit when the insured dies, $920,000 of the proceeds are taxable income to Mary ($1 million – $80,000 basis)

So transferring a life insurance policy for cash or other valuable assets can cause taxes on the death benefit.

What is Considered Valuable Consideration?

The key question in applying the transfer-for-value rule is whether the policy was transferred for “valuable consideration.” This includes:

• Cash: Transferring a policy in exchange for cash payment makes the death benefit above the cash amount taxable.

• Other property: Transfers for property, vehicles, securities or other assets are also considered valuable consideration.

• Loan assumptions: If the buyer assumes an outstanding loan on the policy, this can trigger the rule. The loan amount counts toward the buyer’s cost basis.

• Policy exchanges: Swapping a policy for another policy with a carrier is deemed valuable consideration.

• Split dollar arrangements: Entering a split dollar agreement may be considered a transfer for value in some cases.

Essentially any exchange for material value beyond the policy itself invokes the transfer-for-value rule. Certain exceptions do exist, which will be covered next.

Exceptions to the Transfer-for-Value Rule

Several types of policy transfers are exempt from the rule and will still qualify for tax-free death benefits:

• Gifts: Transferring a policy as a bona fide gift does not trigger the rule. Gifts are not considered valuable consideration.

• Transfers to insured: Selling a policy back to the insured person does not impact taxation.

• Transfer to partner: Transfers to a partner in a partnership for partnership interests is exempt.

• Corporate transfers: Movement between commonly controlled corporations does not trigger the rule.

• Tax-free reorganizations: Transfers through mergers, recapitalizations and other tax-free reorgs are permitted.

Additionally, personal loans secured by a policy and shareholder-insured transactions may avoid the rule in certain cases. Proper legal and tax expertise is important with these arrangements.

When transferring policies using exemptions, documents should clearly indicate the reason to support the tax-free basis.

Common Scenarios for Policy Transfers

Some typical situations where ownership of a life insurance policy may be transferred include:

Gifting a Policy to an Irrevocable Life Insurance Trust

A common estate planning technique is transferring a policy to an irrevocable life insurance trust (ILIT). As a gift not involving valuable consideration, this transfer is exempt from the rule. Death benefits remain tax-free outside the insured’s estate.

Gifts to ILITs should use proper gift tax returns and documentation to support the tax-free basis. Trying to sell a policy to an ILIT for cash runs into transfer-for-value problems.

Selling a Policy to a Life Settlement Company

Life settlements involve selling a policy to investors who continue paying premiums and collect the death benefit. These transfers clearly fall under the transfer-for-value rule since they exchange policies for cash. The buyer’s income tax basis is their purchase price.

Life settlement companies submit 1099 forms to the IRS reporting the taxable portion of death benefits they receive.

Transferring Policies in a Business Context

Transfers between commonly controlled businesses are exempt from the rule. But sales to outside parties trigger it.

For example, a business owner transfers policies to a trust as part of an exit strategy. Or policies held inside a corporation are distributed to shareholders in asset sales or liquidations. The death benefits may become partially taxable to the buyers unless structured properly.

Avoiding the Transfer-for-Value Tax Trap

If you are considering transferring ownership of a life insurance policy, work closely with financial and legal advisors to avoid the transfer-for-value rule’s tax implications.

Some key steps include:

• Carefully structure transfers using exemptions to the rule
• Document that no valuable consideration was exchanged
• Review split dollar arrangements for transfer issues
• Report gifts correctly if gifting policy to an ILIT
• Get expert help assessing corporate policy transfers
• Clarify tax impacts for buyers of policies in life settlements

While life insurance proceeds are generally tax-free, the transfer-for-value rule can create unwanted income taxes if not handled correctly. But with proper planning, the tax benefits of life insurance can be maintained.

Key Takeaways

• Life insurance death benefits are usually exempt from income tax
• The transfer-for-value rule creates taxes if a policy was transferred for cash or other assets
• Exceptions exist for gifts, transfers to insured, and certain corporate transactions
• Transfers to an ILIT are exempt if structured as gifts, not sales
• Life settlements and business transfers can trigger the rule
• Proper documentation and tax advice is key to maintaining tax benefits

Understanding the transfer-for-value rule is crucial when gifting policies or transferring ownership for estate, business or other planning purposes.