What Is the Transfer-for-Value Rule?
The transfer-for-value rule stipulates that if a life insurance policy (or any interest in that policy) is transferred for something of value (e.g., money, property, etc.), a portion of the death benefit is subject to taxation as ordinary income. This portion is equal to the death benefit minus the item(s) of value, as well as any premiums paid by the transferee at the time of the transfer.
For example, if John Doe sells a life insurance policy with a $250,000 death benefit that he had paid $10,000 thus far in premiums on to Jane Doe for $5,000, the amount subject to income tax would be $235,000 ($250,000 - $10,000 - $5,000).
- The transfer-for-value rule ensures that transfers of life insurance policies are taxable.
- There are several exceptions to the rule, including if the policy was purchased by a firm for continuity of business purposes.
- It is always important to examine fine print as it applies to this rule before making a life insurance policy transfer or sale.
Understanding the Transfer-for-Value Rule
The transfer-for-value rule includes the outright sale of a life insurance policy, as well as viaticals and other transfers or assignment of the policy. The life insurance policy does not itself lose its tax-exempt status when the policy is transferred to the insured, a partner of the insured, or to a company where the insured is an officer or stockholder.
One of the key benefits of any kind of life insurance is the tax-free death benefit it confers to beneficiaries. However, some speculators have begun to transfer life insurance policies between parties in order to reap tax-free windfalls. In response, Congress declared that any life insurance policy that is transferred for any kind of material consideration may become partially or fully taxable when the death benefit is paid.
The transfer-for-value rule stands as one of the few exceptions to the general exemption from taxation accorded to all life insurance death benefit proceeds. The Tax Cuts and Jobs Act (TCJA) of 2017 clarified the basis for taxation of insurance policies by including a new term "reportable policy sale."
The term refers to the acquisition of an interest in a life insurance contract directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such a life insurance contract. This helps define the tax liabilities included in certain business situations, such as mergers and acquisitions.
However, the rule has several exceptions, especially as they apply to business-owned life insurance. Some of these exceptions to taxing life insurance policy transfers are listed below.
The transfer of life insurance policies is considered tax free in the following instances:
- Anyone whose basis is determined by reference to the original transferor’s basis
- The insured (or insured’s spouse or ex-spouse, if incident to a divorce under Sec. 1041)
- A partner of the insured
- A partnership in which the insured is a partner
- A corporation in which the insured is a shareholder or officer
Examining the Transfer-for-Value Rule
The transfer-for-value rule is conceptually fairly straightforward, but it must be examined carefully in order to establish when it applies, as various insurers may include different language in their policies. Despite the common understanding that coverage applies to a form of monetary payments, sometimes no formal transfer of any kind need take place or tangible consideration be provided in order to violate this rule.
Consideration can, in this case, be merely a reciprocal agreement of some sort that is tied to the transfer of the policy.
For example, if two shareholders in a closely held business take out life insurance policies on themselves and name each other as beneficiaries to form a buy-sell agreement, then the recipient of the death benefit proceeds from the policy of the partner who dies first will face a substantial tax bill under the transfer-for-value rule. The rule applies here because the two partners presumably agreed to name each other as beneficiaries, thereby introducing the receipt of consideration into the equation.