What is Transfer-For-Value Rule
A transfer-for-value rule stipulates that, if a life insurance policy (or any interest in that policy) is transferred for something of value (money, property, etc.), a portion of the death benefit is subject to be taxed 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 his $250,000 life insurance policy that he has paid $10,000 in premiums on to Jane Doe for $5,000, the amount subject to income tax is $235,000 ($250,000-$10,000-$5,000).
BREAKING DOWN Transfer-For-Value Rule
A transfer-for-value rule includes, but goes beyond, the outright sale of a life insurance policy. The life insurance policy does not 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. However, some speculators began to transfer life insurance policies between parties in order to reap large 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.
This rule is known as the transfer-for-value rule, and it stands as one of the few exceptions to the general exemption from taxation accorded to all life insurance death benefit proceeds. However, the rule itself has several exceptions.
Understanding the Transfer-for-Value Rule
In theory, a transfer-for-value rule is conceptually fairly simple, but it must be examined carefully in order to establish when it applies. 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, 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.