The life insurance "transfer for value" rule. (Estates & Trusts)by Brown, Dennis C.
Under IRC Sec. 101(a)(1), amounts received under life insurance contract by reason of the death of the insured are generally excluded from gross income. However, IRC Sec. 101(a)(2) may cause all amounts in excess of the acquisition consideration and the premiums paid by the transferee to be included in gross income if the "transfer for value" rule is violated.
IRC Sec. 101(a)(2) states that the transfer for valuable consideration of a life insurance contract or interest therein, by assignment or otherwise, will violate the transfer for value rule. Reg. Sec. 1.101- 1(b) spell out that an absolute transfer for value of a right to receive all or a part of the life insurance proceeds, or the mere creation for value of an enforceable contractual right to receive all or a part of the policy proceeds may constitute a transfer for value.
There are several important exceptions to the transfer for value rule in IRC Secs. 101(a)(2)(a) & (8). The transfer for value rule may not apply if--
a.The basis of the policy in the hands of the transferee is determined in whole or in part by reference to the transferor's basis (the basis carryover exception);
b. The transferee is the insured;
c. The transferee is a partner of the insured;
d. The transferee is a partnership in which the insured is a partner; or
e. The transferee is a corporation in which the insured is a shareholder or officer.
Reg. Sec. 1.101-1(b)(2) contains additional guidance concerning the application of the basis carryover exceptions to subsequent gratuitous transfers after a prior transfer of the same policy for value.
There does not appear to be any logical reason to exempt transfers to and among partners of the insured, and not also afford this same exemption to transfers to and among closely-held corporate shareholders if the insured is a co-shareholder. Nevertheless, unless the transferee is the insured, transfers of policies from a corporation to a shareholder, and transfers among shareholders can violate the rule.
C Corporation Issues
It may be wise to transfer (from a C corporation) existing life insurance policies that were acquired to fund stock redemptions pursuant to a shareholders agreement to avoid the corporate alternative minimum tax. As a result of the Accumulated Current Earnings adjustment of IRC Sec. 56(g), many closely-held C corporations have considered substituting cross-purchase shareholder agreements in situations that were previously structured as redemptions.
If the corporation sells or merely distributes a policy to a shareholder other than the insured, the transfer for value rule is violated in the insurance proceeds and will lose their tax-exempt status. A transfer of a policy from the corporation to the insured, followed by a transfer from the insured to the other shareholders, could also result in the loss of the tax-exempt status of the insurance proceeds. Notwithstanding that no money changes hands, consideration can be found in the reciprocal transfers of policies among shareholders or in the transferee shareholder's obligation to use the proceeds for a cross-purchase. The loss of tax-exempt status could result even though the shareholders are related.
S Corporation Issues
An S corporation with accumulated earnings and profits from C corporation years may wish to transfer its life insurance contracts if the ultimate distribution by the corporation of otherwise tax-exempt death proceeds would be taxed as dividends under IRC Sec. 1368. This problem may arise because tax-exempt death proceeds do not increase an S corporation's accumulated adjustments account.
Neither an S corporation nor its shareholders are allowed the liberal IRC Sec. 101(a)(2)(b) exemptions from the transfer for value rules that are available to and among partners of the insured. Therefore, the S corporation is subject to the same transfer for value problems that are noted above for C corporations.
When an S corporation with accumulated earnings and profits uses its life insurance proceeds to redeem the insured/decedent's stock, the recipient of the redemption proceeds might qualify for exchange (rather than dividend) treatment under IRC Secs. 302 & 303 (with no taxable gain due to the basis step-up under IRC Sec. 1014). The corporation may in fact reap a significant benefit by having its accumulated earnings and profits reduced (pursuant to IRC Sec. 1371(c)(2)) in proportion to the percentage of stock redeemed. if this proportionate reduction in accumulated earnings and profits advantage is significant, the S corporation might be better off avoiding the transfer for value risks and simply retaining the insurance in the S corporation to fund such redemptions.
Family Corporation issues
In a family business setting, restructuring the ownership of existing insurance policies on the elder generation to provide the younger generation with funding for a cross-purchase may also serve to minimize the elder generation's overall taxable estate. A seemingly gratuitous transfer of a policy to the younger generation, ultimately resulting in keeping the death proceeds out of the insured's taxable estate, may violate the transfer for value rule if there are reciprocal policy transfers taking place or if the younger generation is obligated to use the proceeds to redeem the elder's stock under a cross-purchase agreement.
It would appear that an inter-family transfer that is economically gratuitous, even when coupled with an obligation to use the proceeds to cross-purchase the decedent's stock, might still qualify under the first exception to the transfer for value rule noted above. However, because of the potential for a transfer for value rule violation, in-house tax counsel for a major life insurance company has cautioned against such a gratuitous policy transfer in a family business setting coupled with a cross-purchase agreement.
Since the transferor is receiving consideration by being discharged from the loan obligation, the transfer of a life insurance policy subject to a nonrecourse loan is a transfer for value. However, if the transferor's basis in the policy is greater than the loan balance, a gratuitous transfer of the policy should qualify for the first exception to the transfer-for-value rule noted above, the basis carryover exception Rev. Rul. 69-187, 1969-1, CB 45; PLR 89510561.
Transfer-for-value rule problems can arise in obvious and some not so obvious ways. Not only will the transfer for value rule apply to the outright sale of a whole-life insurance contract, the rule can even be applied to a term insurance contract. It can apply to many other types of policy modifications and transfers, including the mere naming of a beneficiary in exchange for consideration.
The exceptions to the transfer for value rule contained in IRC Sec. 101(a) (2) are illogical in their harsh treatment of corporations and shareholders compared to partnerships and partners. Apparently even transfer of a policy by a corporation to its shareholders, which would otherwise violate the transfer for value rule, is considered exempt if such shareholders are also partners in a bona fide, but unrelated, partnership (PLR 9045004).
The adverse economics associated with replacing existing whole-life insurance policies with new ones and the changed health of the insured often create the need to transfer existing policies rather than simply acquiring new ones with the desired characteristics. The potential for less obvious transfers and more subtle elements of consideration triggering the transfer for value rule and the inconsistent nature of the exceptions to this problems, make this a dangerous area for the uninformed.
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