The transfer-for-value rule

The transfer-for-value rule says that if a life insurance policy is sold or otherwise transferred for something of value, the buyer can exclude from income only what they paid for it plus the premiums they pay afterward. Everything above that is taxable income when the insured dies. The rule is in 26 U.S.C. §101(a)(2), and it is the main exception to the general rule that death benefits are income-tax free.

What the statute says

Section 101(a)(1) excludes death proceeds from gross income. Section 101(a)(2) then provides that when a policy "or any interest therein" is transferred "for a valuable consideration, by assignment or otherwise," the exclusion is limited to the sum of:

• the actual value of the consideration the buyer paid, and
• the premiums and other amounts the buyer pays after the transfer.

Anything left is ordinary income to the buyer. The word "interest" means a partial interest can trigger the rule too.

A hypothetical example

The following is hypothetical and not a market price.

Say Greg owns a $1,000,000 policy on his own life. A friend, Carla, pays Greg $100,000 for the policy and pays $20,000 in premiums afterward. When Greg dies, the insurer pays Carla $1,000,000.

If Carla instead had been a partner in Greg's business or had been Greg himself, the exception below would have kept the whole payout tax-free.

The exceptions

Two sets of exceptions in §101(a)(2) let a transfer for value happen without losing the exclusion.

Exception A: carryover basis. The rule does not apply when the buyer's basis is determined, in whole or in part, by reference to the transferor's basis. This covers:

• Gifts. A gratuitous transfer is not a transfer for value, so giving a policy to a child or a trust is not caught. A gift made in exchange for the recipient assuming a policy loan can create a partial sale.
• Tax-free exchanges. A 1035 exchanges: swapping policies without tax of one life policy for another keeps the original basis.
• Transfers between spouses or incident to divorce under §1041.
• Certain corporate reorganizations and similar transactions.

Exception B: the right buyer. A transfer is protected if it goes to:

1. the insured,
2. a partner of the insured,
3. a partnership in which the insured is a partner, or
4. a corporation in which the insured is a shareholder or officer.

These are the exceptions that business owners use. A partnership buying a policy on a partner, or a corporation buying a policy on its owner, is protected even for money. IRS guidance has also treated a transfer to a grantor trust that is wholly owned by the insured as protected, since the insured is treated as the owner for income tax purposes.

What is not a transfer for value

Several common events do not trigger the rule:

• Naming or changing a beneficiary.
• Collateral assignment of a policy as security for a loan, which transfers only a security interest. See collateral assignment of life insurance.
• Surrendering the policy to the insurer, or borrowing from it.
• Switching to a new policy with the same insurer.
• Paying premiums on a policy someone else owns, without buying it.

The tax answers can change if a loan is forgiven, a premium obligation is assumed or a sale price is hidden in another deal, so the structure of the transaction matters.

Where the rule causes trouble

Cross-purchase buy-sell agreements. In a cross-purchase plan, each owner buys a policy on each of the others. When one owner dies, the survivors often buy the policies the deceased held on them, which is safe because each buyer is the insured. But if a survivor buys a policy on a different co-owner, or if several owners later consolidate policies in one person's hands, that buyer is not the insured and the sale can be a transfer for value unless the business is a partnership or another exception applies. Many corporate owners avoid the problem with an entity redemption plan, a partnership structure or a trusteed cross-purchase. See funding a buy-sell agreement with life insurance and cross-purchase vs entity-redemption buy-sell plans.

Life settlements. An investor who buys a policy from the insured is not within the exceptions, so the investor's death benefit is taxed above the purchase price and later premiums. The seller's own tax result is separate; see life settlements: selling your life insurance policy.

Selling to a trust or family member. A sale to a child or an ordinary trust for payment is a transfer for value unless the buyer is the insured or a protected entity. A sale to a trust drafted so the insured is treated as its owner for income tax can fit an exception; this is detailed planning for an attorney.

Selling to a business. A corporation in which the insured is a shareholder or officer can buy the policy under Exception B. This can be a way to move a personal policy into the business.

Split-dollar and other business plans. Some compensation and loan plans can create a hidden sale. See split-dollar life insurance.

Reporting for sold policies

When a policy is sold in a reportable policy sale, the buyer must report the sale and payment to the IRS and the seller under §6050Y. The insurer reports death benefits paid on a transferred policy as well. Paperwork gaps can turn into penalties and mismatched income, so keep records of price, date and parties.

A checklist before any transfer

1. Is anything of value, such as cash, a loan assumption or a promise, changing hands for the policy?
2. If so, is the buyer the insured, a partner, the partnership, or a corporation in which the insured is a shareholder or officer?
3. If not, does a carryover-basis exception apply?
4. Is the policy part of a business agreement with several owners?
5. Have you documented the price, the date and the parties?

Because one misstep can turn a tax-free death benefit into a six- or seven-figure income tax bill, run any sale or business arrangement past a tax attorney or CPA before signing.

Key takeaways

• A transfer of a policy for valuable consideration limits the tax-free death benefit to the price paid plus later premiums (IRC §101(a)(2)).
• Gifts and carryover-basis transfers, including 1035 exchanges, are outside the rule.
• Sales to the insured, a partner, a partnership with the insured as partner, or a corporation in which the insured is a shareholder or officer are protected.
• Buy-sell agreements and life settlements are the usual trouble spots.
• Changing a beneficiary or collaterally assigning a policy is generally not a transfer for value.