When selling a life insurance policy makes the death benefit taxable

A life insurance death benefit is normally income-tax-free to whoever collects it. That default has an exception built for one situation: someone pays money, or gives something else of value, to take over a policy that already exists. When that happens, the buyer may be able to exclude from income only what they paid plus the premiums they pay afterward, and the rest of the death benefit can be taxed as ordinary income. This is the transfer-for-value rule in section 101(a)(2) of the Internal Revenue Code.

The rule is easy to read and surprisingly easy to trip. This post looks at it as a mechanism: what counts as a "transfer for value," why the exceptions exist, and which ordinary-looking deals land on the wrong side. The basics, with a tax-law summary, are in the the transfer-for-value rule guide. Here the focus is on how it plays out in realistic situations.

The idea behind the rule

Congress wanted death benefits to stay tax-free for families who buy insurance to protect each other. It did not want the policy itself to become a tax-free trading asset. If a stranger could pay $50,000 for a $1,000,000 policy on someone else's life and collect the full $1,000,000 tax-free, buying and selling policies on aging people would be a way to turn a profit without tax. The rule therefore says that a buyer who pays something to acquire a policy is treated like an investor: they can recover what they put in, and the profit above that is income.

Two features of the wording matter.

• "For a valuable consideration." Valuable consideration is anything that has value: cash, property, a promise, the assumption of a loan, the cancellation of a debt, or a trade of one policy for another policy that is not a tax-free exchange. It does not have to be a market price. A payment of $1 can count.
• "By assignment or otherwise." The rule covers any transfer of the policy or an interest in it, not only a formal sale. A partial interest, such as a share of the death benefit, counts too.

When the rule applies, the buyer's tax-free amount is limited to two things added together: the consideration they paid, and the premiums and other amounts they pay after the transfer. The rest of the death benefit is ordinary income.

A first worked case: the friend who buys

This is a hypothetical, with invented numbers.

Say Helen owns a $500,000 policy on her own life and needs cash. Her friend Omar offers $60,000 for the policy and takes it over. Omar pays $15,000 in premiums over the following years. Helen dies and the insurer pays Omar $500,000.

Omar is not Helen, not a partner of hers and not connected to any business of hers. He is outside every exception. Three things stand out in this example.

First, Omar's bad outcome came from the purchase, not from anything in the policy. The same policy, left in Helen's name with Omar as beneficiary, would have paid him the full $500,000 free of income tax.

Second, the law protects the premiums as part of his cost. The $15,000 he paid in later premiums is added to the tax-free amount.

Third, Helen's own tax result is a separate question. A seller can have income on the sale, and that depends on the policy's basis and cash value. The life settlements: selling your life insurance policy guide explains the layers. The transfer-for-value rule is about the buyer's side of the deal.

Why the exceptions exist

If the rule applied to every transfer, a family could not move a policy into a trust, a business could not buy out a partner's policy and an ordinary swap between insurers would create tax. The statute therefore protects two groups of transfers.

Group one: the buyer inherits the seller's tax basis. If the new owner's basis in the policy is figured by reference to the old owner's basis, the rule does not apply. In practice this covers:

• Gifts. A true gift is not a sale. Giving a policy to a child, a spouse or a trust is not a transfer for value.
• Transfers between spouses or incident to a divorce. These carry basis over by law.
• Tax-free exchanges. A 1035 exchanges: swapping policies without tax of one life policy for another keeps the basis. The exchange rules are covered in that guide.
• Certain business reorganizations where basis carries over.

Group two: the buyer is a protected person. A transfer is safe when it is made 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.

The reasoning is that these buyers have a genuine stake in the insured's life, such as a business partnership, and they are not speculating on a stranger. The list is narrow. A friend, a sibling, a co-shareholder in a corporation (as opposed to the corporation itself) and an ordinary trust for someone else are not on it.

Case two: the sale to the insured

Say Chen owns a $250,000 policy on his brother Wei. Wei is retiring, wants to hold the policy himself and offers Chen $40,000 for it. The buyer is the insured, which is on the protected list. When Wei dies, the death benefit is paid to the beneficiary he names, and the transfer-for-value rule does not apply to that payment.

Wei still needs to think about two other things that have nothing to do with the rule. If Wei owns a policy on his own life at death, the proceeds count toward his estate for estate tax purposes; see seven slip-ups that bring life insurance proceeds back into your estate. And Chen's tax on the sale price is his own matter. A tax professional will look at both.

Case three: the cross-purchase agreement that drifts

Business owners trip this rule more often than anyone. Say three people own a company and sign a cross-purchase agreement, in which each owner buys a policy on each of the others to fund a buyout if one dies. See buy-sell agreement and cross-purchase agreement for the vocabulary. Ana, Ben and Cora each own two policies, one on each partner.

When Ana dies, Ben and Cora collect on the policies on Ana's life, and use the money to buy Ana's share of the company. Ana owned two policies, one on Ben and one on Cora. Those now belong to her estate and are sold:

• Ben buys the policy on Ben's own life from the estate. Ben is the insured. Protected.
• Cora buys the policy on Cora's own life from the estate. Cora is the insured. Protected.

That plan works. The problem appears when the owners try to simplify. Suppose that, instead of Ben buying the policy on his own life from Ana's estate, Cora buys it, so that Cora ends up holding two policies on Ben. Or suppose the policy Ana held on Cora is sold to Ben. In these versions the buyer is not the insured. Whether it is protected now depends on the type of business entity:

• If the business is a partnership for tax purposes, the buyer is a partner of the insured, which is on the list.
• If the business is a corporation, a co-shareholder who buys a policy on another shareholder is not on the list. The corporation can be a protected buyer; a fellow shareholder personally is not.

The guide cross-purchase vs entity-redemption buy-sell plans compares the two buyout designs, and funding a buy-sell agreement with life insurance covers the basics. Many corporate owners avoid the trap by having the company buy the policies (an entity-redemption agreement) or by using a trustee to hold all the policies. The right design depends on the number of owners, the entity type and what the owners want to happen on a death, so it is a question for the company's attorney and tax adviser.

Case four: the gift that is also a sale

Gifts are protected, but only when they are really gifts. Say Mira owns a $400,000 permanent policy on her own life. She wants her daughter to own it. The policy has a loan of $45,000, and Mira has paid $30,000 in premiums over the years, so her basis is $30,000.

Mira "gives" the policy to her daughter, who takes it subject to the loan. The loan does not vanish. By taking over the policy with the loan, the daughter relieves Mira of a $45,000 debt. That relief is something of value, so the transfer is part gift and part sale.

How the tax law treats a part-gift, part-sale transfer is the tricky part. The usual way to analyze it, which an attorney will confirm for the actual facts, is this:

• If the loan is no larger than the giver's basis, the new owner's basis can still be figured from the giver's basis, so the carryover exception generally applies.
• If the loan is larger than the giver's basis, as it is here ($45,000 against $30,000), the new owner's basis is tied to the amount paid, and the exception may not hold.

In this hypothetical, Mira should not simply sign the form. She would ask whether to pay the loan down first, so that the gift is clean, or to choose a different structure. If the loan had been $20,000 against the same $30,000 of basis, the question would be much less worrying.

A related point is the "taint." If a policy was transferred for value earlier in its life and the exceptions did not cover that transfer, later gifts carry the problem forward, because the new owner's basis follows the old one's. Find out a policy's history before you accept it as a gift.

Case five: selling to a trust

A parent sells a policy to a trust for the benefit of the children, to get it out of the parent's estate. The sale is for value, and the buyer, an ordinary trust, is not the insured, a partner or a corporation. The exceptions may not fit, unless the trust is built to be a "grantor trust" that the insured is treated as owning for income tax purposes. Under IRS guidance, a sale to a grantor trust wholly owned by the insured has been treated as protected, but that structure is detailed planning for an attorney.

Compare that to a gift to a trust, which carries over basis and is outside the rule, but which can raise the three-year problem described in the three-year rule for transferring a policy and the issues in seven slip-ups that bring life insurance proceeds back into your estate. Gift versus sale is a trade-off between the transfer-for-value rule and the estate tax rules, and that is why professional advice matters.

Case six: investors and settlements

An investor who buys a policy from the insured in a life settlement is generally outside the exceptions. When the insured dies, the investor's tax-free portion is limited to the purchase price plus the premiums the investor paid. The profit is taxable. Investors accept that, and it is built into what they pay. For the seller, the question is what the sale does to their own taxes, and whether keeping, surrendering or selling is best. The life settlements: selling your life insurance policy guide covers that comparison.

What does not trigger the rule

Several actions look like transfers but are not.

• Changing the beneficiary. That does not move ownership.
• A collateral assignment. Pledging a policy to secure a loan transfers only a security interest. See collateral assignment of life insurance.
• Borrowing from or surrendering to the insurer. These are dealings with the issuer, not transfers to someone else.
• Paying someone else's premiums. Paying premiums on a policy you do not own is not buying it, though you will want written terms for what you get back, if anything.
• A change of owner to a nominee with no value exchanged. A purely gratuitous change is a gift.

The tax answers can change if the deal includes a loan being forgiven, a premium obligation being taken on, or a price hidden in another agreement. How the deal is described on paper matters less than what actually moves.

A checklist before any policy changes hands

1. Is anything of value moving? Cash, a loan, a promise to pay premiums, a debt forgiven, another policy.
2. Who is the buyer? Is it the insured, a partner of the insured, a partnership with the insured as a partner, or a corporation where the insured is a shareholder or officer?
3. If not, is it a true gift or a carryover transfer? If there is a loan, compare its size to the giver's basis.
4. What is the policy's history? Any earlier sale could affect later holders.
5. What are the estate and gift consequences? Moving a policy can start the three-year clock or use gift exclusion.
6. Who reports what? Sales of policies often involve information reporting to the IRS and the seller. Get the details from the insurer and your tax adviser.
7. Is everything documented? Keep the date, price, parties and the signed assignment, and send the insurer its change-of-ownership form. The mechanics are in transferring ownership of a life insurance policy.

When to talk to a professional

A transfer-for-value problem is invisible when the deal is signed and expensive years later, when the insured dies and the tax return is prepared. If you are buying a policy on someone else, selling your own, changing ownership in a buy-sell plan or moving a policy with a loan, ask a tax attorney or CPA before you sign. The insurer processes ownership changes but does not give tax advice.

Key takeaways

• If you pay something of value to acquire an existing policy, your tax-free share of the death benefit may be limited to what you paid plus later premiums, and the rest can be ordinary income.
• The rule is aimed at buyers, but your own sale has tax effects that are separate and worth checking.
• Gifts, spousal and divorce transfers and 1035 exchanges generally escape, as do sales to the insured, a partner, the insured's partnership or a corporation where the insured is a shareholder or officer.
• The common traps are cross-purchase deals between co-shareholders, a gift of a policy that has a large loan, sales to ordinary trusts, and policies with a tainted history.
• Changing a beneficiary or collaterally assigning a policy is not a transfer for value, but check before relying on that for a complicated deal.