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Transfer-for-value

Ensuring compliance is supremely important

The transfer-for-value rule, contained in Internal Revenue Code §101(a)(2), provides:

In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by [the beneficiary of death proceeds under a life insurance contract] shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee.

The transfer-for-value rule provides that when a policy is transferred for valuable consideration, the death proceeds received in excess of the consideration paid are taxed as ordinary income (as opposed to tax-free under the general rule for life insurance proceeds).1

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Key points regarding the transfer-for-value rule

  • It does not matter whether the policy is term or permanent life insurance.

  • It applies to group as well as individually-purchased life insurance coverage.
  • How the policy is transferred is irrelevant.
  • It can apply even if ownership of a policy has not been transferred.
  • A mere shift in an interest in the contract may be sufficient to trigger the rule.
  • For the rule to apply, there must be both a transfer of a policy or an interest in a policy and valuable consideration paid to the transferor for the transfer.

Five safe-harbor exceptions may shelter a transfer from the transfer-for-value rule penalty (even if there is a transfer for valuable consideration):

  1. Transferor’s basis (“in whole or in part”).
  2. Transfer to the insured.
  3. Transfer to a partner of the insured.
  4. Transfer to a partnership in which the insured is a partner.
  5. Transfer to a corporation in which the insured is an owner or officer.

Please note:

  • Transfers to a stockholder are not protected and will trigger the transfer-for-value rule.
  • Transfers to a partnership in which the insured is a partner and transfers to a partner of the 

    insured are statutory exceptions to the transfer-for-value rule under Section 101(a)(2)(b).

When a partnership owns the life insurance which funds the buy-sell, all transfer-for-value traps are avoided.

Transfer-for-value trap:

Switch from entity redemption to cross purchase with a corporation

If the owners wish to change from entity redemption to a cross purchase arrangement, 

the corporation transfers the policies owned on the life of the owner to their other owners.

However, the transfer of a policy to a co-owner is treated as a sale for valuable consideration and therefore the transfer-for-value rule would apply, creating taxable income at death.

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1. 18. IRC §101.

Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

DOFU 10-2022

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