Transfer-for-value Rule

Years ago Isolde transferred her 750,000 dollar policy to an unrelated investor for cash. She has since recovered financially and BUYS THE SAME POLICY BACK from that investor for 210,000 dollars, becoming the owner of a policy on her own life once more. She then names her daughter as beneficiary. At Isolde death, how are the proceeds taxed to the daughter?

1. A.Fully taxable as ordinary income, because the policy was once sold to an unrelated investorA prior tainted transfer is not permanent. A later excepted transfer restores tax free treatment.
2. B.Fully income tax free, because a transfer to the INSURED is an exception to the transfer for value ruleCorrect. A sale back to the insured is an excepted transfer, so the full death benefit is received income tax free.
3. C.Taxable to the extent the 750,000 dollars exceeds the 210,000 dollar repurchase price plus later premiumsThat is the transfer for value formula, but the repurchase by the insured falls within an exception, so the formula does not apply.
4. D.Taxable as long-term capital gain to the extent of the appreciation over the repurchase priceDeath benefits are never characterized as capital gain. When the transfer for value rule does apply, the excess is ordinary income.

Why: The transfer for value rule taxes death proceeds as income to the extent they exceed the buyer consideration plus later premiums, but it has a short list of exceptions. One of them is a transfer TO THE INSURED. When Isolde repurchases the policy on her own life, that sale falls within the exception, which cleanses the prior taint. The proceeds are therefore fully income tax free to her daughter under the general rule of Section 101(a). The other exceptions are transfers to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, and any transfer with a carryover basis.

Two life policies change hands for cash. In the first, Odo sells a policy on his own life to Petra, who is his PARTNER in the partnership they jointly operate. In the second, Rufus sells a policy on his own life to Sable, a fellow SHAREHOLDER in the corporation they both own. Both buyers pay fair value and continue the premiums. Which policy's death benefit remains fully income-tax-free?

1. A.Both, because each buyer had an insurable interest in the insured's lifeIncorrect. Insurable interest is a state-law contract requirement. The transfer for value rule is a separate federal tax rule with its own closed list of exceptions.
2. B.Neither, because any sale of a policy for cash destroys the income tax exclusionIncorrect. The whole point of the exception list is that some sales for value preserve the exclusion, including a sale to a partner of the insured.
3. C.Only the policy sold to Sable, because a shareholder in the insured's corporation is a listed exceptionIncorrect. The exception covers a corporation in which the insured is a shareholder, not another individual shareholder buying in his own name.
4. D.Only the policy sold to Petra, because a partner of the insured is a listed exception while a co-shareholder is notCorrect. The exceptions name a partner of the insured and the corporation itself, but not a fellow shareholder buying personally.

Why: The transfer for value rule taxes the death benefit above the buyer's basis unless a statutory exception applies. The exceptions cover transfers to the INSURED, to a PARTNER of the insured, to a PARTNERSHIP in which the insured is a partner, and to a CORPORATION in which the insured is a shareholder or officer - plus carryover-basis transfers. A sale to a partner of the insured fits an exception, so Odo's policy stays tax-free. A sale to a fellow SHAREHOLDER does not: the exception covers the corporation itself, never a co-shareholder personally.

Bartholomew Quiller owns a $2,000,000 life insurance policy on his own life. He sells it to an unrelated private investor for $300,000. The investor then pays $180,000 of additional premiums before Quiller dies, and collects the $2,000,000 death benefit. Ignoring any separate life settlement reporting rules, how is that death benefit treated for the investor federal income tax purposes?

1. A.The entire $2,000,000 is excluded from gross income, because death benefits paid by reason of the death of the insured are always income tax free.Incorrect. The general exclusion is cut back by the transfer for value rule whenever a policy is transferred for valuable consideration and no exception applies.
2. B.The entire $2,000,000 is ordinary income, because a policy purchased as an investment loses its character as life insurance.Incorrect. The policy remains life insurance. The transferee still excludes the consideration paid plus subsequent premiums; only the excess is income.
3. C.$1,520,000 is ordinary income, because the exclusion is limited to the $300,000 consideration paid plus the $180,000 of premiums subsequently paid.Correct. $2,000,000 less the $480,000 of consideration and subsequent premiums leaves $1,520,000 taxable as ordinary income.
4. D.$1,520,000 is long-term capital gain, because the investor held the contract for more than one year before collecting.Incorrect. Amounts taxable under the transfer for value rule are ordinary income, not capital gain, regardless of the holding period.

Why: Life insurance death benefits are normally excluded from gross income. The TRANSFER FOR VALUE rule is the major exception. When a policy is transferred for valuable consideration, the income tax exclusion is cut back so that only the consideration paid by the transferee plus the premiums and other amounts the transferee subsequently pays remain tax-free; everything above that is ordinary income. Here the investor tax-free amount is $300,000 paid for the policy plus $180,000 of subsequent premiums, or $480,000. Of the $2,000,000 collected, $1,520,000 is therefore ordinary income. The rule has important exceptions that preserve the full exclusion: a transfer to the INSURED, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder, as well as any transfer in which the transferee takes a carryover basis. None applies to an unrelated investor.

The owner of a life insurance policy sells it outright to an unrelated investor for cash. When the insured later dies, the tax treatment of the death benefit in the hands of that investor is that

1. A.the entire death benefit is excluded from income, because it is a life insurance payment.Wrong. The exclusion is forfeited when a policy is bought for consideration by a non-permitted transferee.
2. B.the entire death benefit is taxable, because the buyer never had insurable interest in the insured.Wrong. Insurable interest is a state contract validity question and is not the federal measure of income here.
3. C.the death benefit is taxable only where the buyer is a corporation rather than an individual.Wrong. The rule turns on the transfer and whether the transferee is a permitted one, not on entity form.
4. D.the amount exceeding what the buyer paid plus premiums the buyer later paid is taxable income.Correct. The exclusion survives only up to the investment of the buyer, which is what the rule was written to achieve.

Why: The exclusion of life insurance proceeds from income is not unconditional. Where a policy has been transferred for valuable consideration to someone outside a narrow list of permitted transferees, the transfer-for-value rule limits the exclusion to what the buyer paid plus the premiums the buyer subsequently paid, and the excess is ordinary income. The rule exists to stop the exclusion being sold to an investor who has no insurable relationship with the insured. If the buyer had been the insured, a partner of the insured or a corporation in which the insured was a shareholder or officer, the full exclusion would have survived the transfer.