Typically, life insurance is a key element of an estate plan. If you’re looking to keep the value of a life insurance policy you already own out of your taxable estate, you may consider transferring the policy. However, income tax traps exist that you need to be mindful of before you conduct a transfer – in particular, the transfer-for-value rule. This information can help you determine whether a transfer makes the best sense.
The ABCs of Life Insurance and Exceptions to the Rules
Normally, life insurance proceeds payable by reason of death (a.k.a. “death benefits”) aren’t subject to income tax. However, when the transfer-for-value rule applies, the transferee —or person receiving the policy — will be subject to ordinary income taxes on the policy’s death proceeds, excluding the consideration paid for the policy and any premiums or other charges he or she pays after the transfer.
The transfer-for-value rule is intended to discourage speculation in insurance policies by people who lack an insurable interest. An insurable interest is a legitimate reason for someone to be insured against your death — typically, this refers to a person close to you who would suffer a financial hardship in the event of your death. Examples of people with an insurable interest on you could include your spouse, child, or business partner.
Unfortunately, the rule’s design doesn’t necessarily align with its underlying rationale. For example, though the rule contains several exceptions, there isn’t one for transfers to children or other family members who typically do have an insurable interest.
So what are the exceptions? One is when the transfer is made to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Be aware that this exception doesn’t apply in reverse, when the transfer is to an officer or shareholder.
Transfer-for-value Rule Potential Pitfalls
One reason the transfer-for-value rule is so dangerous is that the term “transfer” goes well beyond an outright sale or physical transfer of a policy. A transfer can occur, for example, when you name a beneficiary or assign someone an interest in the policy.
A transfer won’t cause the death benefits to become subject to income taxes unless the transferee provides “valuable consideration,” but this aspect of the rule can be difficult to navigate, too. Valuable consideration isn’t limited to money. It can be virtually anything of value to the transferor — the person transferring the policy or interest.
It’s logical to assume that the transfer-for-value rule won’t apply to a gift of a policy or of an interest in a policy. In most cases that’s true but even gift transfers should be examined closely to avoid the transfer-for-value trap.
The bottom line is if you want to transfer a policy, give it plenty of thought. The transfer-for-value rule is a tax trap to which many individuals fall prey.
If you’d like to discuss whether a policy transfer makes sense for you and how to prepare for the tax impact of such a transfer, please contact your Untracht Early representative.