The so-called “transfer-for-value” rules under Internal Revenue Code Section 101 govern the tax consequences of the transfer of ownership of an interest in a life insurance policy in exchange for consideration (represented by cash or other property or a change in the rights or obligations of the parties to the transfer). In addition, the Tax Cuts and Jobs Act of 2017 (TCJA) created and defined the new “reportable policy sale” and imposes enforceable reporting requirements on a taxpayer who acquires a policy in such a transfer, as well as on the transferor, the issuing insurer and any party making payments of death benefits with respect to the policy transferred. Furthermore, the transfer of a life insurance policy that constitutes a reportable policy sale under the TCJA can also affect the portion of the policy death benefit that may be subject to income tax. Final regulations were issued with respect to reportable policy sales on Oct. 31, 2019 and are generally effective with respect to transfers after that date. An understanding of the transfer-for-value rules, the reportable policy sale rules and the interplay between them is important when a client contemplates any transfer of a life insurance policy or for any business entity that owns a life insurance policy.
General Rules
The general rule under IRC Section 101(a) is that life insurance death benefits are received by the policy’s beneficiaries income tax free. Specifically, Section 101(a)(1) provides that a taxpayer’s gross income doesn’t include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured.
In situations in which a taxpayer transfers an interest in a life insurance contract for valuable consideration (a transfer for value) or as part of, or following, a reportable policy sale, the owner of the policy will generally be subject to income tax on some or all of the death benefit unless an exception applies.1 The amount of the death benefit that’s subject to income taxes generally is the excess of the death benefit over the amount actually paid for the interest in the contract, plus any premiums and other amounts paid by the transferee following the transfer.2 Both permanent and term life insurance policies are subject to the transfer-for-value rule.3
Example 1: A pays premiums of $500 for an insurance policy with a face amount of $1,000 on the life of B and subsequently transfers the policy to C for $600. C receives the proceeds of $1,000 on the death of B. The amount that C can exclude from his gross income is limited to $600 plus any premiums paid by C subsequent to the transfer.
Note that a transfer of policy interests may constitute a reportable policy sale even though the individual or entity receiving the policy falls under one of the exceptions of the transfer-for-value rules. Similarly, it’s possible for a transfer to violate the transfer-for-value rules, with no applicable exception available, but not constitute a reportable policy sale. As such, it’s important to understand the rules relating to each type of transfer—both transfer for value and reportable policy sale—before piecing together the broader analysis that should be done for every transfer of a policy interest.
Transfer-For-Value Rules
A transfer for value is any absolute transfer of a right to receive all or a part of the proceeds of a life insurance policy in exchange for valuable consideration. This includes more than a transfer of a policy in exchange for money or money’s worth. For example, the creation of an enforceable contractual right to receive all or a part of the proceeds of a policy may constitute a transfer for valuable consideration of the policy or an interest therein.4
On the other hand, the pledging or assignment of a policy as collateral security isn’t a transfer for valuable consideration of such policy or an interest therein, and Section 101 is inapplicable to amounts received by the pledgee or assignee.5
Sections 101(a)(2)(A) and (B) provide several exceptions to the transfer-for-value rule.6 Specifically, the death benefit won’t be subject to income taxes, even in the case of a transfer of the policy, or an interest in the policy, if the transfer is to:
• the insured under the policy;
• 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.
It’s also not subject to income taxes if the transferee’s basis in the transferred policy is determined, in whole or in part, by the transferor’s basis in the contract (commonly referred to as the “carryover basis” exception).
Example 2: X Corporation purchases for a single premium of $500 an insurance policy in the face amount of $1,000 on the life of A, one of its employees, naming X Corporation as beneficiary. Prior to A’s death, X Corporation transfers the policy to N Corporation, in which A is a shareholder. N Corporation receives the proceeds of $1,000 on A’s death. The entire $1,000 is to be excluded from the gross income of N Corporation.7
Example 3: X Corporation purchases, for a single premium of $500, an insurance policy in the face amount of $1,000 on the life of A, one of its employees, naming X Corporation as beneficiary. X Corporation transfers the policy to Y Corporation in a tax-free reorganization (the policy having a basis for determining gain or loss in the hands of Y Corporation determined by reference to its basis in the hands of X Corporation). Y Corporation receives the proceeds of $1,000 on A’s death. The entire $1,000 is to be excluded from the gross income of Y Corporation.8
None of these exceptions apply, however, if the transfer is considered a reportable policy sale (discussed later). Additionally, even if a current transfer does qualify for one of the exceptions, if the policy was transferred in a reportable policy sale at any time prior to the current transfer, some portion of the death benefit may still be subject to taxation.9
Policies transferred by gifts. Generally, if a policy is acquired by gift, the transfer-for-value rule won’t apply because the transferee’s basis will be the same as the transferor’s basis.10 Transfers between spouses or former spouses incident to divorce are also treated the same as gifts for tax purposes.11 When a policy is transferred by gift, the amount of proceeds excluded from income is equal to the amount that would have been excluded by the transferor had the transfer not occurred. However, if a reportable policy sale has occurred prior to the gift of the policy, a portion of the death benefit may be income taxable to the recipient.
Example 4: A, the insured, sells her policy to B for $10,000. The sale constitutes a reportable policy sale because B has no substantial family, business or financial relationship with A. The following year, B gifts the policy on A’s life to C, A’s child, who does have a substantial family relationship with A. At A’s death, C receives $100,000. The amount of death benefit excludible from C’s income is equal to $10,000 (the amount that would have been excludible by B if the transfer hadn’t occurred), plus any premiums paid by C following the gift.
In the case of a gift of a policy subject to a loan, the transfer is treated as a part gift/part sale and will constitute a transfer of the policy for value. If the loan is less than basis, there’ll be no transfer-for-value issue because the transferee will take the same basis as held by the donor (that is, the carryover basis exception applies). If, however, the loan is greater than the basis in the contract, the basis to the transferee is determined using the loan amount, and the basis exception won’t apply, unless another exception to the transfer-for-value rules applies.
Transfers to trusts. The IRS held in Revenue Ruling 85-13 that the transfer of assets between a grantor and grantor trust won’t be treated as a sale for income tax purposes.12 Applying similar reasoning as that from Rev. Rul. 85-13, the IRS held in Rev. Rul. 2007-13 that a transfer between two grantor trusts with the same insured/grantor isn’t a transfer for the purposes of the transfer-for-value rule. Because the grantor is treated as the owner of both trusts for income tax purposes, the grantor is treated as the owner of both the life insurance contract and the cash received for it both before and after the exchange; therefore, there’s no “transfer” under Section 101(a)(2).13
The sale of a life insurance policy from a non-grantor trust to a grantor trust would be considered a transfer for valuable consideration within the meaning of Section 101(a)(2), but generally should qualify under the transfer-to-the-insured exception under Section 101(a)(2)(b), assuming the acquiring trust is a wholly owned grantor trust as to the insured on the policy.14
If the acquiring trust in a policy sale is a non-grantor trust with respect to the insured, the transfer-to-the-insured exception wouldn’t apply, and care should be taken to determine if any other exception may apply to avoid taxation of the death benefit within the trust.
Keep in mind that in some of the aforementioned sales to a trust in which no transfer is deemed to have occurred or for which a transfer-for-value exception applies, the policy sale could still constitute a reportable policy sale if the beneficiaries of the trust don’t have a substantial family, business or financial relationship with the insured.15 In most cases, this shouldn’t be an issue, as typically the beneficiaries of trusts are family members of the grantor/insured, thus constituting a significant family relationship with the insured, but care should be taken when there are beneficiaries who aren’t family members.16
If a transfer to a trust constitutes a reportable policy sale due to one or more beneficiaries lacking a substantial family, business or financial relationship, then none of the transfer-for-value exceptions would be available, and the transfer could cause at least a portion of the death proceeds to be income taxable.17
Curing a transfer for value. In the case of a series of transfers, if the final transfer is to the insured, partner of the insured, partnership in which the insured is partner or to a corporation in which the insured is a shareholder/officer and no reportable policy sales have occurred along the way, the final transferee should be able to exclude the entire death benefit from gross income, assuming such final transfer doesn’t constitute a reportable policy sale.
If a reportable policy sale has occurred prior to the transfer to a partner of the insured, partnership in which the insured is a partner or corporation in which the insured is a shareholder/officer, the amount of the death benefit excluded from tax is limited to the sum of:
1. the higher of the amount that would have been excludible by the transferor if the transfer hadn’t occurred, or the actual value of the consideration paid by the transferee; and
2. the premiums paid by the transferee.18
If the final transferee in a series of transactions following a reportable policy sale is the insured and the insured acquires the policy for valuable consideration at its fair market value (FMV), then the entire death benefit can be excluded from income tax.19
Reportable Policy Sales
The TCJA added a new provision (IRC Section 101(a)(3)) under the transfer-for-value rules related to reportable policy sales.
A “reportable policy sale” is defined generally as the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured (apart from the acquirer’s interest in the life insurance contract).
When a policy is acquired as part of a reportable policy sale, the portion of the death benefit that exceeds the owner’s basis in the contract generally will be subject to income tax. This new provision further provides that none of the exceptions to the transfer-for-value rules apply when a life insurance contract, or any interest in a life insurance contract, is transferred in a reportable policy sale.20
It’s worth noting that the definition of a “reportable policy sale” doesn’t require a “sale” of the policy but merely the “acquisition” of the policy. This includes gratuitous policy transfers in which the donee lacks a substantial relationship to the insured. However, the amount of proceeds excluded from income with respect to gratuitous transfers that constitute reportable policy sales is determined by the amount that would have been excluded by the transferor had the transfer not occurred. As such, a gratuitous reportable policy sale doesn’t always translate into a taxable death benefit.21
As defined in Treasury Regulations Section 1.101-1(d), a “substantial family relationship” includes the following relationships of the acquirer to the insured:
1. same person;
2. a spouse (including domestic partners and other legal relationships permitted under state law);
3. a parent, grandparent or great-grandparent (or the spouse of such);
4. a lineal descendant of any of the foregoing (1), (2) or
(3) (or the spouse of such lineal descendant); or
5. any lineal descendant of a person described in (4).
A former spouse is also considered to have a substantial family relationship with the insured if a transfer is incident to a divorce.
A “substantial business relationship” between the acquirer and the insured exists if:
1. the insured is a key person or materially participates (as owner, employee or contractor) in an active trade or business owned directly or indirectly by the acquirer, and at least 80% of the business is owned (directly/indirectly) by the acquirer or beneficial owners of the acquirer; or
2. the life insurance policy is owned by a business that’s acquired by the acquirer, and the acquirer carries on the acquired business or uses a significant portion of the assets in an active trade or business, assuming one of the following additional requirements is met:
(i) The insured, immediately before the acquisition, is an employee of the acquired business; or
(ii) The insured was a director, highly compensated employee or highly compensated individual and, immediately after the acquisition, the acquirer has an ongoing financial obligation to the insured (for example, non-qualified deferred compensation, pension plan, buy/sell, etc.)
A “substantial financial relationship” between the acquirer and the insured exists if the aquirer:
1. acquires the insurance to fund the purchase (at the insured’s death) of the insured’s assets, liabilities or interests in common investments with the acquirer; or
2. is a charity to which the insured has been a substantial contributor or volunteer.
Care should be taken in applying these definitions when considering a policy transfer, as there may be circumstances in which an acquirer would appear to have a substantial family, business or financial relationship, but, in fact, doesn’t qualify as such as under the final regulations.
Example 5: A is the initial policyholder of a $100,000 insurance policy on A’s life. A contributes the policy to a C corporation (C corp), Corporation W, in exchange for stock. After the acquisition, A owns less than 20% of the outstanding stock of Corporation W and owns stock possessing less than 20% of the total combined voting power of all stock of Corporation W (and is therefore not a “key person,” as defined by IRC Section 264, with respect to Corporation W). Corporation W’s basis in the policy is determinable in whole or in part by reference to A’s basis in the policy. However, no substantial family, business or financial relationship exists between A and Corporation W, so A’s contribution of the policy to Corporation W is a reportable policy sale. Corporation W receives the proceeds of $100,000 on A’s death. Thus, the amount of the proceeds Corporation W may exclude from gross income is limited to the actual value of the stock exchanged for the policy, plus any premiums and other amounts paid by Corporation W with respect to the policy subsequent to the transfer. The “shareholder or officer” exceptions to the transfer-for-value rule don’t apply because the transfer to Corporation W is a reportable policy sale.21
Planning note: Prior to the reportable policy sale rules, the transaction discussed in the previous example shouldn’t have caused the death benefit to become taxable under Section 101 as it would likely have satisfied the basis exception if the transferee takes the same basis as the transferor. Under the new rules, because the regulations identify the transfer as a reportable policy sale, no transfer-for-value exceptions will apply to keep the policy from being subject to income tax.
Exceptions to reportable policy sale rules. The regulations provide22 that none of the following transactions are considered reportable policy sales:
1. Transfers between entities with the same beneficial owners if the ownership interests of each beneficial owner in both the transferring entity and the transferee entity don’t vary by more than 20%.
2. Transfers among corporations that are members of an affiliated group (as defined in the Treasury regulations) that files a consolidated income tax return in the year the transfer is made.
3. A person acquires ownership interest in a partnership/trust or other entity (directly or indirectly) that owns a life insurance policy if the entity acquired the interest in the policy: (i) before Jan. 1, 2019, or (ii) in a reportable policy sale and complied with the requirements for such sales.
4. Immediately before a person acquires an interest in a partnership/trust/entity owning an interest in the life policy:
i. No more than 50% of the gross value of the assets held by the partnership/trust/entity consist of life insurance contracts; and
ii. Following the acquisition, the person acquiring the interest in the partnership/trust/entity and his family members own, in the aggregate:
a. For S corporations: 5% or less of total combined voting power of all voting stock and 5% or less of total value of shares of all classes of stock
b. For trusts/estates: 5% or less of the corpus and 5% or less of annual income
c. For partnerships: 5% or less of capital interest and 5% or less of profits interest.
5. A person acquires an ownership interest in a C corp, and 50% or less of the gross value of the assets of the C corp consists of life insurance contracts immediately before the person acquires its interest.
6. Acquisition of a life insurance contract by an insurance company that issues life insurance contracts in an exchange pursuant to IRC Section 1035.
7. Acquisition of a policy in a Section 1035 exchange if the policy holder has a substantial family, business or financial relationship with the insured at the time of the exchange.
Application to Section 1035 replacements. Although typically, there’s no transfer of policy interests or ownership as part of a Section 1035 policy replacement, replacing a policy can invoke the reportable policy sale rules if the policy owner lacks a substantial family, business or financial relationship with the insured at the time of the exchange because the policy owner is acquiring a life insurance policy as a consequence of the exchange.
Example 6: A, a corporation, purchased a policy on B, a key employee at the time the policy was issued. A later replaces the policy in a Section 1035 exchange at a time when B is no longer working for the company and the company has no financial relationship with respect to the insured. Because A lacks a substantial business or financial relationship with respect to the insured, the replacement of the policy would be considered a reportable policy sale.
Curing a reportable policy sale. The only way to fully cure a reportable policy sale is to transfer the policy to the insured for full and adequate consideration.23
Example 7: A is the initial policyholder of a $100,000 insurance policy on A’s life. A transfers the policy for $6,000, its FMV, to an individual, C, who doesn’t have a substantial family, business or financial relationship with A. The transfer from A to C is a reportable policy sale. Before A’s death, C transfers the policy back to A for $8,000, its FMV. A’s estate receives the proceeds of $100,000 on A’s death. The transfer from C to A isn’t a reportable policy sale because the acquirer A has a substantial family relationship with the insured, A. Although the transfer follows a reportable policy sale (the initial transfer from A to C), A’s estate may exclude all of the policy proceeds from gross income.24
As explained in other rather complicated examples from the final regulations, had A paid less than full and adequate consideration for the final acquisition of the policy, some portion of the death benefit from the policy would have been income taxable to A’s estate.25
Even if a policy is later transferred to a person or entity that meets one of the exceptions to the transfer-for-value rule (for example, a partner of the insured, partnership in which insured is a partner) and such transfer doesn’t, on its own, constitute a reportable policy sale, the amount of death benefit excluded from tax is limited to the sum of:
1. the higher of the amount that would have been excludible by the transferor if the transfer hadn’t occurred, or the actual value of the consideration paid by the transferee; and
2. the premiums paid by the transferee.26
Reporting obligations. The statute and regulations provide that anyone who acquires a life insurance contract or interest in a life policy in a reportable policy sale must file an IRS Form 1099-LS with respect to each life insurance policy (or interest) acquired.27
The 1099-LS requires information about the acquirer, including name, address, telephone number and taxpayer identification number (TIN). This form also requires the name, address and TIN for each payment recipient, name of the issuer, policy number of the contract(s), the amount paid to the payment recipient and the date of sale. A copy of the 1099-LS must be sent to each payment recipient and to the issuer of the policy. On receipt of the 1099-LS (or comparable statement providing this information), the policy issuer must also provide to the IRS information related to the transferor, including the name, address, TIN of the transferor, transferor’s investment in the contract and the policy number of each contract.28
On the death of the insured following a reportable policy sale, the payor of the death benefit must also furnish information regarding the name, address, TIN of each recipient, date of each payment, gross amount of each payment and estimate of the investment in the contract with respect to the buyer.29
To give acquirers and issuers ample time to develop and implement reporting systems, Treas. Regs. Section 1.101-1 provides that no reporting is required for reportable policy sales made and reportable death benefits paid after Dec. 31, 2017 and before Jan. 1, 2019.
Analyzing Policy Transfers
Analyzing transfers of policy interests for potential violations under the transfer-for-value rules has become more complicated with the addition of reportable policy sale rules. To aid in this analysis, it’s helpful to break down the transaction into three simple steps. (See “Determining Potential Violations,” p. 34.)
1. Is the current transfer a reportable policy sale? If the transferee or acquirer doesn’t have a substantial family, business or financial relationship with the insured, then the answer here is “yes.” In that case, no further analysis is needed, and the death benefit will be subject to taxation in accordance with the rules outlined above for reportable policy sales. In addition, reporting requirements associated with reportable policy sales must be followed.
If the answer is “no,” proceed to the next question.
2. Is the current transfer a transfer for value for which no exception applies? If the transfer is to someone other than the insured, a partner of the insured, partnership in which the insured is a member, corporation in which the insured is a shareholder or officer or if the basis of the policy isn’t determined in whole or in part on the basis of the transferor, then the answer is “yes.” In that case, the policy death benefit will be subject to taxation at the death of the insured, unless further steps are taken to “cure” the transfer.
If the answer is “no,” proceed to the next question.
3. Has any reportable policy sale occurred before the transfer? Even if the current transfer of policy interests doesn’t constitute a reportable policy sale or a transfer for value, if a reportable policy sale has occurred at any time prior to the current transfer, then the answer here is “yes.” In that case, a portion of the policy death benefit will be subject to income tax as explained under the reportable policy sale regulations (and previously discussed in this article).30 The one exception here is if the policy is being transferred to the insured for full and adequate consideration; in which case, the death benefit should be received income tax free under IRC Section 101.31
If the answer is “no,” then the transfer of policy interests being contemplated shouldn’t result in the taxation of death benefit due to a reportable policy sale or transfer for value.
—Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, Mass. 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, New York 10595.
Endnotes
1. Internal Revenue Code Section 101(a)(2).
2. Ibid. “Other amounts” include interest paid or accrued by the transferee on indebtedness with respect to such contract or any interest therein if such interest paid or accrued isn’t allowable as a deduction under IRC Section 264(a)(4).
3. See James F. Waters, Inc. v. Commissioner, 160 F.2d 596 (9th Cir. 19447), holding that a transfer for value can occur even though the policy transferred has no cash surrender value.
4. Treasury Regulations Section 1.101-1(e)(1) and (2).
5. Ibid.
6. See also Treas. Regs. Section 1.101-1(b)(1).
7. Section 101(a)(2)(B), Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(1).
8. Section 101(a)(2)(A), Treas. Regs. Section 1.101-1(b)(1)(ii)(A).
9. Section 101(a)(3), Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(2).
10. IRC Section 1015.
11. IRC Section 1041(a).
12. Revenue Ruling 85-13.
13. Rev. Rul. 2007-13.
14. Ibid.
15. Section 101(a)(3)(B), Treas. Regs. Section 1.101-1(c).
16. Treas. Regs. Section 1.101-1(d)(1).
17. Section 101(a)(3), Treas. Regs. Section 1.101-1(b)(1)(ii)(A) and (B).
18. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(2).
19. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3).
20. See supra note 17.
21. Treas. Regs. Section 1.101-1(g)(12) (Example 12).
22. Treas. Regs. Section 1.101-1(c)(2).
23. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3)(i). See also Treas. Regs. Sections 1.101-1(g)(6) and (7) for examples.
24. Treas. Regs. Section 1.101-1(g)(6).
25. Ibid.
26. See supra note 18.
27. IRC Section 6050Y(a)(1), Proposed Treas. Regs. Section 1.6050Y-2(a).
28. Section 6050Y(b), Prop. Treas. Regs. Section 1.6050Y-3(a).
29. Section 6050Y(c), Prop. Treas. Regs. Section 1.6050Y-4(a).
30. See supra note 18.
31. See Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3)(i).