The Transfer-for-Value Rule: When a Life Insurance Death Benefit Becomes Taxable Income

What is the transfer-for-value rule for life insurance?

Amounts paid under a life insurance contract because the insured died are normally excluded from gross income (IRC § 101(a)(1)). If the contract, or any interest in it, was transferred for valuable consideration, the exclusion is capped at the value of that consideration plus the premiums and other amounts the transferee paid afterward (§ 101(a)(2)). The rest of the death benefit is income, unless one of two statutory exceptions applies.

The statute’s words are that the excluded amount “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.” “Other amounts” includes interest the transferee paid or accrued on debt with respect to the contract, if that interest is not deductible because of § 264(a)(4).

The rule is an income-tax rule. It is separate from the estate-tax question of whether the proceeds are in the insured’s gross estate, which is covered on the incidents-of-ownership page.

What counts as a transfer

The statute reaches a transfer “by assignment or otherwise” of a contract “or any interest therein.” The regulation defines a transfer of an interest as the transfer of any interest in the contract, including “title to, possession of, or legal or beneficial ownership of the life insurance contract itself.” Creating an enforceable right to receive all or part of the proceeds is also a transfer (Treas. Reg. § 1.101-1(e)(2)).

The same paragraph lists three events that are not transfers:

• the revocable designation of a beneficiary, until the designation becomes irrevocable other than by reason of the insured’s death;
• the pledging or assignment of a policy as collateral security; and
• the issuance of a life insurance contract to a policyholder.

The two exceptions in the statute

Section 101(a)(2) says the cap “shall not apply” to two kinds of transfer.

• Carryover basis, § 101(a)(2)(A). The contract or interest “has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis” in the hands of the transferor.
• Named transferees, § 101(a)(2)(B). The transfer is “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 a shareholder or officer.”

The second list is complete as written. Read on its terms, it does not name the insured’s spouse, the insured’s child, or a fellow shareholder of the insured, so a sale to one of them is outside paragraph (B) unless the buyer also fits a category that is named. A sale by the insured to the insured’s spouse can still come within paragraph (A): unless the spouse is a nonresident alien, a transfer between spouses is treated as a gift and the spouse takes the transferor’s adjusted basis (IRC § 1041(b), (d)). The regulation confirms that a child is outside paragraph (B). In its first example, an insured sells a $100,000 policy to a child who is not the insured’s partner for $6,000; none of the exceptions applies, and the child may exclude only $6,000 plus later premiums and other amounts paid (Treas. Reg. § 1.101-1(g)(1)).

The regulation adds detail to each exception (Treas. Reg. § 1.101-1(b)(1)(ii)):

• Neither exception is available if the transfer is a reportable policy sale, described below.
• Under the carryover-basis exception the transferee does not start fresh. The excludable amount is limited to what the transferor could have excluded had the transfer not occurred, plus the premiums and other amounts the transferee later paid. A limit that already applied to the transferor therefore carries over.
• The named-transferee exception also requires that the interest was not previously transferred for valuable consideration in a reportable policy sale.

A later transfer to the insured can remove an earlier limit. In the regulation’s third example the child sells the policy back to the insured for its fair market value, and the proceeds paid to the insured’s estate are not limited (§ 1.101-1(g)(3)).

Gifts and bargain sales

The cap in § 101(a)(2) applies to a transfer for valuable consideration. The regulation has a separate rule for a gift. To the extent a transfer is gratuitous, the excludable amount is limited to what the transferor could have excluded had the transfer not occurred, plus the premiums and other amounts the transferee later paid (Treas. Reg. § 1.101-1(b)(2)(i)). A donee of a policy that was never sold therefore keeps the exclusion the donor had. A donee of a policy that was already limited inherits the limit.

The basis rule for gifts points the same way. Property acquired by gift generally takes the basis it had in the donor’s hands (IRC § 1015(a)), which is the kind of basis § 101(a)(2)(A) describes.

A transfer can be part sale and part gift. The regulation treats each part as a separate transaction and applies to each the rule for that type of transfer (§ 1.101-1(b)(2)(iii)). In its seventh example a policy worth $8,000 is transferred for $4,000, and the transferee is treated as having bought 50 percent of the interest and received 50 percent as a gift (§ 1.101-1(g)(7)).

The gift-tax side of giving a policy away is covered on gifting a life insurance policy.

Reportable policy sales

Paragraph (3) of § 101(a) was added by Public Law 115-97 in 2017 and applies to transfers after December 31, 2017. It provides that the two exceptions “shall not apply” to a transfer that is a reportable policy sale (IRC § 101(a)(3)(A)). A reportable policy sale is the acquisition of an interest in a life insurance contract, directly or indirectly, where the acquirer “has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such life insurance contract” (§ 101(a)(3)(B)). An indirect acquisition includes acquiring an interest in a partnership, trust, or other entity that holds the contract.

The regulation defines the relationships. A substantial family relationship is the relationship between an individual and a family member, a term that covers a spouse, parents and grandparents, lineal descendants, and the spouses of lineal descendants, among others (Treas. Reg. § 1.101-1(d)(1), (f)(3)). Being 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 “is not sufficient” by itself to establish a substantial business or financial relationship (§ 1.101-1(d)(4)(ii)).

These sales carry reporting duties under IRC § 6050Y:

• the person who acquires the contract in a reportable policy sale files a return showing the parties, the date of the sale, the issuer and policy number, and the amount of each payment (§ 6050Y(a));
• the issuer, on receiving the acquirer’s statement or notice of a transfer to a foreign person, files a return showing the seller and the seller’s investment in the contract (§ 6050Y(b)); and
• anyone who pays reportable death benefits files a return showing the recipient, the gross amount, and an estimate of the buyer’s investment in the contract (§ 6050Y(c)).

Transfers to a grantor trust

Rev. Rul. 2007-13 addresses a policy on a grantor’s life that moves to a trust the grantor is treated as owning for income-tax purposes. Its general holding is that such a grantor “is treated as the owner of the contract for purposes of applying the transfer for value limitations of § 101(a)(2).” It then decides two situations.

• Situation 1. A transfer of a contract between two grantor trusts that are treated as wholly owned by the same grantor “is not a transfer for a valuable consideration” within the meaning of § 101(a)(2).
• Situation 2. A transfer of a contract to a grantor trust that is treated as wholly owned by the insured “is a transfer to the insured within the meaning of § 101(a)(2)(B)” and is therefore excepted from the limitation.

In both situations the ruling’s facts are a transfer of the contract to the trust in exchange for cash, and in both the receiving trust is wholly owned by the grantor under the grantor-trust rules. The ruling was issued before § 101(a)(3) was enacted and does not discuss reportable policy sales.

The ruling answers only the income-tax question. The estate-tax treatment of selling an existing policy to an insurance trust is on the three-year rule page.

A worked example

Hypothetical. A parent owns a $500,000 policy on the parent’s own life and sells it to an adult child for $40,000, its fair market value. The child is not the parent’s partner, and no partnership or corporation is involved. The child pays $30,000 of premiums over the following years and receives no other amounts under the policy. The parent dies and the insurer pays the child $500,000.

The sale is a transfer for valuable consideration. The facts follow the pattern of the regulation’s first example, in which none of the exceptions applies; a child is not among the transferees named in paragraph (B). The exclusion is capped at $70,000 and the remaining $430,000 is gross income to the child.

Had the parent given the policy to the child instead, the transfer would be gratuitous. The child’s exclusion would then be measured by what the parent could have excluded, which on these facts is the full proceeds.

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