Transfer-For-Value Rule: What it is, How it Works

What Is the Transfer-for-Value Rule?

The transfer-for-value rule stipulates that a life insurance policy (or any interest in that policy) transferred for something of value is subject to taxation as ordinary income. This taxation is based on the death benefit minus the value exchanged and any premiums paid by the transferee.

For example, if John Doe sells his $250,000 life insurance policy for $5,000 and has paid $10,000 in premiums, the amount subject to income tax would be $235,000 ($250,000 – $10,000 – $5,000).

Key Takeaways

• The transfer-for-value rule ensures that transfers of life insurance policies are taxable.
• Exceptions exist, such as when a policy is purchased by a firm for business continuity.
• Examining the fine print is crucial before transferring or selling a life insurance policy.

Understanding the Transfer-for-Value Rule

The transfer-for-value rule applies to the sale, transfer, or assignment of a life insurance policy. The tax-exempt status of the policy is not lost when transferring it to the insured, a partner of the insured, or to a company where the insured has a financial interest.

Life insurance provides tax-free death benefits to beneficiaries. However, some individuals transfer policies for financial gain, leading Congress to enact the transfer-for-value rule, making the death benefit taxable in certain situations.

This rule is an exception to the general tax exemption for life insurance death benefits. The Tax Cuts and Jobs Act (TCJA) of 2017 introduced the term "reportable policy sale" to define the tax liabilities associated with certain business scenarios like mergers and acquisitions.

Special Considerations

There are exceptions to the transfer-for-value rule, particularly for business-owned life insurance. Some of these exceptions include transfers to specific individuals or entities:

• Anyone with a basis determined by the original transferor’s basis
• The insured, spouse, or ex-spouse (incident to a divorce under Sec. 1041)
• A partner or partnership
• A corporation where the insured is a shareholder or officer

Examining the Transfer-for-Value Rule

The transfer-for-value rule is simple in theory but requires careful examination to determine its applicability since insurers may vary in their policy language. It is possible to violate this rule without any formal transfer or tangible consideration, as long as there is a reciprocal agreement tied to the policy transfer.

For instance, if two shareholders in a closely held business name each other as beneficiaries in a buy-sell agreement using life insurance policies, the recipient of the death benefit may face tax consequences under the transfer-for-value rule. This rule applies because the partners mutually agreed to name each other as beneficiaries, introducing consideration into the transaction.

What are exceptions to the transfer-for-value rule?

Life insurance transfers are tax-free when made to the insured, a partner, a partnership, a corporation, or anyone with a basis tied to the original transferor’s basis.

Why was the transfer-for-value rule implemented?

Speculators were taking advantage of the tax-free death benefit provided by life insurance policies, prompting Congress to declare that any policy transferred for material consideration may become taxable when the death benefit is paid.