LIFE INSURANCE TRANSFERS FOR VALUE- WATCH OUT FOR THIS TAX TRAP!

Background
The proceeds of life insurance policies paid because of the death of the insured generally are not subject to income tax. This rule applies regardless of who owns the policies or was paying the premiums at the insured's death and regardless of to whom the proceeds are payable [IRC Sec. 101(a)(l); Reg. 1.101-l(a)(l)].

In spite of this general rule, however, when a life insurance policy is transferred for valuable consideration, the death benefit proceeds are subject to income tax to the extent they exceed the sum of the consideration and post-transfer premiums paid by the transferee [IRC Sec. 101(a)(2)].

Example: Bob owned a $1 million life insurance policy on his life that he sold to Jane for $200,000. She paid the $10,000 annual premium on the policy for four years until Bob's sudden death while having dinner at her apartment. Because the policy was transferred in return for valuable consideration, Jan owes income tax on $760,000 of the policy's proceeds, calculated as follows:

Gross proceeds	$ 1,000,000
Less: Consideration paid	(200,000)
Premiums paid ($10,000 x 4)	(40.000)
Taxable proceeds	$ 760.000

Example: Ty T. Wad, a widower, owns a paid-up $500,000 life insurance policy on himself. Currently the beneficiary of the policy is the local animal shelter, since Ty has disinherited all of his rela-tives. Knowing Ty's family situation and the fact that he is short of cash. May K. Buck, a close friend of Ty's offers him $50,000 in return for Ty irrevocably changing the beneficiary of his policy to May. Ty accepts the offer and then dies a few months later.

May has $450,000 of taxable income ($500,000 - $50,000) when the proceeds from Ty's policy are received. The fact that Ty, rather than May, owned the policy does not affect this result.

A transfer for value can occur even though the transferred policy (e.g., a term life insurance policy) has no cash surrender value (James F. Waters, Inc.).

Example: Walt purchased a $100,000 term life insurance policy a couple of years ago when he graduated from college. He wants to cancel the policy because the $100 per month premium has become a burden and he doesn't really see the need for the coverage.

Walt's parents think he ought to retain the policy to protect against the possibility that he might be uninsurable at some point in the future when he does need insurance. To keep Walt from canceling the policy and in return for his transfer of ownership of the policy to them, his parents agree to pay him $500 and assume his responsibility for making the monthly premium payments. Six months later, Walt is killed in an accident when he makes his first attempt at skydiving.

In addition to their grief over losing their son, Walt's parents are dismayed to learn that $98,900 of the proceeds from the policy insuring his life are subject to income tax ($100,000 proceeds, less the $500 payment and six premium payments of $100 each).

Fortunately, several exceptions to the transfer-for-value rule exist. If at least one of these exceptions applies to a transfer, proceeds of the transferred policy are exempt from income tax.

Excluded Transfers
The transfer-for-value rule was designed to prevent the unscrupulous sale of life insurance policies on the open market. Thus, certain exceptions are built in to the law to satisfy the legitimate needs of taxpayers for transferring a policy. These exceptions include:

• A transfer in which the transferee's basis for the purpose of calculating gain or loss is determined in whole or in part by reference to the transferor's basis [IRC Sec. 101(a)(2)(A)]. In other words, if there is a carryover of basis, such as when a gift of the policy is made, the transfer-for-value rule doesn't apply. A transfer between spouses (or incident to a divorce) also qualifies under this exception [IRC Sec. 1041(b)].
• The sale or other transfer for value of a policy 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 [IRC Sec. 101(a)(2)(B)].
• A pledge or assignment of a policy as collateral for a loan [Reg. 1.101-l(b)(4)].

In spite of these exceptions, there are still traps for the unwary in dealing with policy transfers. The balance of this article discusses three of the most common traps and suggests ways to avoid them.

The Policy Loan Trap
As part of the estate planning process, a client may be advised to transfer ownership of a life insurance policy to another person or entity (e.g., an irrevocable life insurance trust-see TAM-360, dated 7/19/94). Assuming his death comes more than three years after the transfer, the client will have successfully moved the proceeds of the policy out of his gross estate. If the transferred policy has an outstanding loan, however, an income tax problem may be created in the process.

Example: Herman owns a $1,000,000 life insurance policy with a current value (roughly equal to the cash surrender value) of $250,000 and an outstanding loan of $200,000. His adjusted basis in the policy (premiums paid, less dividends received) is $170,000. Herman has been advised by his estate planner to give the policy to Susan, his daughter, so that the death benefit will be excluded from his estate (assuming he survives for at least three years after the gift).

What happens if Herman follows through with this advice?

The transaction will be treated partly as a gift and partly as a sale. The gift portion is $50,000, which equals the excess of the policy's value over the balance of the loan ($250,000 - $200,000). The balance of the transaction is a sale, with the sales price equal to the outstanding debt ($200,000). As a result, Herman recognizes $30,000 of taxable gain ($200,000 - $170,000) on the transfer. He also uses up $40,000 of his unified gift and estate tax credit on the transaction ($50,000 gift-$10,000 annual exclusion).

Susan's unadjusted basis in the policy is the sum of [Reg. 1.1015-4(a)]:

1. the greater of:
   1. the amount she paid (or is deemed to have paid) for the policy (i.e., the amount of the loan- $200,000), or
   2. Herman's adjusted basis in the policy at the time of the transfer ($170,000), and
2. the amount of increase, if any, in basis allowed by IRC Sec. 1015(d) for gift tax paid on the transfer.

Thus, Susan's basis is $200,000. Because this basis was not determined by reference to Herman's basis, the carryover basis exception to the transfer-for-value rule doesn't apply. As a result, the death benefit, less the consideration ($200,000) and subsequent premiums paid by Susan, will be subject to income tax (Rev. Rul. 69-187; PLR 8951056). That's not exactly what Herman and Susan had in mind.

Susan's income tax problem can be avoided if Herman will pay down the policy loan below his $170,000 basis before transferring the policy. Her basis will then equal his (i.e., a carryover basis) and the full policy proceeds will escape income tax. The cost of this approach is that the gift portion of the transaction increases (thus, causing a larger portion of Herman's unified credit to be utilized). Usually, though, using up part of the taxpayer's unified credit is more palatable than causing the policy's proceeds to be subject to income tax.

If Herman has already completed the transfer by the time he talks to you, how do you correct the problem? One way is to transfer the policy back to Herman and then retransfer it to Susan after Herman has paid down the loan below his basis. (See the discussion of multiple transfers later in this article.) Unfortunately, both Susan and Herman will use up a portion of their unified credit. However, this is presumably still better than creating an income tax liability for Susan when the policy proceeds are received.

Go to part 2 of this article