LIFE INSURANCE TRANSFERS FOR VALUE- WATCH OUT FOR THIS TAX TRAP! (part 2)

The Buyout Trap
Corporate buy/sell agreements are often funded with life insurance policies. The policies will be owned by the corporation (in the case of a redemption agreement) or the shareholders (if a cross purchase agreement is used). In a redemption agreement, the corporation's receipt of the insurance proceeds may trigger an alternative minimum tax liability because the death benefits are normally included in adjusted current earnings [Reg. 1.56(g)-l(c)(5)(i)]. In addition, the surviving shareholders do not receive a basis step- up on the shares purchased by the corporation. Thus, it's not unusual for shareholders with a redemption agreement to want to switch to a cross purchase arrangement.

Example: Jima, Inc. (Jima) is owned 75% by Jill and 25% by Mary (who is unrelated to Jill). Jima owns two life insurance policies-one each on the life of Jill and Mary.

As part of restructuring the existing buy/sell agreement related to Jima's stock, Jima transfers ownership of the policy on Jill's life to Mary and ownership of the policy on Mary's life to Jill. To minimize the amount of premiums Jill and Mary will be responsible for, Jima retains the right to receive the cash value portion of each policy and will continue to pay that portion of the premiums representing each year's increase in the cash value. Jill and Mary will pay the premiums related to the life insurance portion of the policy they receive.

In a cross purchase agreement, the two shareholders agree the surviving shareholder will purchase the other's stock from her estate at fair market value. Unfortunately, the surviving shareholder's receipt of the insurance proceeds will be subject to income tax because of the transfer-for-value rule (Monroe v. Patterson; PLR 9045004). The "value" or consideration received is the agreement made by each shareholder to make premium payments and to purchase the stock.

The results would be different, however, if Jill and Mary were partners in a partnership. In this situation, the surviving partner could receive the proceeds of the life insurance policy on the other partner free of income tax since a transfer of a life insurance policy to a partner of the insured is not subject to the transfer-for-value rule [IRC Sec. 101(a)(2)(B)]. If a partnership did not currently exist between the shareholders, one could perhaps be created to hold and rent to Jima new assets that Jima needed for its continuing business activities. As long as the partnership is created for a legitimate business purpose, the IRS has routinely approved of such transactions (e.g., see PLRs 9309021, 9328010, and 9328012). In fact, in PLR 9309021 the IRS implied a partnership could be formed solely to own and manage life insurance policies. However, the general consensus of tax practitioners is that the partnership should have another business purpose (e.g., see Swanson).

The Three Year Trap
Proceeds of insurance on a decedent's life are included in the decedent's gross estate if the decedent held any incidents of ownership in the policy within three years of death (the so called "3-year rule"). This provision applies even if the decedent's estate neither receives nor benefits from the proceeds [IRC Sec. 2035(d)(2)].

One exception to the 3-year rule is to transfer the policy by way of a bona tide sale [IRC Sec. 2035(b)(l)], but as we already know, this creates another problem because of the transfer-for-value rule. Is there a way around both rules? Perhaps.

Example: John owns a $1,000,000 policy on his life. He sells it to his wife, Jane, for its current market value. However, Jane's basis in the policy is the same as John's, rather than being equal to what she paid for the policy [IRC Sec. 1041(b)]. Several months later Jane gives the policy to her daughter, who also takes a carryover basis in the policy [IRC Sec. 1015(a)]. Thus, both transfers are exempt from the transfer-for-value rule [IRC Sec. 101(a)(2)(A)].

Both transfers also avoid the 3-year rule. The initial transfer (from John to Jane) is a sale (for which Jane should use her own separate, rather than joint, funds to complete). The second transfer is not subject to the 3-year rule because Jane is not the insured [IRC Sees. 2035(d)(2) and 2042(2)].

Can the IRS attack this? As you know, they can attack anything they want to. The IRS can attempt to collapse the two transfers into one (using the so called "step transaction" doctrine) and claim John effectively made a gift to his daughter and thus is subject to the 3-year rule. However, the more time that elapses between the two transactions, the less likely such an attack will prevail since this increases the risk that the second transaction cannot be completed (e.g., because John dies before the gift to the daughter can be made).

What about Multiple Transfers?
For a variety of reasons, ownership of a policy is sometimes transferred more than once. When this occurs, the income tax status of the policy is determined by applying the following rules to the final transfer [Reg. 1.101-l(b)(3)]:

1. If the final transfer of a policy (before the death of the insured) is 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, none of the policy's proceeds are subject to income tax (regardless of what occurred in previous transfers of the same policy).

2. If Rule I doesn't apply and the last transfer of a policy (or an interest therein) is for valuable consideration, the transferee can exclude the policy's proceeds from gross income only to the extent of the actual consideration and post-transfer premiums paid by the transferee. Premiums or consideration furnished by prior transferees are not counted.

3. If Rule I doesn't apply and the final transferee takes a carryover basis in the policy (e.g., because it is transferred by gift), the proceeds excluded from gross income equal the sum of the amount the final transferor could have excluded if the final transfer had not been made, plus any post-transfer premiums or other amounts paid by the final transferee.

   Example: Bob made a gift of an insurance policy on his life to Sue, his wife. Sue later sold the policy to their daughter, Robin, in return for $500 and Robin's agreement to continue paying the premiums on the policy. Robin sold the policy to her brother, Steve, for $700 and his promise to continue making the premium payments. Steve owned the policy (and was the named beneficiary) at the time of Bob's death. The insurance proceeds Steve collects as a result of his dad's death are subject to income tax. The amount taxed is the excess of the gross proceeds over the sum of the $700 paid for the policy plus any premiums that Steve paid after the policy was transferred to him. Steve does not get credit for any amount that Robin, Sue, or Bob paid in relation to the policy.

   Example: In the previous example, if Robin had made a gift of the policy to Steve, rather than selling it, the proceeds would still be subject to income tax. Steve would be taxed on the excess of the gross proceeds over the sum of the $500 paid by Robin plus any premiums and other amounts paid by Robin or Steve after the policy was transferred to them.

   Example: In the previous two examples, assume Steve and his dad each own a 50% interest in the Father and Son Partnership. In this situation, no matter how Steve acquired ownership of the policy on his dad's life, none of the proceeds are subject to income tax because the final transfer of the policy is to a partner (Steve) of the insured (Bob).

Go to part 1 of this article