Taking a Look at Transfer for Value

Where insurance policies are concerned, business owners and their financial professionals understand that the proceeds of life insurance policies are generally received income tax-free. Surprisingly, there is a part of the Internal Revenue Code which provides that under certain circumstances income taxes may be paid by beneficiaries on the proceeds of life insurance. This may occur when policies are "transferred" incorrectly.

A transfer occurs when a policy owner changes the ownership, assigns an interest in the policy or makes a change of beneficiary to an existing policy. A transfer for value occurs when such interest in a policy is exchanged for valuable consideration such as money, property or reciprocal promises.

Transfers for valuable consideration may trigger income tax on the proceeds of the policy. However, there are exceptions, and not all transfers are considered "for value," in which case there are no adverse income tax consequences. To qualify for income tax-free proceeds, the real challenge is to ensure policy ownership is properly designed and if policies are transferred, they are transferred to the proper recipient.

While there are certain life insurance policy transfers which can clearly avoid the "transfer for value rule," others may squarely put policy owners in a position where, upon the death of the insured, the life insurance proceeds will be taxable. Therefore, a business must take great care to assure that a policy which has previously been sold or otherwise transferred for a valuable consideration follows the specific guidelines (IRC Sec. 101(a)(2)).

One of the main concerns of both business owners and professionals is navigating the different rules for making transfers so that the proceeds of those life insurance policies do not trigger income taxable events. Here are three basic guidelines:

• When the sale or other transfer for value of an existing life insurance policy is to the insured (IRC Sec. 101(a)(2)(B)).
• When the sale or other transfer for value of an existing life insurance policy is 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 an officer or shareholder (IRC Sec. 101(a)(2)(B)).
• A transfer where the transferee`s basis is determined in whole or in part by reference to the transferor`s basis (IRC Sec. 101(a)(2)(A)).

For a variety of reasons, an officer or shareholder of a corporation might wish to transfer an existing life insurance policy to the corporation. In this particular situation, there may be a distinct advantage. IRC Sec. 101(a)(2)(B) states that the transfer for value rule does not apply if the transfer is "to a corporation in which the insured is a shareholder or officer." In addition, if a policy is transferred more than once, and the last transfer is to a corporation in which the insured is an officer or shareholder, the proceeds will be wholly income tax-exempt regardless of any previous sale or other transfer for value (Reg. Sec. 1.101-1(b)(3)(ii)).

However, note that many professionals doubt whether holding a few shares of stock actually provides protection as a result of being "a shareholder." There is also doubt as to whether a person who is only nominally an officer with no authority or duties within the corporation should actually be considered an "officer" (Rev. Rul. 80-314, 1980-2 CB152).

Often, a case study helps to address some of the more common questions which business owners and consultants routinely ask.

Let's assume that North Country Aerospace, Inc., had a cross-purchase plan between individual stockholders Adams and Barker, and decides to switch to a stock redemption plan . In this instance, Adams and Barker, as stockholders, will be transferring their policies on each other to North Country Aerospace, Inc. This transfer qualifies as one of the exceptions to the transfer for value rule because the insureds are shareholders of the corporation.

But now consider this example: North Country Aerospace, Inc., decides to change its insurance-funded stock redemption plan to a cross-purchase plan. North Country Aerospace, Inc., then sells a policy on stockholder Adams to stockholder Barker. Upon that event, the proceeds at death will lose their income tax-exempt status. Even if North Country Aerospace does not sell the policies but merely distributes them to Adams and Barker, there is a transfer for value. The valuable consideration here is the reciprocal promise between Adams and Barker to fulfill the cross-purchase plan.

However, a transfer by North Country Aerospace, Inc., to a shareholder would be ruled within the "exceptions" if stockholders Adams and Barker were also partners in a bona fide (although unrelated) partnership (IRC Sec. 101(a)(2)(b); PLR 9347016; PLR 9045004).

A final important consideration is that the Internal Revenue Service may closely scrutinize a partnership that has been established or created solely for the purpose of holding life insurance policies to avoid the transfer for value problem. It is therefore advisable to plan in what manner life insurance policies will be held, issued, and transferred before actually executing the transfer.

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