Be Wary of Taxes Sapping Life Insurance Proceeds




Life insurance can provide an “instant” source of liquidity to the estate of an owner of a closely held business, preferably when the policy insuring the business owner’s life is held by an irrevocable life insurance trust (ILIT). Especially when business owners face succession issues, CPAs advising them can suggest life insurance as a valuable tool in estate planning. Among the points to cover are recapture rules for transfer of an existing policy to an ILIT (IRC § 2035) and transfer-for-value rules under IRC section 101(a)(1).

Transferring an existing policy into an ILIT can shield a death benefit from estate taxes and generation-skipping transfer taxes. Clients should be advised, however, that under section 2035 the proceeds are included in the decedent’s gross estate if the ownership of the policy was transferred to the ILIT within three years of the insured’s death.

Under the provisions of section 101, generally speaking, life insurance proceeds received as a result of an insured’s death are income tax free. However, if a life insurance policy or interest in one is transferred for valuable consideration of any form, such as cash or mutuality of promises, then the income tax exclusion is not available, and the proceeds are taxable. The portion of the proceeds equal to consideration paid to acquire the policy or interest in it, plus any future premiums paid by the transferee (that is, the transferee’s basis in the contract) are received income tax free, but the remaining proceeds are taxed as ordinary income. See Treas. Reg. § 1.101-1(b)(3)(i).

Even term life insurance policies that have no cash value are subject to the transfer-for-value rule. See, for example, Private Letter Ruling 7734048. The transfer does not have to be of the policy itself. A transfer of some or all of the underlying interests in the policy (such as the death benefit proceeds) is sufficient to invoke the rule, which is broadly defined. For example, the creation, for value, of an enforceable contractual right to receive all or a part of the proceeds of a life insurance policy may constitute a transfer for a valuable consideration. This would be the case when a shareholder of a company who owns a policy on his life is contractually bound under a buy-sell agreement to name a fellow shareholder as the beneficiary of the policy. Another example of a transfer for value would be to name a particular person as a beneficiary of the policy in exchange for valuable consideration.

A reciprocal promise can also constitute valuable consideration. For example, if several insured co-shareholders agree to “gift” their policies to one another to fund a cross-purchase arrangement, the reciprocal gifting constitutes valuable consideration. Also, if the co-shareholders agree to continue paying premiums on the “gifted” policies (to fund the cross-purchase agreement), this too constitutes valuable consideration. However, if the co-shareholders are all partners, then the transaction may be exempt from the transfer-for-value rule under the partner-protected party exception, which is mentioned below. See J.R. Monroe v. Patterson , 197 F. Supp. 146 (N.D. Ala. 1961), and Private Letter Ruling 199903020.

On the other hand, a pledge or assignment of a life insurance policy as collateral security for a loan or other obligation owed by the policy owner is not a transfer for valuable consideration. IRC § 101(a)(2) is not applicable to amounts received by the pledgee or assignee that are treated as a repayment of capital and are therefore generally income tax free to the extent of the outstanding debt amount. However, insurance proceeds representing interest on the debt are taxed as ordinary income to the creditor. See Treas. Reg. § 1.101-1(b)(4).

Practice Point. Two income tax issues must be considered when selling/transferring a life insurance policy for valuable consideration: (1) the transfer-for-value rule and (2) the income tax consequences to the seller of the policy.

Under five exceptions in IRC § 101(a)(2), life insurance proceeds are received income tax free even if there has been a transfer for valuable consideration of a policy or an interest in it to:

  1. Anyone whose basis is determined by reference to the original transferor’s basis.
  2. The insured (or insured’s spouse or ex-spouse, if incident to a divorce pursuant to section 1041).
  3. Partner of insured.
  4. Partnership in which insured is a partner.
  5. Corporation in which insured is a shareholder or officer.

By Sebastian V. Grassi Jr., founding partner of Grassi & Toering PLC, Troy, Mich. This article is adapted from his book A Practical Guide to Drafting Irrevocable Life Insurance Trusts (Second Edition), ALI/ABA (


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