Little Harold ran into the kitchen where his Mother was preparing dinner and said, “Hey Mom! You know that antique vase on the stand in the front hall that has been handed down from generation to generation?” When she looked up he reported, “Well my generation just dropped it!”
The transfer of valuable assets must be done with care. And so it is with life insurance handed down or handed off through a change of ownership.
Long before the life settlement prairie fire swept across the industry landscape, Congress was concerned about the practice of brokering in the lives when no true insurable interest existed. Section 101 of the Internal Revenue Code doesn’t prohibit the purchase of a policy, but it does curtail the tax advantages of such an “investment” to an extent that could be significant to the unsuspecting.
In a nutshell
Death proceeds are not includible in gross income (i.e. they are income tax-free) unless the policy was acquired for “valuable consideration”, then they are excluded only to the extent of the consideration paid (basis). And consideration doesn’t have to be cash. The IRS will go far afield in construing any hard or intangible assets, services or other benefits rendered in the acquisition of the policy as consideration. There are some common exceptions. Most business-related TFVs are protected if they occur between partners or their partnership (LLCs taxed as a partnership are considered partnership), or if the transfer is to a corporation in which the insured is a shareholder or officer. Most transfers within a domestic situation are not affected because they are considered gifts.
Beyond that attorneys and accountants must struggle with the “gray areas” that always gather like a fog around the real life situations addressed by the letter of the law. The two most common scenarios we encounter follow with a description and our best guess as to the response that a qualified advisor might give:
The regulations to IRC 101 state that “the creation, for value, of an enforceable contractual right to receive . . . proceeds of a policy may constitute a transfer for a valuable consideration . . . [but] the pledging or assignment of a policy as collateral security is not a transfer for a valuable consideration . . .” Consequently, use of a policy to secure a loan is not a TFV. But an assignment for some other reason may be.
There are several reasons it may not be wise to make someone a beneficiary in return for some consideration, but a potential TFV problem is probably not one of them. Again, the regulation states there must be “an enforceable contractual right to receive . . . proceeds of a policy”. A revocable beneficiary change does not create such a right.
Fortunately there is a “fix” for policies tainted by a transfer-for-value. Unlike the family vase (pronounced vahze if you are in good company), this is a Humpty-Dumpty that can be put back together again. The regulations have two pieces of good news. First, a transfer back to the insured is never a TFV and, second, it is only the last transfer that governs taxable status. It may be possible to cleanse the troubled policy with a transfer back to the insured and then work forward from there.
Call with any concerns you have about the tax results of transferring ownership of an existing policy, or if you need help rescuing one from the grip of potentially taxable proceeds.