You may have noticed a reference to “dividends” on your life insurance policy statement and wondered whether you had to pay tax on them. The answer depends upon the type of policy you have, when you took the policy out, and how much you have received cumulatively from the policy.

Generally speaking, life insurance dividends are treated as a non-taxable return of part of your premium. As is true with a rebate on any other kind of product, no tax is owed on the payment. That’s the rule whether the dividends are paid to you in cash, used to reduce your premiums or to buy additional paid-up coverage, or remain with the insurer to accumulate interest. In the latter case, you would owe tax on the interest earned on the dividends. Dividends are taxable if the amount of dividends together with any other amounts received tax-free from the policy exceed the total of premiums paid. These rules apply both while you’re paying premiums and after the policy is fully paid-up.

These very favorable rules don’t apply to distributions from single-premium policies or other life insurance policies that become fully paid-up at a rate faster than seven level annual premium payments, and that were taken out after June 20, 1988. Dividends and other distributions from these policies (which are known as modified endowment contracts) are treated as coming first from the policy’s income, rather than reducing premium payments. Thus, they are taxable to the extent that the policy’s cash value exceeds your investment in the policy. With certain exceptions, taxable distributions from these policies also are subject to a 10% penalty tax if paid before age 59-1/2. However, even dividends from modified endowment contracts aren’t taxable if used to buy additional paid-up insurance protection.

While these rules seem pretty straightforward, there are a number of more complex issues. For example, policies that aren’t modified endowment contracts when issued may become subject to the tougher rules if benefits are reduced during the policies’ early years. Please call me for more details if you’re considering making any major changes to your existing insurance policies, or if you have any further questions about the taxation of life insurance dividends and other lifetime distributions.

A major aspect of life insurance as an estate and financial planning tool is the income and estate tax treatment of the death proceeds.

Introduction

Fundamentally, with some exceptions, the proceeds of a life insurance policy received by a beneficiary are completely free from income tax (Sec. 101(a)(1)). Nevertheless, an often overlooked provision of the tax law, known as the ‘transfer-for-value’ rule, can result in the loss of this advantageous tax treatment.

Tax Advisors  often advise their clients to purchase new life insurance or restructure the ownership of existing policies to serve as a liquidity strategy in the estate and business succession planning process. When dealing with life insurance transactions, one of the most important and perplexing areas that the tax adviser must properly address is the ‘transfer-for-value’ rules under Sec. 101(a)(2).

Generally, under the provisions in Sec. 101, life insurance proceeds, payable as a result of the death of the insured, are received income tax free. If properly structured, through third-party ownership of the policy, the proceeds can also be received estate tax free. However, if a life insurance policy, or interest in a policy, is transferred for valuable consideration of any form (which would avoid estate and gift taxation of a policy), such as a sale in a cash transaction, to liquidate a debt or to satisfy mutuality of promises, then the income tax exclusion is not available to the beneficiary and the death proceeds are subject to federal income tax.

For the buyer of the policy, the portion of the death proceeds equal to the consideration paid by the buyer to acquire the policy or interest in the contract, plus all future premiums paid by the transferee (i.e., the transferee’s basis in the contract), are received income tax free, but the remaining death proceeds received by the ‘buyer’ are taxed as ordinary income under Regs. Sec. 1.101-1(b)(3)(i).

Frequently, estate planners recommend that the insured who owns their life insurance policy create an irrevocable life insurance trust and transfer the policy to the trust. Transferring an existing life insurance policy into an irrevocable life insurance trust (ILIT) can shield the entire death benefit from federal estate and generation-skipping transfer tax consequences as well as avoid income taxation of the proceeds. However, under Internal Revenue Code Sec. 2035, the death proceeds of the policy transferred to an irrevocable trust are fully included in the decedent’s gross estate for transfer tax purposes if ownership of the policy was transferred by the insured to the ILIT within three years of the insured’s date of death if transferred without the trust paying the value of the policy at the time of the transfer. Some commentators believe if the ILIT is a Grantor Trust (a trust in which the trust income is taxable to the Grantor because of certain powers retained as described in the Internal Revenue Code) the proceeds will not only avoid inclusion for estate tax purposes but also be income tax free when received by the ILIT. Contact us for more information on that issue. Do not attempt to structure a ILIT on your own. These issues are extremely complex and fraught with pitfalls and traps for the unwary.

Safe-Harbor Exceptions to the Transfer-for-Value Rule

Fortunately, a number of safe-harbor exceptions to the transfer-for-value rule allow a life insurance policy transfer to be made for valuable consideration without jeopardizing the income tax–free nature of the death benefit. Any one of these exceptions to the rule can effectively serve to insulate a policy’s death proceeds from adverse income tax consequences.

There are five exceptions to the transfer-for-value rule contained in Sec. 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 a policy, if the transfer is 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 under Sec. 1041);

3. A partner of the insured;

4. A partnership in which the insured is a partner; or

5. A corporation in which the insured is a shareholder or officer.
Transfer-for-Value Pitfalls and Opportunities

Transfers

  Discharge from Policy Loan

When the transferor of a life insurance policy receives consideration and is discharged from a policy loan obligation on the contract, the transfer of a policy subject to a nonrecourse loan is deemed a transfer for value. However, if the transferor’s basis in the policy is greater than the loan balance, a gratuitous transfer of the policy should qualify for the first exception to the transfer-for-value rule noted above, reflected in the basis carryover exception (Rev. Rul. 69-187; Letter Ruling 8951056).

          Transfer to a partner or partnership:

Since the transfer of a policy to a partner of the insured is one of the exceptions to the rule, the transfer-for-value issue does not occur in the context of a business partnership. Therefore, when restructuring business succession plans, it is possible to change from an entity-purchase or stock-redemption agreement to a cross-purchase agreement and use the same policies to fund the new transaction.

Transfers to a Shareholder

While the transfer of a life insurance policy to a partner of the insured is a protected transaction for transfer-for-value purposes, a policy transfer to a co-shareholder of the insured is not protected and results in a violation of this rule. Therefore, when a corporation owns life insurance policies on the lives of its shareholders, structured in the form of an entity purchase or stock redemption agreement, it is not possible to convert to a cross-purchase agreement and use the same policies to fund the new agreement. The resulting transaction would violate the transfer-for-value rule because a corporation’s transfer of an existing policy on the life of one stockholder to another stockholder is not one of the safe-harbor exceptions to the transfer-for-value rule.

While there does not appear to be any logical reason to exempt transfers of an interest in a life insurance policy to and among partners of the insured and not also afford this same exemption to transfers to and among closely held corporate shareholders, if the insured is a co-shareholder, unless the transferee is the insured, transfers of policies from a corporation to a shareholder and transfers among shareholders can easily violate the rule.

However, if the co-shareholders are all deemed partners in a partnership, the transaction may be exempt from the transfer-for-value rule under the partnership exception. In a private letter ruling, the IRS has approved the creation of a partnership for the purpose of receiving corporate-owned policies (Letter Ruling 199903020). Although a partnership must have a valid business purpose under state law and not be just an entity created to avoid taxes, this ruling appears to approve the creation of a partnership whose sole purpose is to “engage in the purchase and acquisition of life insurance policies on the lives of the partners.”

In Letter Ruling 9701026, three shareholders in a professional corporation were also partners in a partnership that owned and leased an office building to the professional corporation. The parties planned to enter into a cross-purchase agreement to provide the surviving shareholders with funds that might be needed to purchase a deceased shareholder’s shares in the professional corporation from his estate. Each shareholder owned insurance on the lives of the others, and the professional corporation owned a life insurance policy on one shareholder’s life that was subject to a collateral assignment split-dollar plan. The professional corporation proposed to transfer its ownership interest in the split-dollar policy to the other shareholders, who would assume the corporation’s position under the split-dollar plan. The letter ruling held that the transfer qualified for the partnership exception under Sec. 101(a)(2)(B).

Beneficiary designation:

The designation of a policy beneficiary in exchange for any kind of valuable consideration constitutes a transfer for value. The consideration could be an exchange of policies or a promise to render future services and does not have to involve the exchange of money. However, the mere pledging or assignment of a life insurance policy as collateral is not deemed to be a transfer for value.

More specifically, 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. Sec. 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 (Regs. Sec. 1.101-1(b)(4)).

  Term life insurance:

Term life insurance policies, even though such policies do not accumulate cash value, are subject to the transfer-for-value rule (Letter Ruling 7734048). The transfer does not have to be of the policy itself. A transfer of some or all of the underlying interest in the policy (e.g., the death benefit proceeds) is sufficient to invoke the transfer-for-value rule. For example, the creation, for value, of an enforceable contractual right to receive all or part of a life insurance policy’s proceeds may constitute a transfer for valuable consideration. This can occur when an insured shareholder-owner of a corporation, which owns the policy on his life, is contractually bound under the terms of an enforceable buy-sell agreement to designate a co-shareholder as the policy beneficiary in order to fund the transaction.

Reciprocal promise transaction:

A reciprocal promise can also constitute valuable consideration. For example, if several insured co-shareholders agree to “gift” their policies to one another in order to fund a cross-purchase arrangement, the reciprocal gifting constitutes valuable consideration. In addition, if the co-shareholders agree to continue paying premiums on the gifted policies (to fund the cross-purchase agreement), this too constitutes valuable consideration (Letter Ruling 199903020).

Intentionally defective grantor trust:

A grantor trust that is taxed as if the underlying assets were owned by the insured grantor can purchase or obtain existing policies on the grantor’s life without adverse income tax consequences, since the transfer falls within the transfer-to-the-insured exception to the rule. More specifically, when a taxpayer wants to establish a new irrevocable trust in order to purchase an existing policy from another trust, for the purpose of changing the dispositive provisions, a transfer for value can occur. If the trust terms are no longer appropriate, then with the trustee’s consent, the insured may use the transfer-for-value exception to acquire the policy from the insurance trust and transfer the policy to a new trust with acceptable terms. Warning:  the three-year rule of Sec. 2035 will begin with the new transfer.

Alternatively, the transfer could be made directly to a new insurance trust that satisfies one of the transfer-for-value safe-harbor exceptions. For example, the transfer to an intentionally defective grantor trust can be used to transfer a policy from one insurance trust to another. In Swanson, 518 F2d 59 (8th Cir. 1975), the insured retained the power to alter or amend a trust but could not vest ownership in himself. The insured was deemed the trust’s owner under Sec. 674; as a result, the sale of an insurance policy to the trust was deemed to be a transfer to the insured within the meaning of Sec. 101(a)(2)(B).

  The Ultimate Transactions in a Series of Transfers

In a series of transfers of the same life insurance policy, if the final transfer is a transfer for value, the transfer-for-value rule will apply, and the exclusion, for income tax purposes, generally will be limited to the consideration paid for the policy by the transferee, plus any subsequent premiums paid by the transferee to keep the policy in force (Regs. Sec. 1.101-1(b)(3)(i)). However, if the final transfer is 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 an officer, the entire death proceeds of the policy will be received by the beneficiary income tax free (Regs. Sec. 1.101-1(b)(3)(ii)). If none of the stated exceptions to the transfer-for-value rule applies, but the final transferee carries over the transferor’s basis in whole or in part, the excludible amount is the amount that would have been excludible by the transferor had the transfer not taken place, plus any premiums paid by the final transferee (Regs. Sec. 1.101-1(b)(3)(iii)).

Planning Strategies

Transfer-for-value problems can occur in many unexpected circumstances. As noted above, adverse income tax consequences can be triggered by a violation of the rule in both personal and business transactions and can apply far beyond the outright sale of a life insurance policy to a third party.

Without a thorough policy review, a transfer-for-value violation is a fraught with danger,  since the problem often remains undiscovered until after the insured’s death, when it is too late to remedy potentially severe income tax consequences to the beneficiaries.

Conclusion

Life insurance continues to be an excellent financial planning vehicle to provide the infusion of cash—precisely when needed—to generate an instant source of liquidity in order to promptly discharge the final debts, taxes, and administrative expenses arising at a client’s death. However, whenever individuals or business owners own life insurance or are contemplating the transfer of a policy in conjunction with the review or revision of their estate or business succession plan, they and their advisor must consider potential transfer-for-value traps and effects.

Therefore, any proposed transfer of an existing life insurance policy by insureds should take into account the transfer-for-value rules under Sec. 101. Failure to carefully address these rules could cause the policy proceeds to be exposed to income taxes when received by a beneficiary as a result of the insured’s death. With proper planning and foresight by the client’s team of tax, legal, and insurance advisers, this is a tax problem that can generally be completely avoided.

While life insurance continues to remain a flexible financial planning tool in the estate planner’s arsenal, both planning opportunities and tax pitfalls do exist. The tax, estate and financial advisors must have a strong grasp of the issues surrounding life insurance and the transfer-for-value rule to help guide their clients through the maze of complex, and often inconsistent, tax rules. This knowledge can help  minimize the potential tax burden and maximize the transfer of wealth to the client’s surviving family members.

Under the estate tax rules, insurance on your life will be included in your taxable estate if either:

(1) your estate is the beneficiary of the insurance proceeds, or
(2) you possessed certain economic ownership rights (“incidents of ownership”) in the policy at your death (or within three years of your death).

Avoiding the first situation is easy: just make sure your estate is not designated as beneficiary of the policy.

The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called “incidents of ownership” in the policy. Rights that, if held by you, will cause the proceeds to be taxed in your estate include:

• the right to change beneficiaries,
• the right to assign the policy (or to revoke an assignment),
• the right to pledge the policy as security for a loan,
• the right to borrow against the policy’s cash surrender value, and
• the right to surrender or cancel the policy.

Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.

Buy-sell agreements. Life insurance obtained to fund a buy-sell agreement for a business interest under a “cross-purchase” arrangement will not be taxed in your estate (unless the estate is named as beneficiary). For example, say A and B are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, A buys a life insurance policy on B’s life. A pays all the premiums, retains all incidents of ownership, and names himself or herself as beneficiary. B does the same regarding A. When the first partner dies, the insurance proceeds are not taxed in the first partner’s estate.

Life insurance trusts. An irrevocable life insurance trust (often referred to as an “ILIT”) is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured’s estate. Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums. Alternatively, the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in the insured’s estate.

The three-year rule. If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, please call me as soon as you reasonably can to effect these moves. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule doesn’t apply.