Tax Trap For Policyholders
An important exception exists to the general rule of I.R.C. §101 that life insurance proceeds are excluded from the gross income of the beneficiary. This is known as the “transfer for value rule.” Thus, after the initial issuance of a life insurance policy, if it is subsequently transferred for “valuable consideration,” the income tax exclusion under §101(a) is lost, and the beneficiary will have to include in gross income, the death proceeds received, to the extent that they exceed the consideration paid by the transferee of the policy plus any subsequent premium payments or other costs of maintaining the policy subsequent to the transfer [I.R.C. §101(a)(2)].
The exempting of life insurance proceeds from income taxation is presumably based upon a rationale that insurance functions as an alleviation of economic hardship flowing from the insured’s death. This rationale may well be inapplicable in cases where an insurance policy has been transferred for valuable consideration. When a policy is “purchased” by one party from another the situation begins to look more like an investment or business type transaction, in which the eventual receipt of the proceeds on death of the insured is a bargained for benefit, having no strong policy rationale for exclusion from income of the recipient.
Example
John purchases a $750,000 life insurance policy on his own life, naming his brother Tom as the beneficiary. Subsequently, John transfers the ownership of the policy to Tom for $5,000. This is a transfer for value under I.R.C. §101(a)(2). During the succeeding four years Tom pays annual premiums of $4,000 per year. Thereafter, John dies and Tom receives the $750,000 death benefit under the policy. Because of the transfer for value rule, Tom realizes ordinary income in the amount of $729,000 (the $750,000 proceeds, less the $21,000 which he paid to acquire and maintain the policy).
The transfer for value rule frequently becomes a tax trap for unwary policyholders.