Planning With Life Insurance – Transfer For Value Rule

This month’s edition of Estate Planning Matters focuses on financial and tax planning issues that could arise when planning with life insurance. 

Remember that Internal Revenue Code (“Code”) Section 2042 causes inclusion of the proceeds of a policy on the life of an insured if an estate receives the proceeds or if the decedent retained significant control over the policy, for example, by retaining the right to change beneficiaries of the policy or to pledge the policy as collateral for a loan. The Code refers to these rights as “incidents of ownership” and includes the policy proceeds in the estate of the decedent if the decedent dies holding any of these rights on the policy.

Setting up an Irrevocable Life Insurance Trust (“ILIT”) provides an effective way to remove the value of the policy proceeds from the decedent’s estate. By owning the policy in the ILIT and naming the ILIT as the beneficiary of the policy, as well as including restrictions on the trust which do not permit the insured to serve as a trustee, the insured releases all incidents of ownership in the life insurance policy. Of course, removing the policy proceeds from the insured’s estate requires advance planning and the insured should consult with a competent estate planning attorney to properly draft and implement the Life Insurance Trust  

If the insured did not create an ILIT to own the policy prior to purchasing the policy, the insured has two options:  gift the policy to an ILIT or sell the policy to an ILIT. If the insured gifts the policy, then the insured has gifted the current value of the policy, likely far less than the death benefit of the policy. This may not matter to the insured; however, there’s another issue. Code Section 2035 will include the policy proceeds in the decedent’s taxable estate if the decedent dies within three (3) years of the transfer. For some clients the three-year rule poses a significant hurdle to estate planning with life insurance.

Selling the policy to an ILIT for fair market value allows the insured to remove the policy proceeds from their taxable estate immediately, without gift tax consequences, thereby avoiding the application of the three-year rule. However, the sale of a life insurance policy to an improperly structured ILIT could cause income tax consequences because of the “Transfer for Value” Rule. 

Generally, Code section 101(a) excludes the life insurance death benefit from taxable income. However, if the policy was transferred for valuable consideration, (which would be the case if the policy were sold), then the Code includes the policy proceeds in the policy owner’s income, due to the “Transfer for Value Rule.”  Unless an exception to the Transfer for Value Rule applies, the proceeds are taxable, except to the extent of the amount paid by the purchaser.

The Transfer for Value Rule contains the following safe-harbor exceptions:  (1) a transfer in which the transferee derives their basis from the transferor (gift); (2) a transfer to the insured, (3) a transfer to a partner of the insured, (4) a transfer to a partnership in which the insured is a partner, or (5) a transfer to a corporation in which the insured holds office or is a shareholder. 

Creating a trust that qualifies as a grantor trust with respect to the insured removes the sale from the application of the Transfer for Value Rule because this type of transaction is treated as a transfer to the insured. 

For example, let’s assume that Grace owned a life insurance policy with a $5 million death benefit. On the advice of her attorney, she sold the policy for $100,000 (its fair market value) to an irrevocable trust that her attorney drafted for Grace. Unfortunately, Grace’s attorney made a critical mistake and failed to ensure that the trust was a grantor trust with respect to Grace. 

One month later, Grace died and the Trustee of Grace’s trust received the $5 million death benefit but was shocked to learn that receipt of the policy proceeds resulted in $4,900,000 of taxable income to the trust. Since trust tax rates are very compressed, an income tax liability resulted in excess $1.8 million, leaving only $3 million for distribution to the trust’s beneficiaries.

Now let’s roll back the clock and assume Grace engaged a competent trust and estate planning attorney who created a grantor trust as to Grace, to purchase the policy. Again, the Trustee sold the policy to the trust for its $100,000 fair market value; however, under this scenario, because Grace’s attorney structured the trust as a grantor trust as to Grace, the sale fell into one of the safe-harbor exceptions to the Transfer for Value Rule, which transfer was deemed a transfer to the insured. When Grace died a month later, the receipt of the death benefit was not treated as taxable income and the Trustee was delighted to distribute the entire $5 million death benefit to Grace’s beneficiaries.

This edition of Estate Planning Matters, and the above example, demonstrate the complexities that arise when clients own and transfer their life insurance policies to trusts. It is vitally important to understand the relevant tax rules and planning strategies in order to properly advise clients in the area of planning with life insurance, especially since there are numerous tax traps for the unwary.