Life insurance proceeds paid by reason of the death of the insured are normally exempt from federal income tax under IRC Section 101. However, if the policy has been “transferred for value,” then only the amount paid by the transferee plus additional premiums paid by the transferee are exempt from tax. The balance of the proceeds are taxable. There are a few exceptions to this rule, one of which is for transfers of policies to the insured.
In Rev. Rul. 2007-13, the IRS considered a situation where a life insurance policy was owned by a trust that was a grantor trust with respect to the insured. A grantor trust is a trust where the person who transferred property to the trust has retained certain rights or powers over the trust. The ruling does not say which right or power the insured had over the trust to make it a grantor trust. If a trust is a grantor trust, it is essentially ignored for income tax purposes. The trust property is considered to be owned by the grantor, who reports all income and deductible expenses related to the trust property on his own income tax return. Irrevocable life insurance trusts designed to exclude the policy proceeds from the estate of the insured can also be structured as income tax grantor trusts.
The grantor trust that owned the life insurance policy sold the policy to a second trust that was also a grantor trust with respect to the insured. Since the grantor was considered to own the property of both trusts, the IRS ruled that no transfer had occurred that could be treated as a transfer for the value. Thus, upon the death of the insured, the policy proceeds would still be exempt from income tax.
In a variation of the facts, the policy was owned by an irrevocable trust that was not a grantor trust. It sold the policy to a second trust that was a grantor trust with respect to the insured. In this case, a transfer for consideration was found to have occurred, but since the insured was treated as owning the assets of the purchasing grantor trust, the IRS ruled that the sale was a transfer to the insured and thus not subject to the transfer-for-value rule.
Any transfers of life insurance policies must be handled with care to avoid inadvertently running afoul of the transfer-for-value rules. It is a good idea to review any contemplated transfers with your tax adviser before completing them.