In How to avoid tax traps in life insurance, I mentioned that an employer-owned life insurance contract might not qualify for the usual exclusion from regular income tax because an “employer-owned life insurance contract” (a term that applied to much more than one would think) does not receive the exclusion unless certain notice and consent requirements are met. That article also included a link to a free webinar discussing using life insurance in buy-sell agreements.
But that is not the only tax trap. If you transfer a life insurance policy in exchange for money or other property (a “transfer for value”), the death benefit may become subject to income tax. This rule applies even to nontaxable transfers, such as transferring a policy to corporation or partnership (including an LLC) you own.
Before the 2017 tax law changes, a transfer for value would cause the death benefit to become subject to income tax unless one of two exceptions was met. The first exception – which I call a “permitted transfer” – is a substituted basis transfer, where the tax basis in the hands of the person receiving the policy is determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the person transferring the policy. (Tax basis is described in Tax basis: The key to reducing gain on sale or deducting asset purchases.) Permitted transfers generally include transferring a policy to a corporation or to or from a partnership, giving a family member a policy subject to policy loans or swapping life insurance policies on the same insured.
The second exception – which I call a “permitted transferee” – is a transfer 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 officer. Even a fully taxable sale was protected from the transfer for value rule if it was to a permitted transferee.
Thus, before the 2017 tax reform, if a transfer for value was a permitted transfer or to a permitted transferee, the transfer for value would not cause the death benefit to become taxable. However, the tax reform changed the rule so that now neither a permitted transfer nor a permitted transferee would protect the policy from the transfer for value rule if the policy was ever the subject of a “reportable policy sale.”
The change to the rule is generally understood as attacking sales on the life settlement market – selling a policy to a group of investors who hold a portfolio of policies and expect to make money as the insureds die. However, it is not limited to that. A “reportable policy sale” is any transfer for value (whether or not an exception would have applied), “directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured apart from the acquirer's interest in such life insurance contract.” And “indirect” is quite broad.
Generally, buy-sell life insurance should not be a “reportable policy sale.” To avoid treatment as a reportable policy sale, generally, the transfer of the policy needs to (1) be a permitted transfer or to a permitted transferee, and (2) avoid the notice and consent requirements referred to in the first paragraph of this article.
Unfortunately, once an interest in a policy is subject to a “reportable policy sale,” the law makes that interest in the policy forever tainted. Fortunately, in response to a letter I wrote, the U.S. Treasury and the IRS provided a way to cleanse a reportable policy sale, reduced the scope of transferees triggering a reportable policy sale, and made it easier to cleanse a policy that was not subject to a reportable policy sale.
Unfortunately, the reportable policy sale rule is too detailed to describe in full here. Please keep in mind that, each time you transfer a life insurance policy, you should review the transfer for value regulations issued October 31, 2019, as well as making sure that any policy owned by a business entity complied with the rules referred to in the first paragraph of this article.
If these ideas intrigue you, consider calling me or, if you are a CPA, lawyer, trust officer, family office professional or financial advisor, subscribing to my free quarterly “Gorin’s Business Succession Solutions” newsletter. My fourth quarter 2019 newsletter will discuss and include links to this rule, and my free webinar on January 28, 2020 will discuss this rule for about 30 minutes. For a more extensive discussion (approximately 90 minutes), consider listening to Final Regs Released 10/25: Major Changes to Transfer for Value Rule! - TD 9879 (not free).