Policy loans and the transfer-for-value rule: A trap for the unwary

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


The general rule is that life insurance death benefits are income tax free. But there is an exception to that rule when a policy is transferred for any kind of valuable consideration. If so, the beneficiary can only exclude from gross income the total consideration, subsequent premiums and other amounts paid by the transferee for the policy. This is known as the transfer-for-value (TFV) rule and was enacted by Congress to prevent speculators from purchasing life insurance policies to reap large, tax-free death benefits.

There are, fortunately, five exceptions to the TFV rule:
    1. transfers to the insured;
    2. transfers to a corporation where the insured is an officer or a shareholder;
    3. a transfer to a partner of the insured (LLC members are considered partners, but not co-shareholders);
    4. a transfer to a partnership/LLC where the insured is a partner/member; and
    5. a transfer where the cost basis carries over (in whole or in part) from the transferor to the transferee (e.g., a gift of the policy).
The fifth exception to the TFV rule can be relied upon whenever the insured transfers a policy to his/her children. However, the transfer of a policy subject to a loan could result in the application of the TFV rule if the amount of the loan exceeds the insured’s basis in the policy. The reason is that the discharge of the non-recourse loan (upon the transfer of the policy to the child) is treated as a sale and not a gift. Thus, the child’s basis in the policy is the loan amount and not the insured’s basis (as required for the fifth exception to the TFV rule).

One simple solution to this problem is for the insured to gift the policy to an irrevocable life insurance trust (ILIT) for the benefit of his/her children. If the ILIT is designed as a “grantor trust” (i.e., the grantor/insured is treated as the owner of the trust for income tax purposes), the transfer is treated as a transfer to the grantor/insured. Therefore, the transfer is eligible for the first exception to the TFV rule. (Revenue Ruling 2007-13.)

Moreover, if the policy is sold to the ILIT for its FMV, it might also be possible to avoid the three-year estate tax inclusion rule of IRC Sec. 2035(a). The reason is that the three-year rule does not apply to a “bona fide sale for adequate and full consideration in money or money’s worth”. (IRC Sec. 2035(d).) However, to fall within that exception, the policy must be sold for its fair market value. Otherwise, the transfer will result in estate tax inclusion under IRC Sec. 2035 if the insured dies within three years.
That begs the question: What is the fair market value of a life insurance policy? The gift tax value of a life insurance policy that has been in force for some time and on which premiums are still being paid is the policy’s interpolated terminal reserve value plus the unearned (unused) premium. (Treas. Reg. Sec. 25.2512-6(a).) But it’s not certain that the gift tax regulations can be used to determine the fair market value of a policy for the purposes of the TVF rule. There are no cases on point, and the IRS’s position in private letter rulings has been inconsistent.

Moreover, if the insured is in poor health, the Tax Court has held that the normal valuation rules do not apply. See Estate of Pritchard v. Commissioner, 4 TC 204 (1944). In those situations, it might be advisable to look to the life settlement market to determine the policy’s fair market value.

Finally, when selling a policy to an irrevocable life insurance trust (ILIT), the IRS could apply the “step transaction” rule. If the grantor-insured gifts the cash needed to purchase the policy to the ILIT, and the ILIT immediately turns around and uses the cash to purchase the policy, the grantor-insured is left in the same position he/she would have been by simply gifting the policy to the ILIT. Under the step transaction rule, the IRS could argue that the two transactions (i.e., the gift of cash and the purchase of the policy) is really a single transaction (i.e., a gift of the policy), which could trigger the three-year rule. It might be possible, however, to avoid the step transaction rule by allowing a substantial period of time (e.g., six months or more) to lapse between the gift of cash and the purchase of the policy.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.