Retroactive medicine for transfer for value problems with life insurance.

As a general rule, proceeds from a life insurance policy received by a beneficiary are excluded from gross income under Sec. 101(a). One exception to this general rule is the "transfer-for-value" rule of Sec. 101(a)(2). Sometimes Sec. 101(a)(2) is found to apply to an existing life insurance policy, causing a disallowance of the exclusion. Often this situation resuits when a life insurance policy is transferred several times. When a transfer is made for valuable consideration and subject to the transfer-for-value rule, creative use of the statutory exception can avoid loss of the exemption.

The key to planning is that the rules look at the final transfer in a series of xs and work backwards. Thus, a transfer that qualifies as an exception under Sec. 101{a}(2)(A} and (B} will remove the "transfer-for-value" taint from a prior transfer. This opens up possibilities for recycling insurance policies through exempt transfers, thus avoiding the transfer-for-value rule.

In IRS Letter Ruling 8906034, a series of transfers was used to remove corporate-owned life insurance from the corporation to an owner/father who in turn transferred the policy by gift to his son. The son was to use the policy proceeds to buy the stock of the corporation from the estate. A direct transfer from the corporation to the son would have been tainted as a transfer for value. However, the transfer to the father qualified as a transfer to the "insured" {one of the exceptions under Sec. 101(a)(2)(B)) and the gift to the son qualified as a transfer in which "basis in hands of the transferee is determined by basis of transferer, (another exception under Sec. 101(a)(2)(A)).

In IRS Letter Ruling 8951056, a father purchased life insurance subject to policy loans from an irrevocable insurance trust that included his wife as trustee and beneficiary. He then contributed the same policy to a newly formed irrevocable life insurance trust benefiting only his children. Again, the Service ruled that the transfers fell within the exceptions under Sec. 101{a)(2)(B) and (AL respectively.

In a more recent ruling, Letter Ruling 9012063, the IRS ruled favorably on the outcome of a series of transfers. First the taxpayer proposed a transfer of insurance policies by corporation X, owned equally by A and B, to a real estate partnership also owned equally by A and B. The partnership leased the operating plant and facilities to X; this transfer was to be in partial payment of these lease obligations. After the transfer, the real estate partnership changed the beneficiary of the transferred policies, as well as other previously owned policies on the lives of A and B, so that A was the beneficiary of B's policy and B was the beneficiary of A's policy. The insurance proceeds were to be used to provide financial means for the surviving shareholder to purchase the decedent's X stock and retain control. One of the reasons also listed for the transfer was X's exposure to alternative minimum tax as a result of the policies owned. Again the Service ruled that "although the proposed series of transfers are transfers for valuable consideration, the trans/ers fall within the exceptions to the transfer-for-value rule."

In conclusion, taxpayers can avoid a transfer-for-value taint by carefully planning the last in a series of transfers, so that the transferee will qualify under Sec. 101(a)(2)(A) or (B).

From Lawrence W. McKoy, CPA, Goodman & Company, Norfolk, Va.