Transfers for value.

Life insurance can be an attractive financial planning tool because the proceeds payable on the death of an insured generally are exempt from taxation. This is not always the case, however.

TRANSFER-FOR-VALUE RULE

If a life insurance policy (or interest in such a policy) is transferred for consideration, the proceeds are exempt from tax only up to the amount of the consideration paid by the transferee and any premiums he or she paid after the transfer.

This rule applies to outright sales of insurance policies but also extends to other transactions: the naming of a beneficiary in exchange for consideration, the creation (through a separate contract) of a right to receive the insurance policy's proceeds, the assignment by two shareholders of existing policies to each other to fund a cross-purchase agreement or the transfer of a policy by a corporation to a shareholder in a liquidation distribution. A transfer for value can occur even if the policy has no cash surrender value and even if no purchase price is paid, provided some sort of consideration is involved.

EXCEPTIONS TO THE RULE

There are several exceptions to the transfer-for-value rule. If any of these transactions occurs, the life insurance proceeds are exempt from income taxation:

* A sale or transfer for value to the insured himself or herself.

* A transfer for value to a partner of the insured, to a partnership of which the insured is a partner or to a corporation of which the insured is an officer or shareholder.

* A transfer for value in which the transferee carries over the transferor's basis in the policy--for example, when a policy is transferred from one corporation to another as part of a tax-free reorganization, when a policy is transferred between spouses or when a policy is acquired as a gift.

Series of transfers. If the same policy is transferred several times, the final transfer determines its status. If the final transfer is a transfer for value, a portion of the policy proceeds is taxable. If the final transfer is to someone exempt in accordance with the exceptions, the entire proceeds are tax-free.

The transfer-for-value rule, therefore, can be both an advantage and a disadvantage. Obviously, if the rule applies, the disadvantage can be mitigated through an exempt transfer. At the same time, if care is not taken, a life insurance policy that has been transferred several times can inadvertently come within the scope of the general transfer-for-value rules.

Gifts. Because most insurance policy transfers among family members are (at least in part) gifts, the application of the transfer-for-value rule does not apply. However, even in these situations the rule may apply if the amount the transferee pays for the policy, or the amount of a loan to which the policy is subject, exceeds the transferor's basis in the policy. When this is the case, the transferee's basis is not considered the carryover of the transferor's basis. Rather, the basis is what the transferee paid for the policy.

Planning. The transfer-for-value rule comes into play most often in connection with funding buy-sell agreements, when a life insurance policy is transferred by a corporation to one of its shareholders. It also applies when a corporation or partnership gives policies to insured executives on retirement; if the executive transfers the policy so the transfer-for-value rule applies, the proceeds become taxable.

Transfer-for-value problems can be avoided by involving an entity subject to the exceptions (for example, a partnership). Rather than transferring the policy directly to the shareholder, the corporation transfers it to a partnership of which the shareholder is a partner.

Note: In all of these situations, the partnerships must be legitimate: They must have partners, be set up to conduct valid business activities and have a profit motive. It is important that this aspect not be overlooked; if the partnerships are not legitimate, the transfers are considered shams and the possible benefits lost.

For a discussion of the transfer-for-value rule and related developments, see the Tax Clinic department, edited by Philip Wiesner, in the June 1993 issue of The Tax Adviser.

Ed. note: the material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.