Transfers for valuable consideration: tax issues when transferring a life insurance policy.
Many individuals concerned with the change in the estate tax exemption are considering a sale of the policy, rather than a gift, in order to avoid the three-year rule (IRC section 2035). This rule brings certain gifts--specifically, life insurance on the life of the party making the transfer--back into the taxable estate for a period of three years from the date of the transfer. Regardless of the reason, violating this transfer-for-value rule subjects a portion of the death proceeds to income taxation, which can easily result in individuals failing to achieve their financial objectives and can possibly subject both insurance and tax professionals to litigation.
The Transfer-for-Value Rule
Transfer for valuable consideration--often referred to as the transfer-for-value rule--states that if the policy, or any interest in the policy, is transferred for valuable consideration, then the proceeds received by the beneficiary shall only be exempt from income tax to the extent of the beneficiary's cost basis (IRC section 101[a]). But this rule can potentially come back to haunt an individual any time the owner transfers ownership of a life insurance policy, or designates or changes a beneficiary, in exchange for anything that has value. While a sale for cash is an obvious example, there are many others, discussed below. This issue is even more complicated because IRC sections 101(a)(2)(A) and (B) provide exceptions to the transfer-for-value rule itself, such as--
* transfer to the insured;
* transfer to a partner of the insured (i.e., a legal business partner, not personal partner);
* transfer to a partnership in which the insured is a partner;
* transfer to a corporation in which the insured is a shareholder or officer; and
* perhaps the most confusing, a transfer where the basis of the policy in the hands of the transferee (the party receiving the benefit) is determined in whole or in part by reference to its basis in the hands of the transferor (the party releasing the benefit).
The sidebar, Scenarios Where Transfer for Value Could Apply, provides examples of situations that might be subject to the transfer-for-value rule.
Transfers of Personally Owned Policies
The situation seen most often with respect to transfers of personally owned policies is a transfer between spouses. If the transfer is an outright gift or is made for valuable consideration, it does not violate the transfer-for-value rule. In such a situation, the basis carryover exception applies. There is no gain or loss recognized on transfers between spouses, and the basis of the transferee remains that of the transferor (IRC section 1041[a] and [b]). This exception will not apply if the transferee is a nonresident alien (IRC section 1041[d]). Currently, transfers for valuable consideration between same-sex married partners are not treated as transfers between spouses for federal tax purposes and are subject to the rules for transfers between nonspouses, according to the 1996 Defense of Marriage Act.
Another question arises, however: what if the transfer is the result of a divorce and the individuals are no longer married on the date of transfer? If the transfer is incident to a legally recognized separation agreement or divorce decree, then there is no transfer-for-value violation and there is a carryover basis (IRC section 1041). Even if the transfer is not directed by a court, the transfer will be treated as "incident to the divorce" and not subject to transfer for value, as long as it takes place within one year of, the termination of the marriage (Treasury Regulations section 1.1041-1T, A-1, A-6).
Transfers to other family members typically occur when the original owner of a life insurance policy gifts or sells it in order to remove it from the taxable estate. Other than spouses, family members have no exempt status under the transfer-for-value exceptions, and thus such transactions are fraught with possibilities to trigger taxation. If the transaction qualifies as an outright gift, the transferor needs to be concerned about the three-year rule under IRC section 2035. If the transfer does not qualify as a gift and is, in fact, a "bona fide sale for an adequate and full consideration in money or money's worth" (IRC section 2035[d]), then it will be subject to the transfer-for-value rule (IRC section 101[a]). But what if it is a part-gift, part-sale transaction? Related parties transferring an asset for something less than full consideration will find themselves having made a gift, possibly subjecting the transaction to gift tax and the three-year rule, * and having made a sale. Because the cost basis of this transaction is partially determined by the transferor's basis, however, the transaction is not subject to the transfer-for-value tax (MC section 2512[b]).
Transfers of Business-Owned Policies
One common transaction is the distribution of business-owned policies to individual owners in order to fund a cross-purchase buy-sell agreement. This can arise due to a switch from an entity purchase to a cross-purchase, or simply from a decision to repurpose existing business-owned coverage for the cross-purchase agreement. The proper structuring of a cross-purchase involves each owner owning a policy on each other owner's life, as shown in Exhibit 1.
This transaction requires the business to distribute a life insurance contract on the life of Owner A to Owner B, and on the life of Owner B to Owner A. Each owner is the beneficiary of the policy he owns on the life of the other owner. Whether the policies are characterized as a distribution or purchased by the owners of the business does not change the fact that there is a transfer for value. If the policy transfer was through a cash sale, then the trigger is the sale and no exception applies. If the transfer was characterized as a distribution, then the trigger is that the transfer was done in exchange for relieving the company from the obligation to continue the contract and the promise contained in the buy-sell agreement to use the death benefit to complete the agreement. These promises constitute valuable consideration.
There is one exception: if the owners are partners, the transaction falls under the "partners' exception" to the transfer-for-value rule. Identical issues exist if the owners attempt to repurpose individually owned policies to fund the cross-purchase by exchanging, purchasing, or otherwise transferring ownership of the policies to each other.
Another scenario that occurs when attempting to avoid a transfer for value in a buy-sell agreement is to have each owner purchase a policy on her own life. They are the owner and the insured, but they have named the other business owner as beneficiary. Typically, this is presented as a way to avoid a policy exchange at a later date, when the owner no longer believes she will need the buy-sell agreement, and when each owner would like to start accessing the cash value in her own policy to supplement retirement income on a tax-preferred basis (mc section 72[e]). At this point in time, they would simply change the beneficiary designation back to their family, trust, or other party. The problem here is, once again, an exchange of valuable consideration for the naming of the owner/insured's co-business owner as the beneficiary. And yet again, the partners' exception or the "transfer to the insured exception" might be available.
What would otherwise appear as a properly designed life insurance funding arrangement can still go wrong if there are three or more owners and each owns a policy on the others. Upon the first death, the buy-sell agreement is triggered. The policies owned by the survivors on the life of the decedent pay to the survivors. The death benefit is used to purchase the decedent's share of ownership.
One problem that might arise concerns the policies owned by the decedent on the lives of the survivors; for example, A, B, and C each own equal parts of a $3 million business and have a cross-purchase buy-sell agreement funded with life insurance. Policies owned by A insure B and C for $500,000 each; B owns identical policies insuring A and C, and C owns identical policies insuring A and B. Assuming that A dies first, the policies on A's life--owned by B and C--pay out, and the proceeds are used to purchase A's ownership interest.
What happens to the contracts on the lives of B and C that were owned by A? If the policies are transferred to the insured, they are no longer useful for the buy-sell agreement because they will be owned by the insured. While this is an exception to the transfer-for-value rule under the transfer to the insured exception, it renders the remaining portion of the buy-sell agreement underfunded. If the policies are transferred in a manner that continues the proper funding of the cross-purchase agreement (B obtains ownership of the policy on C; C obtains ownership of the policy on B), then the transfer-for-value rule is once again violated, because the policies were obtained for the purpose of utilizing the death benefit to complete the buy-sell agreement.
This situation demonstrates two potential exceptions to the transfer-for-value rule: the first would be the previously discussed partners exception, and the second would be to transfer the policies owned by A on the lives of B and C to the corporation previously owned by A, B, and C--now owned only by B and C--and create a combination cross-purchase/stock redemption buy-sell agreement. B and C would still use the life insurance contracts they own to fund a portion of the buy-sell agreement, and the corporation would use the policies it owns to fund the remaining portion of the agreement. This structure falls under the "transfer to a corporation in which the insured is a shareholder exception" to transfer for value. Once again, the partners' exception could apply if--and only if--there is an existing partnership that included A, B, and C at the time of A's death. It is important to remember that the partnership does not have to be the business concern that is involved in the current buy-sell agreement.
Businesses with multiple owners often look to a trusteed cross-purchase buy-sell agreement (sometimes described as an "escrowed" buy-sell agreement). While there are several advantages to the basic cross-purchase structure, ease of administration is not one of them if there are more than two owners. The number of policies needed is N(N-1), where N is equal to the number of owners; for example, a business with five owners would require 20 policies to fund the agreement. In an attempt to mitigate the administrative issues associated with a large number of policies, businesses have a trustee own one policy on each owner and authorize the trustee to administer the cross-purchase buy-sell agreement. This significantly eases administrative issues.
On the other hand, this strategy does nothing for the transfer-for-value issue that exists when existing policies are transferred to facilitate a cross-purchase agreement. In the previous example--where A, B, and C each own an equal interest in a business worth $3 million--the appointed trustee would receive the funds from A, B, and C required to purchase one $1 million policy on each owner. Assuming the death of A, the trustee receives the proceeds of the life insurance policy on A and uses those proceeds to purchase A's ownership interest from A's estate. The trustee then evenly distributes the ownership to B and C, thus keeping their ownership interests equal. From a transfer-for-value perspective, the problem occurs because the beneficial interest in the remaining policies is now modified. B and C each now have a greater interest in each policy for the sole purpose of using the proceeds to complete the remaining portion of the buy-sell agreement; again, the one clear exception is if there was an existing partnership among A, B, and C.
Because the partners' exception continues to pop up in each example, one must ask: is there a way to integrate a partnership into the buy-sell agreement itself? The IRS has issued private letter rulings (PLR) that have concluded that a partnership may be created for the sole purpose of completing the buy-sell agreement (PLR 9042023, PLR 9309021). If there is a concern that state law might not recognize a partnership designed solely to complete a buy-sell agreement, then another recognized business activity could be housed in the partnership, such as owning or managing real estate or leasing office equipment to the primary business.
Split-dollar agreements can be another source of frustration in the transfer-for-value arena. One component of many split-dollar agreements is either transfer of ownership or the naming of a beneficiary in exchange for something of value. As discussed above, such events can have negative results under the transfer-for-value rule. Although a discussion of the tax issues specific to split-dollar plans is beyond the scope of this article, many articles have appeared in The CPA Journal specifically addressing the subject.
The most common structure of split-dollar agreements today is the "economic benefit endorsement split-dollar agreement." In this structure, the life insurance policy is owned by the business, and the employee or owner is given the right to designate a beneficiary for some or all of the death proceeds. The typical agreement gives the company the right to receive an amount of the death proceeds equal to the greater of premiums paid or cash value; however, other variations exist.
The most common alternative is to give the owner or employee the right to name the beneficiary for the nonbusiness portion of the death proceeds. This would not result in a transfer for value under the transfer to the insured exception. But sometimes the right to name the nonbusiness portion of the death benefit is given to a different party. This party could be a trust, drafted with the desire to prevent an incident of ownership in an attempt to keep the death proceeds out of the individual's taxable estate under IRC section 2035. But unless that third-party owner is a partner of the insured or can be treated as the insured, such as a grantor trust (IRC sections 671-677), the proceeds will be subject to the transfer-for-value tax.
A newer type of split-dollar agreement created under the final regulations, known as a loan regime split-dollar agreement, provides for a policy owned by an employee or owner to have some or all of the premium paid by the company as a loan, with the policy itself being transferred under a collateral assignment in order to secure the loan (Treasury Regulations sections 1.6122, 1.83-3[e], 1.83-6[a], 1.301-1[q], 1.7872-15; Technical Decision [TD] 9092, Internal Revenue Bulletin [IRB] 2003-46). This transaction avoids the transfer-for-value tax issue for any death benefit received by the company, because a collateral assignment is not deemed a transfer for value (Treasury Regulations section 1.101-1[b]). This extends to old grandfathered economic benefit collateral assignment split-dollar plans as well.
In an attempt to avoid split-dollar issues, the parties will sometimes enter into a shared or split ownership agreement. In this form, the company's premium payments are secured through an absolute assignment in the policy. Because this type of assignment is not protected under Treasury Regulations section 1.101-1(b)(4), there is no exemption from transfer for value, and it will exist from the inception of the plan. The only remaining possible exceptions to the transfer-for-value rule would be if the insured is a shareholder or officer of the company, or--much less like-ly--if the employer is a partner of the insured. It is important to keep in mind that the party being subjected to the transfer-for-value tax here is the employer: it is the party who is exchanging something of value for the right to receive death benefit. This is one of those issues where the resulting tax is usually minimal and, therefore, acceptable to the parties involved. The reason for this is that the transfer-for-value tax is applicable only to the benefit received in excess of the party's cost basis. Because most shared ownership agreements stipulate that the employer will receive the greater of the premium paid or the cash value, there is rarely significant tax exposure.
Regardless of how many transfers a policy goes through or how many times it is exposed to the transfer-for-value tax, it is the last transfer before death that ultimately determines whether the proceeds will be subjected to the tax. If a policy is currently positioned in such a way that the tax would be triggered, it should be reviewed in light of the proscribed exceptions to the rule.
While the focus of this article is transfer for value, it is also important to remember that whenever a life insurance policy is being transferred, either through a gift or sale, the proper valuation is the fair market value. In conjunction with the transfer-for-value discussion, a common question is whether the cash value is an appropriate value for the policy. The IRS has made it abundantly clear that it is not (Revenue Procedure 2005-25).
It is also important to remember that other IRC sections might inadvertently trigger taxation of the death benefit, such as IRC section 101(j), which addresses the treatment of certain employer-owned life insurance contracts. Furthermore, the sale or purchase of life insurance by a grantor trust, from the grantor on the life of the grantor, will be treated as a sale to the grantor, thus circumventing both the three-year rule and the transfer-for-value problem (Revenue Ruling 2007-13).
RELATED ARTICLE: SCENARIOS WHERE TRANSFER FOR VALUE COULD APPLY
Mother (M) owns a life insurance policy with a current death benefit of $1 million. M sells the policy to her son (S) for its fair market value of $200,000. S continues to pay the premiums on the policy until the death of M, an additional $50,000. Transfer for value applies in this situation. S purchased a life insurance contract and does not fit into any of the exceptions of Internal Revenue Code (IRC) section 101(a)(2)(A) or (B). At M's death, S will receive $1 million. S has a total cost basis of $250,000 (the original purchase price of $200,000 plus the additional $50,000 in premiums); $750,000 (death benefit minus cost basis) will be subject to ordinary income tax under the transfer-for-value rule.
This example follows the same fact pattern as Example 1, but with one twist--M and S are partners in a business at the time of the transfer. In this case, transfer for value does not apply because the transfer was to a partner of the insured.
M owns a life insurance policy with a current death benefit of $1 million. It has a cost basis of $50,000 and has an outstanding loan of $100,000. M gifts the policy to. S continues to pay the premiums on the policy until the death of M, an additional $50,000.
Transfer for value applies in this example. M actually received something of value when she otherwise gifted the policy to S--she was relieved from the loan obligation, which was greater than her cost basis--and none of the exceptions apply. S accepted the obligation to repay the loan and this, in and of itself, is valuable consideration. S will receive $900,000 upon M's death (the $1 million death benefit minus the loan amount, assuming it has not been repaid prior to death). S has a total cost basis of $150,000; $750,000 will be subject to ordinary income tax under the transfer-for-value rule.
This example has the same fact pattern of Example 3, but with one twist--the outstanding loan is $40,000. Transfer for value does not apply in this situation. Because S received the policy with a cost basis greater than the value of the loan, this transfer would fall under the basis transfer exception because it would be deemed a part-gift, part-sale transaction.
A and B, two equal shareholders of a corporation (C), valued at $2 million, enter into a cross-purchase buy-sell agreement. A is no longer insurable due to medical reasons. C currently owns a life insurance policy on each owner for $1 million. Those policies had been viewed as key person policies, but A and B decide to repurpose them for the benefit of the buy-sell agreement. Knowing that the proper structure of the cross-purchase buy-sell agreement requires A to own the policy on B and vice versa, they distribute the policies correctly and recognize the proper income taxation on the distribution. The taxable value of each policy on the date of distribution is $200,000, and each pays an additional $50,000 in premiums before A dies.
Transfer for value applies in this situation for two reasons. First, the transfer, which could not be described as a gift, is to a person other than the insured. Second, the transfer occurred for the purpose of securing the buy-sell agreement, which has value in and of itself. B would receive the $1 million death benefit with a cost basis of $250,000 (the taxable value at transfer of $200,000, plus the additional premium of $50,000); $750,000 (the $1 million death benefit received minus the cost basis of $250,000) would be subject to taxation.
Andrew I. Shapiro, MSM, CLU, ChFC, holds the title of director--advanced consulting group, Nationwide Financial, Columbus, Ohio.
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|Title Annotation:||personal financial planning|
|Author:||Shapiro, Andrew I.|
|Publication:||The CPA Journal|
|Date:||Oct 1, 2012|
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