Banking and Business Monthly – November 2021

During this time of the year, and especially this year, we are engaged in many succession-planning matters for our clients. Often, succession plans and buy-sell obligations are funded with life insurance, which is attractive because, generally speaking, the proceeds of a life insurance policy received by a beneficiary are entirely free from income tax under IRC 101(a)(1). However, if one does not comply with the transfer-for-value rule under IRC 101(a)(2) with respect to transfers of life insurance policies, this tax treatment can be lost.

Transfer-for-Value Rule

The transfer-for-value rule says that if a life insurance policy, or interest in a policy, is transferred for valuable consideration of any form, such as to satisfy mutuality of promises with respect to buy-sell obligations, then the income tax exclusion is not available to the beneficiary and the death proceeds are subject to federal income tax. More specifically, the portion of the death proceeds equal to the consideration paid to acquire the policy or interest in the contract, plus all future premiums paid by the transferee (i.e., the transferee’s basis in the contract), are received income tax-free, but the remaining death proceeds are taxed as ordinary income under Treas. Reg. Section 1.101-1(b)(1)(i).

Exceptions

When restructuring the ownership of life insurance policies, advisors need to be mindful of this rule and the exceptions to it to allow a life insurance policy transfer to be made for valuable consideration without jeopardizing the income tax-free nature of the death benefit. Any of the below five exceptions found in IRC 101(a)(2) can be utilized to shield a policy’s death benefits from income tax even if there has been a transfer for valuable consideration of a policy or an interest in a policy, if the transfer is to:

1. Anyone whose basis is determined by reference to the original transferor’s basis;
2. The insured (or insured’s spouse or ex-spouse, if incident to a divorce under Sec. 1041);
3. A partner of the insured;
4. A partnership in which the insured is a partner; or
5. A corporation in which the insured is a shareholder or officer.

Transfers to and Among Partnerships and Partners vs. Among Corporations and Shareholders

For purposes of this article, I want to focus on the last three exceptions, which we often utilize in succession planning for businesses. Regarding partnerships and LLCs taxed as partnerships, since the transfer of a policy (a) to a partnership in which the insured is a partner, or (b) to the partner of the insured, are both exceptions to the rule, the transfer-for-value rule is easy to avoid for such entities, and these exceptions enable a change from an entity-purchase or redemption agreement to a cross-purchase agreement, using the same policies to fund the new transaction.

It gets more complicated when the business is a corporation though. While the transfer of a life insurance policy to a partner of the insured is a protected transaction for transfer-for-value purposes, a policy transfer to a co-shareholder of the insured is not protected and results in a violation of this rule. Therefore, when a corporation owns life insurance policies on the lives of its shareholders, structured in the form of an entity purchase or stock redemption agreement, it is not possible to convert to a cross-purchase agreement and use the same policies to fund the new agreement. Such a transaction would violate the transfer-for-value rule because a corporation’s transfer of an existing policy on the life of one shareholder to another shareholder is not one of the exceptions.

Note the differing treatment then between transfers to and among partnerships in which insureds are partners and the partners of the insured, which are exempt, versus transfers to and among corporations and their shareholders if the insured is a co-shareholder, which are not exempt unless the transferee is the insured or the corporation. In other words, transfers of policies from a corporation to a shareholder (who is not the insured) and transfers among shareholders can easily violate the rule. Put another way, when dealing with a business organized as a corporation, transfers of policies up to a corporation can be exempt, but transfers down from a corporation may not be exempt unless they are to an insured or otherwise qualify for one of the other exceptions.

The transfer-for-value rule and its exceptions can be complicated. Business owners are encouraged to consult with their attorneys and tax advisors when formulating their succession plans to avoid inadvertently being subject to the transfer-for-value rule. For further inquiries or questions, please contact me at smigala@lavellelaw.com or at (847) 705-7555.