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An important exception exists to the general rule of Internal Revenue Code § 101 that life insurance proceeds are excluded from the gross income of the recipient. This exception is known as the "transfer for value rule," and it works like this: after the initial issuance of a policy, if it is subsequently transferred for "valuable consideration," the income tax exclusion under IRC § 101(a) is lost, and the beneficiary must include in gross income the proceeds received to the extent that they exceed both the consideration paid by the transferee of the policy and any subsequent premium payments or other costs of maintaining the policy after the transfer.
Exempting life insurance proceeds from income taxation is based on a rationale that insurance functions as an alleviation of economic hardship flowing from the insured's death. When a policy is "purchased" by one party from another the situation begins to look more like an investment or business type transaction, in which the eventual receipt of the proceeds on the death of the insured is a bargained-for benefit, having no strong policy rationale for exclusion from income of the recipient. Thus, the economic hardship rationale may well be inapplicable in cases in which an insurance policy has been transferred for valuable consideration.
Example
John purchases a $750,000 life insurance policy on his own life, naming his brother Tom as the beneficiary. Subsequently, John transfers the ownership of the policy to Tom for $5,000. This is a transfer for value under IRC § 101(a)(2). During the succeeding four years Tom pays annual premiums of $2,000 per year. Thereafter, John dies and Tom receives the $750,000 death benefit under the policy. Because of the transfer for value rule, Tom realizes ordinary income in the amount of $737,000 (the $750,000 proceeds, less the $13,000 which he paid to acquire and maintain the policy).
The Transfer for Value Rule
The transfer for value rule can become a tax trap for unwary advisors and their clients.
Neither Cash Consideration Nor Formal Transfer of Policy Ownership Is Necessary to Trigger Rule
The transfer for value rule can come into play under a variety of circumstances in which a party acquires an interest in the proceeds for some form of valuable consideration. There...