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INTRODUCTION
Generally, the proceeds of a life insurance policy are not included in gross income under section 101(a)(1).1 However, section 101(a)(2) provides an exception to this rule when a life insurance policy is transferred for valuable consideration. This exception is referred to as the "transfer for value rule." If the transfer for value rule applies, the transferee who has paid valuable consideration for the policy will have to recognize income in an amount that exceeds the sum of the consideration paid and any other amounts subsequently paid by the transferee under the policy. Section 101(a)(2), however, provides several exceptions to the transfer for value rule. One such exception involves a transfer to "the insured." The other exceptions are a transfer in which the transferee takes a carry-over basis from the transferor; a transfer to a partner of the insured; a transfer to a partnership in which the insured is a partner; and a transfer to a corporation in which the insured is a shareholder or officer.
In the estate planning context, there may be numerous reasons for selling an existing life insurance policy to or between family entities or trusts. For instance, an existing trust may contain provisions that would cause its assets to be includible in the grantor's gross estate under sections 2036, 2038 and/or 2042 because the grantor retains a prohibited power or interest. If this is the case, the grantor may need to consider techniques to eliminate this problem. Additionally, the terms of an existing trust may no longer meet the grantor's objectives or the needs of his or her family. A client may own an insurance policy in his or her individual name. If the policy is gratuitously transferred to or for the benefit of his or her family, the client must live for a three-year period following the date of the transfer to avoid inclusion in the gross estate.2 Selling the policy for its fair market value to the client's family or to a trust for the benefit of the client's family may be a technique that can be used to avoid this three-year inclusion rule.3 Additionally, the insurance policy may be owned by a corporation or other business from which it is desirable to shift the ownership. Whenever...