2 minute read – The transfer of valuable assets must be done with care. And so it is with life insurance handed down or handed off through a change of ownership.
Bobby and I were both 9 years old, and goofing around at grandma’s house one day. One thing lead to another and we accidentally hit the dinner table while crawling under it, and down came crashing all of grandma’s plates. Yup….just like you would see it in a movie……GULP! All I remember from that moment was how gracious grandma was. No yelling, or, crying. We never heard another thing about it. But, we never saw those dishes again either. If there was any great value to these plates, we never did see it once they were in small pieces on the floor! Thus is the basis to today’s article as it relates to transferring value rules.
Section 101 of the Internal Revenue Code doesn’t prohibit the purchase of a life insurance policy, but it does curtail the tax advantages of such an “investment” to an extent that could be significant to the unsuspecting.
Death proceeds are not includible in gross income (i.e. they are income tax-free) unless the policy was acquired for “valuable consideration”, then they are excluded only to the extent of the consideration paid (basis). And consideration doesn’t have to be cash.
ATTENTION BUSINESS-OWNED LIFE INSURANCE: The IRS will go far afield in construing any hard or intangible assets, services or other benefits rendered in the acquisition of the policy as consideration. There are some common exceptions. Most business-related Transfer For Values are protected if they occur between partners or their partnership (LLCs taxed as a partnership are considered partnership), or if the transfer is to a corporation in which the insured is a shareholder or officer. Most transfers within a domestic situation are not affected because they are considered gifts.
Beyond that attorneys and accountants must struggle with the “gray areas” that always get foggy around the real life situations addressed by the letter of the law. The two most common scenarios we encounter follow with a description and our best guess as to the response that a qualified advisor might give:
The regulations to IRC 101 state that “the creation, for value, of an enforceable contractual right to receive . . . proceeds of a life insurance policy may constitute a transfer for a valuable consideration . . . [but] the pledging or assignment of a policy as collateral security is not a transfer for a valuable consideration . . .” Consequently, use of this policy to secure a loan is not a TFV. But an assignment for some other reason may be.
There are several reasons it may not be wise to make someone a beneficiary in return for some consideration, but a potential TFV problem is probably not one of them. Again, the regulation states there must be “an enforceable contractual right to receive . . . proceeds of a policy”. A revocable beneficiary change does not create such a right.
Wondering if your policy is in violation of a TFV?
Fortunately there is a “fix” for policies tainted by a transfer-for-value. Unlike grandma’s set of dishes my cousin and I accidentally busted up (we were 9 years old and rambunctious!) this is a Humpty-Dumpty that can be put back together again. The regulations have two pieces of good news. First, a transfer back to the insured is never a TFV and, second, it is only the last transfer that governs taxable status. It may be possible to cleanse the troubled policy with a transfer back to the insured and then work forward from there.
Reviewing of key-person life insurance, disability income, and long-term care insurance. Succession planning and preparations towards meeting with your attorney? Let’s talk more.
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