Removing Life Insurance Without Triggering the Transfer for Value Rule

This is the second in a two-part series of articles regarding life insurance and removing it from the taxable estate. The first article examined why life insurance is in the taxable estate and how to remove it, including the trap of the three-year lookback. This second article examines the application of the “Transfer for Value” rule and how to navigate around that rule while keeping the life insurance out of the taxable estate.

In the first article in the series, we saw that life insurance is included in the taxable estate if owned by the insured, even if the beneficiary isn’t the insured or their estate. In that article, we also saw that gifting the insurance to an irrevocable trust could remove it from the taxable estate, but there would be a three-year waiting period for the removal.

So, what could Mary do if she wanted to remove the policy from her estate right away? She could sell the policy to the trust for its fair market value. Let’s say the fair market value of the policy is $50,000. If Mary contributes $50,000 to the trust and the trustee of the trust purchases the policy from Mary, Mary wouldn’t have to wait the three years to remove it from her taxable estate. However, while this will solve Mary’s estate tax issue, it may cause the death benefit to be income taxable.

Normally, the life insurance death benefit isn’t included in taxable income due to section 101(a) of the Internal Revenue Code. But if the insurance had been transferred for valuable consideration, then it is subject to income taxation, except to the extent of the consideration paid, unless an exception to the Transfer for Value rule applies.

Here’s what would happen in our example of Mary and her trust: Mary owned a policy on her life. It has a death benefit of $3 million. She sells it to an irrevocable trust (which is not a grantor trust as to Mary) for its fair market value of $50,000. Mary dies and the trust receives the death benefit of $3 million. The trust will face income tax on the amount it receives, $3 million, less what it paid, $50,000. The trust will likely pay more than $1 million in tax on the $2,950,000 in taxable income from the life insurance death benefit. But there’s a way to draft the trust to fall within a safe harbor of the Transfer for Value rule.

There are 5 safe harbors from the Transfer for Value rule:

1. A transfer where the transferee derives their basis from the transferor. This would be in the case of a gift, typically. However, this rule has a couple of carve-outs such as if the policy had already been tainted by the Rule, a transfer by gift isn’t going to cleanse it. It just won’t create a taint itself.
2. A transfer to the insured. So, a sale of a policy to the insured will not be subject to the Rule because of this safe harbor. Importantly, a trust which is drafted as a grantor trust falls under this safe harbor.
3. A transfer to a partner of the insured.
4. A transfer to a partnership in which the insured is a partner.
5. A transfer to a corporation in which the insured is an officer or shareholder.

If the trust to which Mary sells the life insurance had been drafted as a “grantor trust” as to Mary, the sale of the policy to the trust would not trigger the Transfer for Value rule since the sale would have been considered the same as a sale to the insured herself, Mary, for income tax purposes. In that case, the trust would receive the $3 million death benefit and it would not be included in taxable income for the trust.

The Transfer for Value rule is just an example of the complexity which can be involved when considering the removal of life insurance from the taxable estate. It’s best to consult with an attorney who focuses their practice in estate planning so you and your loved ones can avoid the many traps out there.

Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com