This chapter discusses selected key income tax issues concerning life insurance and ILITs.1 Recent changes in the Internal Revenue Code now permit an insured to receive life insurance proceeds income tax free under certain conditions, such as during a terminal or chronic illness. An ILIT drafted with sufficient flexibility can take advantage of these special benefits. The income tax aspects of life insurance must be under- stood if the death benefit is to be received income tax free. Thus, the transfer for value rule is extremely important and is an income tax trap for the unwary. This special rule, which can cause life insurance proceeds to be subject to income taxation is also important for under- standing how to fix a “damaged” ILIT. See, Chapter 15, below. The grantor trust rules, among other things, provide tremendous flexibility, especially if the grantor wants to make additional “tax-free” gifts to the ILIT that are in excess of the grantor’s gift tax annual exclusion amount, or if the grantor wants to transact with the ILIT on an income tax free basis. The grantor trust rules also provide flexibility in fixing a damaged ILIT. This chapter also contains a brief discussion of the “tax-free” exchange of a life insurance policy; the income taxation of policy dividends and loans; the income taxation upon the surrender, cancellation, or lapse of a policy; and the income taxation upon the sale of a policy.
2A.1 LIFE INSURANCE PROCEEDS RECEIVED INCOME TAX FREE
Generally, proceeds paid under a life insurance contract (as defined in IRC section 7702 concerning policies issued after December 31, 1984; and as defined in Helvering v. LeGierse, 312 U.S. 531 (1941) for policies issued before January 1, 1985) by reason of the insured’s death 2 are not subject to income tax.3 IRC section 101(a)(1). There is no limitation on the amount of life insurance proceeds that a beneficiary can receive income tax free. IRC section 101(a)(1) is an exception to the definition of gross income under IRC section 61(a)(10).
Caution: Interest paid by the life insurance company because of a delay in payment of the life insurance proceeds is subject to income tax.4 IRC sections 101(c) and (d). Interest or dividends paid by the Veterans Administration on a United States Government Life Insurance policy or on a National Service Life Insurance contract (i.e., a U.S. military government life insurance policy) are however income tax free. 38 U.S.C. section 38 U.S.C. §5301(a)(1).; Rev. Rul. 91-14, 1991-1 C.B. 18; Rev. Rul. 71-306, 1971-2 C.B. 76.
2A.2 ACCELERATED DEATH BENEFITS AND VIATICAL SETTLEMENTPROCEEDSRECEIVED INCOME-TAXFREE
2A.2(a) Accelerated Death Benefits
Accelerated death benefits paid under a life insurance policy because of the insured being either terminally ill (i.e., death is reason- ably expected to occur within 24 months) or chronically ill (i.e., meets the criteria established under IRC section 7702B(c)(2)) are generally not subject to income tax. IRC sections 101(g)(1) and (4).
2A.2(b) Viatical Settlements
Similarly, proceeds from the sale or assignment of any portion of the death benefit of a life insurance policy on a terminally ill (i.e., death is reasonably expected to occur within 24 months) or chronically ill insured paid by a viatical settlement provider (defined in IRC section 101(g)(2)(B)) are generally not subject to income tax.5 IRC section 101(g)(2).
Practice Point: A viatical settlement will provide the ILIT with cash that can be distributed to the beneficiaries, such as the insured’s spouse. The beneficiaries can then use the money (if they choose) to assist in the care and comfort of the dying grantor–their loved one. In this regard, make sure the ILIT trustee has the authority to make discretionary distributions to the beneficiaries (but not to the grantor insured) during the grantor-insured’s lifetime. Also make sure the trustee can change the governing law or situs of the trust to a jurisdiction that has favorable laws governing viatical settlements and/or life settlements. See, Paragraphs 4.1 and 8.3(A) of Sample ILIT.
Practice Point: IRC section 101(g)(3) limits the amount that a chronically ill person may receive income tax free under a viatical settlement. The amount is $63,875 (adjusted for inflation) per calendar year. Thus, viatical settlements for a chronically ill insured should be paid in installments if the settlement amount is greater than $63,875. However, for the proceeds from a chronically ill viatical settlement to be income tax free, the viatical payments must be for the reimbursement of the actual cost of qualified long-term care services (as defined under IRC section 7702B) that were actually incurred by the chronically ill insured. The prohibition on receipt of settlement proceeds for expenses reimbursable under Medicare may result in many individuals not being able to satisfy the requirements for a chronically ill viatical settlement. Payments for a chronically ill viatical settlement are income tax free only within the limits allowed under long- term care insurance contracts pursuant to IRC section 7702B. A viatical settlement for a chronically ill grantor- insured will not be income tax free because the viatical proceeds will be paid to the ILIT and not to the insured. However, the viatical proceeds should be income tax free if the ILIT were an intentionally defective grantor trust for income tax purposes. Regardless of the income tax consequences of a viatical settlement for a chronically ill insured, a chronically ill insured-grantor cannot be a beneficiary of an ILIT without running afoul of IRC section 2036. See, section 4.2, below.
2A.3 ACCELERATED DEATH BENEFITS AND VIATICAL SETTLEMENT PROCEEDS SUBJECT TO INCOME TAX
If a life insurance policy is owned by a business in which the insured has a financial interest, or if the policy is owned by a business in which the insured is an officer, director, or employee, the viatical settlement proceeds and the accelerated death benefits payable as a result of the insured being either chronically ill or terminally ill are subject to income tax if they are not paid directly to the insured. IRC section 101(g)(5).
2A.4 INCOME TAXATION OF A LIFE SETTLEMENT
A “life settlement” is the sale to a third party (such as a hedge fund or an institutional investor) of a life insurance policy (including term life insurance) of an elderly (but not chronically or terminally ill) insured (usually age 65 or older) who has an abbreviated life expectancy (generally between 2 to 12 years), has a policy(ies) with an aggregate death benefit of $250,000 or more, and the insured has owned the policy(ies) for at least two years. The proceeds from a life settlement (which are typically more than the cash surrender value but less than the face amount of the policy(ies)), are not exempt from income taxation under IRC section101, and are subject to the general rules of taxation. There are two unresolved issues concerning the income taxation of life settlements: (i) how to compute the policy owner’s basis in the policy, and (ii) if there is gain on the sale of the policy, is the gain capital gain or ordinary income?6 See, IRS Internal Legal Memorandum 200501004 and Priv. Letter Rul. 9443020, concerning the income tax basis issue in a life settlement. See also, footnote to section 2.5(b), below, concerning how to determine “basis.”
Practice Point: Life settlements concerning variable life insurance policies and variable universal life insurance policies are also subject to rules promulgated by the National Association of Securities Dealers.7 However, many states do not require licensing of life settlement brokers or dis- closure of compensation practices, and so these transactions largely occur without regulatory oversight. The lack of regulatory oversight and lack of disclosure to the policy owner has led to abuses in the industry, including alleged schemes of broad and pervasive fraud.
Practice Point: A life settlement involving an ILIT that is a grantor trust for income tax purposes will result in the grantor being taxed on the portion of the life settlement proceeds that are subject to income or capital gains tax. If the ILIT does not contain a reimbursement provision for the grantor’s payment of income/capital gains tax, the grantor has in effect made a tax-free gift (of the amount of the income/capital gains tax paid by the grantor) to the ILIT beneficiaries, and has done so without having to use any of the grantor’s gift tax annual exclusion amount or lifetime gift tax applicable exclusion amount. See, section 3.18, below.
Practice Point: A life settlement may be an alternative to surrendering or terminating a policy that is no longer needed, no longer suitable, no longer affordable, or is under-performing. When undertaking a life settlement, a trustee may want to obtain several life settlement quotes.
2A.5 TRANSFER FOR VALUE RULE AND INCOME TAXATION OF LIFE INSURANCE PROCEEDS
A major exception9 to the income-tax free receipt of life insurance proceeds is if there has been a “transfer for value” of an interest in a life insurance policy. IRC section 101(a)(2). If a life insurance policy (or any interest in an existing life insurance policy) is transferred for valuable consideration (of any form, such as cash, mutuality of promises, etc.), then the income tax exclusion under IRC section 101(a)(1) is not available and the regular income tax rules apply (concerning the income taxation of the life insurance proceeds).10 The result is that the consideration paid to acquire the policy (or an interest in the policy) plus any future premiums paid by the transferee (i.e., the transferee’s basis in the contract) are received income tax free, but the remaining proceeds are taxed as ordinary income. Treas. Reg. §1.101-1(b)(3)(i).
To invoke the transfer for value rule, there must be a transfer of the policy (or an interest in the policy) and valuable consideration must have been given in exchange for the transfer.
A transfer for value is any absolute transfer for value of a right to receive all or any part of a life insurance policy. Treas. Reg. §1.101- 1(b)(4). Even term life insurance policies that have no cash value are subject to the transfer for value rule. See, e.g., Priv. Letter Rul. 7734048. The transfer does not have to be of the policy itself. A trans- fer of some or all of any of the underlying interests in the policy (such as the death benefit proceeds) is sufficient to invoke the rule, which is broadly defined. For example, the creation, for value, of an enforceable contractual right to receive all or a part of the proceeds of a life insurance policy may constitute a transfer for a valuable consideration, as would be the case when an insured shareholder owning a policy on his life is contractually bound under a buy-sell agreement to name a fellow shareholder as the beneficiary of the policy. Another example of a transfer for value would be to name a particular person as a beneficiary of the policy in exchange for valuable consideration. A reciprocal promise can also constitute valuable consideration. For example, if several insured co-shareholders agree to “gift” their policies to one another to fund a cross-purchase arrangement, the reciprocal gifting constitutes valuable consideration. Also, if the co-shareholders agree to continue paying premiums on the “gifted” policies (to fund the cross- purchase agreement), this, too, constitutes valuable consideration. However, if the co-shareholders are all partners, then the transaction may be exempt from the transfer for value rule under the partner-protected party exception, which is discussed below. See, J.R. Monroe v. Patterson, 197 F. Supp. 146 (N.D. Ala. 1961); Priv. Letter Rul. 1999- 03020. On the other hand, the pledging or assignment of a life insurance policy as collateral security for a loan or other obligation owed by the policy owner is not a transfer for a valuable consideration of the policy or an interest therein. IRC section 101(a)(2) is not applicable to any amounts received by the pledgee or assignee (which amounts are treated as a repayment of capital and are therefore generally income tax free to the extent of the outstanding debt amount; however, insurance proceeds representing interest on the debt are taxed as ordinary income to the creditor). Treas. Reg. §1.101-1(b)(4).
Practice Point: There are two income tax issues that must be considered when selling/transferring a life insurance policy for valuable consideration: (1) the transfer for value rule, and (2) the income tax consequences to the seller of the policy. See, section 2.19, below.
2A.5(a) Five Statutory Exceptions To Transfer For Value Rule
There are five statutory exceptions to the transfer for value income tax rule. Under these five exceptions, life insurance proceeds are received income-tax free even if there has been a transfer for valuable consideration of a policy or an interest in the policy.11 IRC section 101(a)(2)(A) and (B).
2A.5(b) Transferor’s Basis Exception
The first exception to the transfer for value rule is if the transferee’s basis in the life insurance policy is determined in whole or in part by reference to the original transferor’s basis in the policy.12 IRC sections 1015(a), 101(a)(2)(A), 72(c)(1) and 72(e)(6); Treas. Reg. §1.101-1(b)(1); James F. Waters, Inc. v. Commissioner, 160 F. 2d 596 (9th Cir. 1947), cert. denied, 332 U.S. 767 (1947). This exception is commonly referred to as the “transferor’s basis exception,” and applies to transfers if the transferee takes a carryover income tax basis in the policy from the original transferor.
2A.5(b)(1) Gift, Or Part Sale And Part Gift Of Policy
The most common example of the transferor’s basis exception is a gift (or a part sale and part gift) by the original transferor.13 To qualify under the part sale and part gift exception, the transferee’s consideration for the policy14 must be: (i) less than the policy’s fair market value (see, section 3.1, below concerning valuation of life insurance policies), and (ii) less than the original transferor’s basis in the policy. Thus, if: (i) the amount of the transferee’s consideration exceeds the original transferor’s basis in the policy, or (ii) the policy is subject to an outstanding loan amount that exceeds the original transferor’s basis in the policy, the transfer will be subject to the transfer for value rule (unless another exception to the transfer for value rule applies).
2A.5(b)(2) Problems Caused By Policy Loans
If there is an outstanding policy loan15 and the policy loan amount exceeds the original transferor’s basis in the policy, the transferee’s basis in the policy is not the transferor’s basis but the amount of the loan (debt) assumed by the transferee (unless the transferee is an intentionally defective grantor trust with regard to the transferor). In such a case, the transfer for value rule is triggered because the assumption of the loan amount is considered to be both valuable consideration to the transferor and “the amount paid by the transferee for the property” under Treas. Reg. §1.1015-4(a)(1)(i).16 See, e.g., Rev. Rul. 69-187, 1969-1 C.B. 45; Treas. Reg. §1.1001-2(a)(4)(i); Pvt. Letter Ruls. 8951056 and 7724048. Thus, the assumption of the loan amount by the transferee is treated as a sale by the transferor to the transferee of the policy for the amount of the outstanding loan. Consequently, the transferor will be required to recognize gain on the transfer of the policy because the transferor’s loan has been effectively discharged. The amount of the assumed (i.e., discharged) loan will be treated as the amount realized by the transferor for gain purposes, and the transferor will report the amount of gain that exceeds his or her basis in the policy. The gain will be taxed as ordinary income (and not as capital gain). Edwin A. Gallun v. Commissioner, 327 F.2d 809 (7th Cir. 1964); Simon v. Commissioner, 285 F.2d 422 (3d Cir. 1960); Commissioner v. Percy W. Phillips, 275 F.2d 33 (4th Cir. 1960); Abram Nesbitt 2d v. Commissioner, 43 T.C. 629 (1965).
On the other hand, if the assumed loan amount does not exceed the original transferor’s basis in the policy, the transferee’s basis in the policy will be determined in part by reference to the original transferor’s basis; the transfer for value rule will not be triggered and the transferor will not recognize any gain on the transfer of the policy. Also, even if the loan amount exceeds the original transferor’s basis in the pol- icy, if the transferee is an intentionally defective grantor trust with regard to the original transferor, the trust will receive the original transferor’s carryover basis in the transferred policy and the transfer for value rule will not be triggered (nor will the transferor recognize any gain on the transfer of the policy). See, Rev. Rul. 85-13, 1985-1 C.B. 184.
Practice Point: In order for a transfer of a life insurance policy to come within the transferor’s basis exception under a part sale part gift transfer, the amount of the consideration given for the transfer of the policy (which amount includes the policy loan amounts assumed by the transferee) must be (i) less than the policy’s fair market value, and (ii) less than the original transferor’s basis in the policy.
Caution: Generally speaking, in order to come within the transferor’s basis exception, do not transfer a life insurance policy with a loan amount in excess of the transferor’s basis. Instead, before making the transfer, repay all or a portion of the loan so that the outstanding loan amount is less than the amount of the transferor’s basis in the policy.
2A.5(b)(3) Tax-Free Reorganization
Another common example of the transferor’s basis exception is when the life insurance policy is transferred from one company to another company pursuant to a tax-free reorganization (assuming the policy is not already tainted because of a prior transfer for value). Because the tax basis for the insurance policy does not change under the tax-free reorganization rules, the transfer for value rule is not invoked. Corporate tax-free reorganizations under IRC section 368 include mergers, consolidations, and the transfer of substantially all of one corporation’s property solely in exchange for the voting stock of another corporation. Also included in the transferor’s basis exception is the transfer of a life insurance policy to a corporation in a manner that qualifies as a tax-free transfer of property in exchange for stock under IRC section 351. Treas. Reg. §1.101-1(b)(5), Example 2.
A corporation’s purchase of another company’s assets is not a tax-free reorganization, and therefore, if the assets purchased include a life insurance policy owned by the selling company, the transfer for value rule will come into play (unless another exception to the transfer for value rule applies, such as the insured is an officer or shareholder of the purchaser corporation). See, Spokane Dry Goods Co., T.C.M. (PH) ¶43182, [pg. 43-559], 1 T.C.M. (CCH) 921 (1943).
Practice Point: When a life insurance policy is acquired in the acquisition of a business, care must be taken that the pol- icy is not transferred for value (directly or indirectly) when the business is acquired. If possible, the purchaser of the pol- icy should attempt to structure the acquisition so that the policy comes within an exception to the transfer for value rule, such as the original transferor’s basis exception. If this is not possible, allocate as much of the purchase price (as is reasonable) to the consideration paid for the policy. This will provide a higher cost basis for the purchaser and will minimize the subsequent income taxation of the death proceeds.
2A.5(b)(4) Sale Of Life Insurance Policy By Insured To A Grantor Trust
Another example of the transferor’s basis exception is a sale between the same taxpayer (or a sale between the insured and the insured’s grantor trust, which is discussed in section 2.5(b)(7), below).
2A.5(b)(5) Transfer Of Life Insurance Policy To Insured’s Spouse Or Incident To A Divorce
Under the carryover basis rule of IRC section 1041(b), certain transfers (including sales) between an insured and his or her spouse (or ex-spouse pursuant to a divorce, if certain criteria are met) are not treated as “sales,” and therefore come within the transferor’s basis exception to the transfer for value rule. (Special rules apply for intra-spousal transfers of life insurance policies issued before July 18, 1984.) Even if at the time of the transfer (or sale) the fair market value of the policy is less than, equal to, or greater than the transferor-spouse’s basis in the policy, the carryover basis rule under IRC section 1041(b) applies (because the transfer is treated as a gift, and not as a “transfer for valuable consideration”). For purposes of the transfer for value rule, the transferee spouse’s (or ex spouse’s) basis in the transferred policy is the same as the transferor spouse’s basis in the policy, even if the policy has an outstanding loan amount that is in excess of the transferor’s basis in the policy. The rules of IRC section 1041 provide a special form of protection under the transferor’s basis exception to the transfer for value rule. The intra-spousal transfer basis rule under IRC section 1041 is an exception to the general rule concerning the determination of the basis of gifted property under IRC section 1015.8 Consequently, Example 6 of Treas. Reg. §1.101-1(b)(5) appears to be obsolete because the wife would receive a carryover basis in the policy from her insured husband, and the subsequent transfer of the policy by the wife to their son would come within the transferor’s basis exception.
Caution: Transfers to a trust for the benefit of a spouse (or ex-spouse) do not come within the purview of IRC section 1041(b). IRC section 1041(e). This is a potential trap concerning the transfer of a life insurance policy to a trust for the benefit of the insured’s spouse (or ex-spouse) if the transferor’s basis in the policy is subject to an outstanding loan amount that exceeds the transferor’s basis in the policy. A way to avoid this potential trap is for the spouse (or ex-spouse) to be treated as the grantor of the trust under IRC sections 671-677. Pvt. Letter Rul. 200120007. Transfers from a corporation to the insured’s spouse for valuable consideration also do not come within the purview of IRC section 1041(b) and constitute a transfer of value, even though the spouse may pay less than fair market value for the policy. Estate of B. Joseph Rath v. U.S., 608 F. 2d 254 (6th Cir. 1979). IRC section 1041 does not apply to transfers to nonresident alien spouses or nonresident alien ex-spouses. IRC section 1041(d). Furthermore, IRC section 1041(b) does not apply to a “future spouse” that the insured plans to marry. Consequently, IRC section 1041(b) does not apply to the transfer of a life insurance policy pursuant to a premarital agreement.
If an ILIT that is a grantor trust as to the insured transfers an existing life insurance policy to the noninsured spouse, the noninsured spouse can then transfer the policy to a new ILIT. The original transferor’s basis exception to the transfer for value rule should apply (because the spouse takes the insured-spouse’s basis in the policy under IRC section 1041(b)). Although IRC section 2035 will not apply to the transfer of the policy by the spouse to the new ILIT (because IRC section 2035 applies to an insured), IRC section 2036 will apply to the non-insured spouse if the spouse is a beneficiary of the new ILIT. IRC sections 2037, 2038, and 2041 may also apply to the non-insured spouse’s retained beneficial interest in the new ILIT. When a donor transfers property into a trust in which he or she retains a beneficial interest, state law may permit the donor’s creditors to reach the donor’s retained interest in the trust, particularly if the donor is serving as a trustee. See, Restatement (Third) of Trusts §58(2).
A way to avoid IRC sections 2036, 2037, and 2038 is for the non-insured spouse to sell, for full and adequate consideration, the policy to the new ILIT, of which the non-insured spouse is treated as the grantor under IRC sections 671-677. (IRC sections 2035, 2036, 2037, and 2038 do not apply to a bonafide sale for full and adequate consideration in money or money’s worth.) See, section 3.1, below, concerning the valuation of a life insurance policy. The sale of the pol- icy to the new ILIT should be a non-event for income tax purposes under Rev. Rul. 85-13, 1985-1 C.B. 184, and the sale of the life insurance policy should come within the original transferor’s basis exception to the transfer for value rule. For the more cautious practitioner, con- sider having the new ILIT also be a partner with the insured in a bonafide partnership or limited liability company. See, section 2.5(c), below. However, if under applicable state law the non-insured spouse’s creditors can reach the assets of the new ILIT (because of the non- insured spouse’s beneficial interest in the new ILIT), the spouse may have a general power of appointment under IRC section 2041. Unlike IRC sections 2035-2038, IRC section 2041 does not have an exception for transfers for “full and adequate consideration in money or money’s worth.” The more cautious approach is for the non-insured spouse not to be a beneficiary of the new ILIT if under applicable state law a creditor of the non-insured spouse can reach the trust’s assets.
2A.5(b)(6) Sale Of Life Insurance Policy To Insured’s Spouse
A method of using the transferor’s basis exception and having the insured avoid the three-year inclusion rule of IRC section 2035 is by having the insured sell the existing life insurance policy to his or her non- insured spouse for full and adequate consideration in money or money’s worth (with the spouse using his or her own separate funds to purchase the policy).9 Treas. Reg. §20.2043-1(a). See, section 3.1, below, concerning the valuation of a life insurance policy. Under IRC section 1041, the spouse would have the same basis in the policy as the insured, and there would be no transfer for value under IRC section 101(a)(2).10 Because the spouse has paid full and adequate consideration for the pol- icy, the three-year inclusion rule of IRC section 2035 would not apply to the transfer of the policy by the insured. IRC section 2035(d). The spouse could then gift the policy to an ILIT for the benefit of the insured’s descendants. Because of retained interest rules of IRC section 2036-2038, the non-insured spouse should not be a beneficiary of the new ILIT that holds the gifted policy. IRC section 2035 would not apply to the spouse’s gift of the existing policy to the ILIT because the three-year inclusion rule only applies to transfers by the insured.
2A.5(b)(7) Use Of An Intentionally Defective Grantor Trust
Another method of using the transferor’s basis exception is by creating an intentionally defective irrevocable trust (i.e., a grantor trust) under IRC sections 671-677. Grantor trust status means that the insured-grantor is treated as the owner of the trust for income tax purposes (but not for federal estate tax purposes). Thus, a transfer from the insured-transferor to the transferor’s grantor trust is disregarded for income tax purposes, and the basis in the life insurance policy remains the same, whether the policy is gifted or sold to the trust. Because the transfer or sale between the grantor and his or her grantor trust is dis- regarded for income tax purposes, if the policy has an outstanding loan amount greater than the transferor’s basis in the policy, there is no recognition of gain on the sale or transfer of the policy to the trust. Also, because the transfer or sale between the grantor and his or her grantor trust is disregarded for income tax purposes, there is no transfer for value issue since there has been no “transfer for valuable consideration” between the transferor and his or her grantor trust. Rev. Rul. 2007-13, 2007-11 I.R.B. 684 (3/12/2007); Rev. Rul. 85-13, 1985-1 C.B. 184; Pvt. Letter Ruls. 200636086 (sale of policy by insured to an ILIT for the benefit of his children if the ILIT is a grantor trust and the grantor’s spouse is the trustee and has the power to make discretionary distributions of income and principal to the grantor’s descendants), 200606027, 200518061, 200514001, 200514002, and 200228019 (concerning the sale-transfer of a second to die life insurance policy between two intentionally defective grantor trusts involving the same grantor). See, Pvt. Letter Rul. 200247006 (concerning transfer of individual and second-to-die life insurance policies). See also, Rev. Proc. 2007-3, 2007-1 I.R.B. 108, section 3.01(7).11 Furthermore, the insured’s sale of an existing life insurance policy for full and adequate consideration (see, section 3.1, below for the valuation of life insurance policies) to an intentionally defective grantor trust will avoid both the three-year inclusion rule of IRC section 2035 and the transfer for value rule. Priv. Letter Rul 9413045. (See, section 2.7, below, for a discussion of IRC sections 671-677 concerning the grantor trust rules.)
Practice Point: If an existing ILIT, which is a grantor trust for income tax purposes,12 contains a provision that would result in the life insurance proceeds being included in the insured’s gross estate (or if the insured wants to “move” the policy to a new ILIT with more desirable provisions or different beneficiaries), consider having the existing ILIT sell for fair market value (or transfer) the life insurance policy to a new ILIT that is also a grantor trust for income tax purposes. See, Rev. Rul. 2007-13, 2007-11 I.R.B. 684 (3/12/2007); Pvt. Letter Ruls. 200606027, 200518061, 200514001, and 200514002. If the policy is sold, the new ILIT comes within the transfer for value exception concerning transfers of a life insurance policy to the insured (which is discussed immediately below)25 and also avoids the three-year inclusion rule of IRC section 2035. Pvt. Letter Ruls. 200518061, 200514001, and 200514002. If the policy is transferred (and not sold), the new ILIT also comes within the transfer for value exception because it acquires the transferor’s basis in the policy. However, there must be provisions in the existing ILIT that would permit such a transfer. See, Paragraph 7.1(D)(4) of Sample ILIT.
Caution: Once a policy is tainted by the transfer for value rule, a subsequent transfer under the transferor’s basis exception will not eliminate the taint, and the proceeds will be subject to income taxation. Treas. Reg. §§1.101- 1(b)(3); 1.101-1(b)(5) Example 6. See also, James F. Waters, Inc. v. Commissioner, 160 F. 2d 596 (9th Cir. 1947), cert. denied, 332 U.S. 767 (1947). However, if the policy is transferred to one of the four “protected party exceptions” (discussed below), the prior taint is removed. Treas. Reg. §1.101-1(b)(3)(ii). If however, the protected party subsequently transfers the policy (or an interest in the policy) for valuable consideration, the transfer for value rule will (once again) be applicable unless the transfer by the protected party comes within the transferor’s basis exception or is to another protected party.
2A.5(c) Protected Party Exceptions
The next four exceptions, which are contained in IRC section 101(a)(2)(B) and Treas. Reg. §1.101-1(b)(1), are commonly referred to as the “protected party exceptions”:
2A.5(c)(1) Transfer To The Insured
The first protected party exception is the transfer of the life insurance policy to the insured26 (W. Clarke Swanson, Jr. Trust v. Commissioner, 518 F.2d 59 (8th Cir. 1975) aff ’g T.C Memo 1974-61 (1974))27 or the transfer of the life insurance policy to a grantor trust created by the insured (or the transfer of the life insurance policy from one grantor trust to another grantor trust, involving the same insured- grantor) (Rev. Rul. 2007-13, 2007-11 I.R.B. 684 (3/12/2007)28; Pvt. Letter Ruls. 200606027, 200514001, and 200247006)29;
2A.5(c)(2) Transfer To A Partner Of The Insured
The second protected party exception is the transfer of the life insurance policy to a bona fide partner13 (or member of a limited liability company that is being taxed as a partnership) of the insured (Pvt. Letter Ruls. 200228019, 199905010, and 9347016);
2.5(c)(3) Transfer To A Partnership
The third protected party exception is the transfer of the life insurance policy to a bona fide partnership (or limited liability company that is being taxed as a partnership) in which the insured is a general or limited partner(or a member)14 at the time of the transfer(Pvt. Letter Ruls. 200111038, 9843024, and 9625013).
- 2.5(c)(3)(A) Create A Partnership Between The Insured And The ILIT. A popular method of using the protected party exception is to crate a partnership between the insured (or insureds in the case of a second-to-die policy) and the ILIT.15 It appears that a limited liability company (that is being taxed as a partnership33), with the insured(s) and the ILIT as members, not only will work but may be a preferable manner of using this exception. See, e.g., Pvt. Letter Ruls. 200120007 and 9625013. The partnership should exist for reasons other than solely to avoid the transfer for value rule. In other words, the partner- ship should carry on a trade or business for profit and own some assets, with an incidental purpose being the avoidance of the transfer for value rule.16 See, e.g., Pvt. Letter Ruls. 199905010, 9843024, and 9347016. See also, IRC sections 761(a) and 7701(a) (2) for the definition of a “partnership.”
Note that the IRS will not rule whether, in connection with the transfer of a life insurance policy to an unincorporated organization (such as a partnership or limited liability company) (1) the organization will be treated as a partnership under IRC sections 761 and 7701; or (2) the transfer of the life insurance policy to the organization will be exempt from the transfer for value rule of IRC section 101, when substantially all of the organization’s assets consist or will consist of life insurance policies on the lives of the members. Rev. Proc. 2007-3, 2007-1 I.R.B. 108, section 3.01(8).
Practice Point: If an existing ILIT, which is not a grantor trust for income tax purposes, contains a provision that would result in the life insurance proceeds being included in the insured’s gross estate (or if the insured wants to “move” the policy to a new ILIT), the insured can establish a new ILIT that is a grantor trust and have the existing ILIT transfer or sell the policy to the new ILIT. The transfer or sale from the existing ILIT to the new ILIT will be treated as a transfer to the insured—one of the protected party exceptions. Another alternative is for the existing ILIT to sell for fair market value (or transfer) the life insurance policy to a new ILIT (that does not have to be a grantor trust) that is a partner with the insured in a bonafide partnership (or member in the case of a limited liability company being taxed as a partnership). This would make the transferee ILIT a partner of the insured at the time of the policy’s transfer. Thus, the purchase of the existing policy from the “old” ILIT by the new ILIT would come within the safe harbor for a transfer to a partner of the insured. See, Pvt. Letter Ruls. 199903020 (real estate investment partnership) and 9347016 (investment partnership holding a working interest in an oil and gas well, futures contracts, and various shares of stock). In addition, such a sale avoids the three-year rule of IRC section 2035 because that section does not apply to transfers made for full and adequate consideration in money or money’s worth.
Caution: Although the transfer may be “exempt” from the transfer for value rule (and the life insurance proceeds will not be subject to income taxation), the sale or transfer of a policy from the existing non-grantor ILIT to the new ILIT may still result in the selling ILIT realizing income/gain if the consideration for the transfer of the policy exceeds the selling ILIT’s basis in the policy. See, section 2.19, below.
2A.5(c)(4) Transfer To A Corporation
The fourth protected party exception is the transfer of the transfer of the life insurance policy to a corporation in which the insured is either a shareholder or bona fide officer at the time of the transfer. However, if the insured is an employee or a director and is not an officer or a shareholder of the corporation, the exception does not apply and the policy will be subject to the transfer for value rule.
Practice Point: To come within the bona fide officer exception, consider whether the board of directors should appoint the shareholder as an officer of the corporation before the transfer of the policy.
- 2.5(c)(4)(A) Transfer To A Co-Shareholder. Note that the transfer of a life insurance policy to a co-shareholder of the insured does not fall within the statutory exceptions, nor does a corporation’s transfer of a life insurance policy to a shareholder, employee, director, or officer who is not the insured. See J.R. Monroe v. Patterson, 197 F. Supp. 146 (N.D. Ala. 1961). This is a potential trap for buy-sell agreements that permit a co-shareholder to buy a policy on the life of another share- holder from a deceased shareholder’s estate, or from the corporation.35 See also, Priv. Letter Rul 7734048.
In Estate of B. Joseph Rath v. United States, 608 F.2d 254 (6th Cir. 1979), the insured had the option to name a purchaser for (or to personally purchase) a corporate-owned policy on his life that was no longer needed by the corporation. Instead, the insured named his wife as the purchaser of the policy and directed the corporation to name her as the new owner. The wife’s purchase of the policy from the corporation resulted in a transfer for value. Had the insured purchased the policy from the corporation and gifted the policy to his wife, there would have been no transfer for value.
Another potential trap arises when an insured-shareholder names his or her co-shareholders as the beneficiary of the insured’s policy to fund a cross-purchase of the insured’s shares of stock upon his or her demise, and the other shareholders do the same for one another with regard to their life insurance policies. If there is no valid partner- ship between the shareholders, a transfer (i.e., the transfer of the death proceeds) for value occurs. The consideration (i.e., value) is the mutual naming of the co-shareholders as beneficiaries in return for their naming the insured as a beneficiary of their policy and for the parties’ mutual obligation to use the death proceeds to fund the cross-purchase arrangement. See, J.R. Monroe v. Patterson, 197 F. Supp. 146 (N.D. Ala. 1961). Furthermore, the life insurance proceeds payable to the co- shareholders would be includable in the insured’s gross estate under IRC section 2042 (concerning incidents of ownership)—a disastrous result!
2A.5(c)(5) Protected Party Exceptions Do Not Avoid Gain
The protected party exceptions applies solely for purposes of IRC sections 61 and 101, and do not apply for purposes of determining the transferor’s gain or loss under IRC section 1001. Thus, if the policy has an outstanding loan in excess of the transferor’s basis in the policy, the transferor may have taxable gain upon the transfer of the policy to one of the protected parties. See, section 2.5(b)(2), above.
2A.5(d) Final Transferee Of The Policy
Once the insured (or one of the other three protected parties described above) becomes the final transferee of the policy, all prior transfer for value taint is eliminated and the proceeds once again become income tax free. Treas. Reg. §§1.101-1(b)(3)(ii); 1.101- 1(b)(5), Examples 5 and 7.
2A.5(e) Summary Of Transfer For Value Rule Exceptions
| Transferee For Value | Income Taxation Of Death Benefit |
| Anyone whose basis is determined by reference to original transferor’s basis | Not taxable |
| Insured | Not taxable |
| Insured’s spouse (or ex-spouse—if incident to a divorce and meets the IRC section 1041 tests) | Not taxable |
| Partner of insured | Not taxable |
| Partnership in which insured is a partner | Not taxable |
| Corporation in which insured is a shareholder or office | Not taxable |
| Assignee or pledgee to secure policy owner’s debt | Not taxable |
| Co-stockholder of insured | Taxable36 |
| Anyone else | Taxable37 |
The exceptions to the transfer for value rule can be generally summarized as follows (regardless of the identity of the transferor):
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