Plan the Transfer of a Key Person Life Insurance Policy to a Departing Owner

Before you transfer key person life insurance policy to departing owner, know this rule. A transfer can make part of the death benefit taxable. Whether it does depends on how the transfer is structured.

This page explains the transfer-for-value rule, the main exceptions, how the taxable part is figured, and what to settle before any paperwork is signed. Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice of NR CPAs & Business Advisors, a Miami CPA firm.

What the Transfer-for-Value Rule Means for a Key Person Policy

A transfer for value can make part of the death benefit taxable to the new owner. Here is how that works.

A key person policy is life insurance that a business owns on the life of an owner or employee whose loss would hurt the company. The Insurance Information Institute explains that key person life insurance compensates a business for financial losses caused by the death or disability of a key employee.

Death benefits are usually not income. Under IRC § 101(a)(1), gross income does not include amounts paid by reason of the insured’s death, subject to listed exceptions. The transfer-for-value limit is one of those exceptions.

The limit applies when a policy changes hands for value. Under IRC § 101(a)(2), the amount excluded from gross income cannot exceed the actual value paid for the policy plus the premiums and other amounts the new owner pays later. This cap does not apply if the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. It also does not apply if the new owner’s basis is figured in whole or in part from the prior owner’s basis. Anything above that cap can be taxable.

So the core answer is this: a transfer can make part of the death benefit taxable. Some transfers fall outside the limit, so the structure of the transfer decides the result.

Who Faces This Question and When

Anyone who owns or is leaving a key person policy can run into this rule. It usually comes up at a change point in the business.

• A departing owner or partner who wants to keep coverage on his or her own life.
• A company that owns a policy on a departing owner and must decide whether to transfer it, sell it, or let it lapse.
• A buyout, a retirement, a change in ownership, or a dissolution under a buy-sell agreement.

Timing is the main risk. The tax result comes from the transfer itself, so the numbers should be worked out before anyone signs. Many owners agree on a price first and check the tax later. Those two decisions are linked and should be settled together.

A buy-sell agreement often sets how owners value their interests. Read it before setting a price for the policy. Its terms may limit what the parties can agree to.

Exceptions That Can Keep the Death Benefit Not Taxable

Some transfers fall outside the transfer-for-value limit. Each exception turns on the exact facts.

The statute lists specific transfers that the limit does not reach. Whether one applies depends on who receives the policy and how the deal is built. Confirm the exemption against the actual transfer before relying on it.

Several related rules also matter:

• Transfers excluded from the transfer-for-value limit. IRC § 101(a)(2)(B) excludes from the transfer-for-value limit a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.
• Employer-owned policies. If the company owns a policy on an employee, IRC § 6039I sets reporting and recordkeeping duties for the applicable policyholder: an annual return showing the required details for each year it owns employer-owned contracts issued after the date of enactment, plus records for any year it owns one or more such contracts; this section does not itself exclude any amount from income.
• Gifted policies. If a policy moves as a gift, IRC § 1015(a) says the new owner’s basis generally matches the donor’s basis, except that for determining loss the basis cannot exceed the property’s fair market value at the time of the gift when the donor’s basis is higher.

Each of these points can change the numbers. Check them before the transfer, not after.

How the Taxable Portion Is Calculated

The portion excluded from income is capped at the price paid plus later premiums. The rest may be taxable.

Transfers of a life insurance policy can have tax consequences that depend on the facts of each case, so the tax treatment of a transfer is worth reviewing with a CPA before any transfer takes place.

Here is a hypothetical example, for illustration only. A company pays $100,000 for a policy. The new owner later pays $40,000 in premiums. The death benefit is $1,000,000. The exclusion cap is $140,000, so $860,000 could be taxable.

The formula uses the price paid and later premiums. It does not use cash value. The Florida DFS life insurance guide explains cash value and policy loans in plain words.

Gather these records before building the numbers:

• Premium payment history, with dates and amounts.
• Any policy loan and its current balance.
• The agreed transfer price and how it was set.
• The insurer’s policy form and the transfer or assignment papers.

Steps to Transfer Key Person Life Insurance: What to Expect

Before you transfer key person life insurance policy to departing owner, work through five steps. They run from gathering documents to the insurer’s ownership change.

1. Gather the documents. Collect the policy papers, premium history, loan balance, and the buy-sell or ownership agreement.
2. Model the tax. Have a CPA model the tax on the proposed transfer, including the exception that applies, the taxable portion, and any effect on the company’s books.
3. Hold a coverage review. Meet with the licensed insurance agent to compare keeping, converting, or replacing the coverage. All limitations and exclusions should be stated.
4. Settle the terms in writing. Set the transfer price, documents, and payment terms before anyone signs.
5. Complete the ownership change. File the insurer’s ownership change forms and confirm the new owner and beneficiary in writing.

Timing varies with the insurer’s processing times and how fast documents come in.

Questions to Settle Before Any Transfer Is Signed

Five questions should be answered in writing before a transfer is signed.

• Does the buy-sell agreement already set a price or method for valuing the policy?
• Is the buyer the insured, a related party, or an unrelated buyer? Each choice changes the tax result.
• Who pays the premiums after the transfer, and can the new owner keep the policy in force?
• How will the company record the transfer and any gain or loss on its books?
• Will the transfer replace an existing policy?

A replacement needs a fair side-by-side comparison and the replacement paperwork completed. Do not rely on a single illustration. The NAIC Life Insurance Buyer’s Guide covers term and permanent life insurance and lists questions to ask before buying.

Under IRC § 1035(a)(1), no gain or loss is generally recognized when a life insurance contract is exchanged for another life insurance contract, or for an endowment or annuity contract, or for a qualified long-term care insurance contract. That tax result does not decide whether the new coverage fits your needs.

Why Work With NR CPAs & Business Advisors on This Transfer

NR CPAs & Business Advisors is a Miami CPA firm. It helps families, professionals, and business owners across the United States choose and buy life insurance. That includes key person and buy-sell coverage. The firm also serves Indian-American households and business owners.

Our team brings a CPA’s view of tax and cash flow to each transfer. The CPA firm performs the tax work. Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice.

Any commission on an insurance product is disclosed in writing before we are engaged. We offer no rebates or inducements. Fees for a coverage review are confirmed in writing before any work begins, with all variables disclosed.

Frequently Asked Questions