Thinking About Moving a Life Insurance Policy? Understand the Transfer-for-Value Exceptions First

The exceptions to the transfer-for-value rule for life insurance policies listed in IRC § 101 include 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. They cover transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer, and also transfers where the contract has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis in the hands of the transferor. Here is each exception in plain words.

What the Transfer-for-Value Rule Says, in Plain Words

Death benefits are usually excluded from income tax. Under IRC § 101(a)(1), amounts paid because of the insured’s death are not gross income. The transfer-for-value rule is a limit on that general rule.

The cap equals the value the buyer paid, plus the premiums the buyer pays later. Any death benefit above that cap can be taxable income.

The exceptions are the situations where that cap does not apply. For the full rule, read our transfer-for-value rule guide. Keep the cap in mind as you read the examples below.

Exception One: Transfers to the Insured

A transfer to the insured person is excepted from the cap.

Here is a simple case. A policy owner signs the policy over to the person whose life is insured. The cap does not apply to that transfer.

Still, a transfer is a transfer. Keep the signed papers and note the date. Clear records show what changed and when, which matters if the policy is reviewed later.

Exceptions for Partners and Partnerships

A transfer to a partner of the insured is excepted. A transfer to a partnership in which the insured is a partner is excepted too.

Consider Dana, a partner in a professional firm. Dana owns a policy on her own life and transfers it to her partner, Lee. Lee is a partner of the insured, so the cap does not apply.

These rules matter most in buy-sell planning. In a cross-purchase arrangement, partners may own policies on each other. Each ownership change should be checked against the exception before it happens. Our buy-sell agreement insurance page explains how these agreements are set up.

Exceptions for Corporations and Shareholders

A transfer to a corporation in which the insured is a shareholder or officer is excepted from the cap.

Take Maria, who owns part of a closely held company and serves as its officer. If she transfers a policy on her own life to the company, the cap does not apply. The company is a corporation in which she is a shareholder and officer.

Key person coverage works differently. A business usually buys it on a key employee’s life, so the company is the owner from the start. That is a purchase, not a transfer. Key person insurance, as the Insurance Information Institute describes it, helps a business recover financial losses from the death or disability of a key employee. Florida law also sets rules on who may hold that insurance. See Fla. Stat. 627.404.

Other Rules to Keep Apart From the Exceptions

The statute also sets a rule on insurable interest for buyers and sellers of business-entity interests: an individual party to a contract for the purchase or sale of an interest in any business entity has an insurable interest in the life of each other party to such contract for the purpose of such contract only. The commercial-transfer rule for reportable policy sales is in IRC § 101, not this statute. IRC § 101(a)(3) defines a “reportable policy sale” as the acquisition of an interest in a life insurance contract, directly or indirectly, by an acquirer who has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such contract.

A buyer with no other tie to the insured should not assume the exceptions above will apply. Check that rule first.

Gift tax is a separate question from income tax. A gift of a policy is valued under 26 CFR 25.2512-6. Keep the income-tax and gift-tax questions apart when you review a transfer.

Common Questions About Transfers of Life Insurance

Term life insurance generally does not build cash value. The NAIC Life Insurance Buyer’s Guide explains the difference between term and permanent coverage.

Talk Through Your Situation Before Changing Ownership

You may be reading this because a partner has left, a co-owner has died, or a buyout has come up that you did not plan. That is a hard place to make decisions. Take time to check the facts first.

Before a policy changes owners, match the change against the exceptions. Note the dates, the signed papers, and who paid the premiums. The outcome depends on the policy and the parties involved.

Nischay Rawal is the responsible agent for this page. Nischay Rawal is a licensed insurance agent, and insurance is offered separately from the firm’s accounting practice at NR CPAs & Business Advisors. To talk through your facts, reach out through our contact page to request a coverage review.