When can transferring a life insurance policy make death benefits taxable?
Key takeaway
A life insurance policy transfer can make death benefits taxable when it involves valuable consideration and no exception applies. A gratuitous transfer generally limits the transferee's exclusion for proceeds to the transferor's available exclusion plus premiums and other amounts the transferee later pays. For business owners, the insured's relationship to the acquiring business and the rights transferred affect how the rules apply.
Transfers for value can affect the exclusion
A transfer for valuable consideration may make part of a death benefit taxable if no exception applies. A policy interest includes title or possession and an enforceable right to proceeds, economic benefits, or beneficiary designation. A beneficiary designation exchanged for valuable consideration can raise the transfer-for-value issue even when the consideration is not money.
Business and financial relationships matter
A reportable policy sale generally involves acquiring a contract interest without a substantial family, business, or financial relationship with the insured apart from the policy interest. A substantial business relationship may exist when the insured is a key person or materially participates in an active business that is at least 80 percent owned by the acquirer or its beneficial owners.
An entity acquisition has a specified exception when no more than 50 percent of the entity's gross asset value consists of life insurance contracts immediately before acquisition, provided specified post-acquisition ownership conditions are met.
Some policy actions are not transfers
A revocable beneficiary designation, a policy pledge or assignment as collateral security, and issuance of a contract to a policyholder are not transfers of an interest under the reportable policy sale rules. A collateral pledge or assignment is also described as outside the transfer-for-value rule.
A transfer that is not gratuitous can still have its proceeds exclusion determined under a separate rule. A policy transfer to a partnership can fall outside the reportable policy sale rules while remaining subject to a separate rule for the proceeds exclusion.