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IRS allows tax-free transfer of life insurance policies to and from grantor trusts
Posted in Tax and Finance

The Internal Revenue Code provides that life insurance proceeds generally are not subject to income tax. However, sales or certain policy transfers-for-value can result in taxable proceeds. Specifically, the Internal Revenue Code provides that if a life insurance contract is transferred for valuable consideration, the exclusion from gross income does not apply to the policy proceeds unless 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. Under this transfer-for-value rule, the policy buyer will be taxed on any proceeds over the amount of consideration plus any future premiums paid by the transferee.

The transfer-for-value rule can be troublesome when a taxpayer intends to transfer life insurance policies between trusts. However, in a recent Revenue Ruling the IRS provided some favorable guidance as to whether the transfer-for-value rule applies when the grantor transfers a life insurance policy (on his or her life) from one grantor trust to another, or from a non-grantor trust to a grantor trust. In both situations, the new Revenue Ruling provides that the transfer-for-value rule does not apply, thereby preserving the policy proceeds’ income tax exemption.

To illustrate this point, the IRS provides two examples. In the first example, trust 2, a grantor trust, transfers a life insurance policy on the grantor’s life to trust 1, also a grantor trust. In this example, since the grantor is treated as the owner of both trust 1 and trust 2 for federal income tax purposes, the grantor also is treated as the owner of all trust assets before and after the transfer. Accordingly, the transfer-for-value rule does not apply.

In the second example, all the facts are the same, except that trust 2 is not a grantor trust. Here, the grantor is considered the owner of the cash before the transfer and the owner of the insurance policy after the transfer. Therefore, the transaction is considered a transfer to the insured and is exempt from the transfer-for-value rule.

Accordingly, if you have two grantor trusts, one of which owns a life insurance policy on your life, you can transfer or sell the policy between the trusts without income tax consequences. Also, if you have a grantor trust and are the insured on a life insurance policy held by a nongrantor trust, you can have the grantor trust purchase the policy without tripping the transfer-for-value rule.

  • Partner

    John is a partner in the firm's Estate Planning Department. He focuses his practice on estates, trusts, family business and disability planning, and the administration of estates and trusts. John also has an active health law ...

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