How can the transfer of all ownership rights in a life insurance policy be accomplished?

Generally, the proceeds of your life insurance policy are included in your taxable estate. You can remove them by transferring ownership of the policy, but there’s a catch: If you wait too long, your intentions may be defeated. Essentially, if ownership of the policy is transferred within three years of your death, the proceeds revert to your taxable estate.

Eliminating “incidents of ownership”

The proceeds of a life insurance policy are subject to federal estate tax if you retain any “incidents of ownership” in the policy. For example, you’re treated as having incidents of ownership if you have the right to:

• Designate or change the policy’s beneficiary,
• Borrow against the policy or pledge any cash reserve,
• Surrender, convert or cancel the policy, or
• Select a payment option for the beneficiary.

You can eliminate these incidents of ownership by transferring your policy. But first you need to determine who the new owner should be. To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs.

Understanding the ILIT option

An irrevocable life insurance trust (ILIT) can be one of the best ownership alternatives. Typically, if you transfer complete ownership of, and responsibility for, the policy to an ILIT, the policy will ― subject to the three years mentioned above ― be excluded from your estate. You’ll need to designate a trustee to handle the administrative duties. It might be a family member, a friend or a professional. Should you need any additional life insurance protection, it would work best if it were acquired by the ILIT from the outset.

An ILIT can also help you accomplish other estate planning objectives. It might be used to keep assets out of the clutches of creditors or to protect against spending sprees of your relatives. Also keep in mind that, as long as the policy has a named beneficiary, which in the case of an ILIT would be the ILIT itself, the proceeds of the life insurance policy won’t have to pass through probate.

The sooner, the better

If transferring ownership of your life insurance policy is right for you, the sooner you make the transfer, the better. Contact us with any questions regarding life insurance in your estate plan or ILITs.

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Life insurance policies sometimes have a need to be transferred from the original policy owner to a new policy owner. When a transfer of ownership takes place (absolute assignment or change of ownership form), financial professionals should be concerned about the so-called Transfer for Value Rule (TFV) and qualifying for one of the TFV exceptions.

IRC Section 101(a)(1) states that the proceeds paid from life insurance after the death of the insured are income tax free EXCEPT when a transfer of ownership has taken place while the insured was still alive (IRC Section 101(a)(2)).  These transfers are usually in the form of:

1. A sale of a policy to a new owner
2. Taxable compensation to the new owner based on an employer-employee relationship or
3. A gratuitous transfer of a policy (gift) to the new owner based on love and affection.

Income and gift tax consequences of each transfer must be examined independently for each ownership transfer.

Here are some typical life insurance ownership changes and transfer situations involving life insurance:

1. A transfer from the insured to his/her children or to an irrevocable life insurance trust (ILIT) for their benefit. The fair market value of the policy is a gift, for gift tax purposes, where gift-tax annual exclusions and lifetime gift exemption may be allocated on a Form 709 U.S. Gift Tax return. (See Treas. Reg. 25.2512-6(a)). The insured must live for at least 3 years from the date of the transfer to avoid inclusion in the gross estate for estate tax purposes under IRC Section 2035.
2. A transfer from a corporation to the insured employee. The value of the policy is treated as taxable income as a transfer of a corporate asset under the guidance of IRC Section 83 and Rev. Proc. 2005-25.
3. A transfer from a The value of the policy is treated as taxable income to the participant under the guidance of IRC Section 402 and Rev. Proc. 2005-25.
4. A transfer from one share owner of a business entity to another share owner of the same business entity.  The transfer is treated as a “sale” of the policy where the gain amount in excess of cost basis is taxable income to the transferor.
5. A transfer from a qualified retirement plan (QRP) to the participant’s irrevocable life insurance trust (ILIT). The transfer is treated as a “sale” of the policy from the QRP to the ILIT. This sale transfer will avoid the 3 year rule requirement for inclusion in the gross estate under IRC Section 2035.
6. A transfer from one ILIT to another ILIT. The transfer is treated as a “sale” of the policy where the gain amount, in excess of cost basis, is taxable income. Often, these transfers between trusts involve grantor ILITs for income tax purposes where the grantor will report any gain amounts personally. For guidance on ILIT to ILIT transfers involving grantor trusts see Rev. Rul. 2007-13.

It’s important that the transfers described above are made in such a way that they qualify for one of the EXCEPTIONS to the Transfer for Value Rule in order to preserve the income tax free character of the death proceeds (IRC Section 101(a)(2)(A)(B)). If the transfer of policy ownership does not qualify for one of these exceptions, the death benefit will be taxable income to the policy beneficiary to the extent they exceed the value of the consideration paid, plus any future premiums paid.

Here are the exceptions:

1. A transfer to the insured. A transfer to a grantor ILIT is treated as a transfer to the insured for purposes of the TFV Rule. However, the death proceeds will remain tax free for estate tax purposes.
2. A transfer to a corporation where the insured is an officer or shareholder
3. A transfer to a partner of the insured. Limited liability company (LLC) owners are considered to be partners for purposes of the TFV Rule
4. A transfer to a partnership or LLC where the insured is a partner or LLC owner
5. A transfer where the cost basis of the policy carries over from the transferor to the transferee. The most common situation is where a policy if gifted from a parent to an adult child or ILIT for the benefit of children

Be aware of the following policy transfers that will NOT qualify for one of the exceptions to the TFV rule which may expose the death proceeds paid to the beneficiary as taxable income.

1. A transfer from one co-shareholder of a corporation to another co-shareholder of the same corporation.
2. A transfer from a qualified retirement plan (QRP) to a non-grantor ILIT. A transfer to a grantor ILIT is considered to be a transfer to the insured and a valid exception for TFV Rule purposes (See Rev. Rul. 2007-13)
3. A transfer from one ILIT to another non-grantor ILIT. Again, a transfer to a grantor ILIT is considered to be a transfer to the insured and a valid exception for TFV Rule purposes (See Rev. Rul. 2007-13)
4. A sale of a policy to a life settlement company on the secondary market. Death proceeds paid will be taxable income to the life settlement company to the extent they exceed the purchase price of the policy plus any future premiums paid.

Contact your BSMG Life Advisor when you have an existing policy that needs to be transferred to a new owner.  BSMG can provide the change of ownership forms and provide case support on the Transfer for Value issues described above. A potential term conversion or Section 1035 exchange will often be involved either before or after policy ownership has been transferred to the new owner.

Russell E. Towers  JD, CLU, ChFC  
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group