TRANSFER FOR VALUE RULE
Using a Transactional Analysis to Avoid the Transfer for Value Rule Author: LAWRENCE BRODY AND STEPHAN R. LEIMBERG, ATTORNEYS LAWRENCE BRODY is a partner in the St. Louis office of the law firm of Bryan Cave LLP and is a Fellow of the American College of Trust and Estate Counsel. He is also an adjunct professor in the Graduate Tax Program at Washington University School of Law in St. Louis, and a visiting adjunct professor in the Graduate Tax Program at Miami University School of Law. STEPHAN R. LEIMBERG is an attorney and CEO of Leimberg Information Services, Inc. (http://www.leimbergservices.com), a provider of commentary on recent cases, rulings, and legislation; CEO of Leimberg and LeClair, Inc., an estate and financial planning software company in Bryn Mawr, Pennsylvania; and President of Leimberg Associates, Inc., a software and publishing company. He is coauthor, with Howard Zaritsky, of the RIA treatise, Tax Planning With Life Insurance. Mr. Leimberg is also the co-creator of NumberCruncher Software and principal author of the nine-book Tools and Techniques series, including Tools and Techniques of Estate Planning and Tools and Techniques of Life Insurance Planning. His e-mail address is
[email protected]. Copyright © 2005, Lawrence Brody and Stephan R. Leimberg. Failure to analyze carefully the potential application of the transfer for value rule can result in unanticipated tax and the risk of a malpractice claim. This second part of a twopart article examines the issues raised by the transfer for value rule along transactional lines. Life insurance proceeds are generally received income tax-free, but failure to avoid the transfer for value rule 1 may result in a loss of the exclusion from income. 2 The first part of this article examined the rule and its exceptions. 3 The following discussion analyzes the transfer for value rule through a series of common factual situations facing tax practitioners in the areas of: (1) (2) (3) (4)
Buy-sell planning. Retirement planning. General business planning. Personal (including marriage dissolution) planning.
Transfer for value problems in planning buy-sell agreements In the area of planning for corporate or partnership buy-sell agreements funded with life insurance, as in the other areas that will be discussed, any transfer of a life insurance policy (or an interest in a policy) funding the buy-sell arrangement must be scrutinized by the planner, to be sure that: (1) it is not a transfer for valuable consideration; or (2) even if it is, it is a transfer that will meet one of the exemptions in Section 101(a)(2) , so that, in either case, the policy proceeds will be excluded from income when collected by the transferee.
Copyright 2006 Larry Brody and Stephan R. Leimberg. For Most Recent Cases and Rulings, See http://www.leimbergservices.com and Tax Planning With Life Insurance (800 950 1216)
Consideration. The leading case in the buy-sell planning area is Monroe v. Patterson. 4 The issue there was whether life insurance proceeds collected by the taxpayer at the death of one of the other shareholders of his corporation were reportable as taxable income. The case involved a key employee policy, which had been owned by and payable to the corporation, which was transferred to a trust to fund a cross-purchase arrangement. A cross-purchase buy-sell agreement was established, and a trust was created to facilitate the transaction and assure an orderly transfer of the corporate stock. The corporate insurance policy on the shareholder's life was then transferred to the trustee who was to collect the policy proceeds and pay them to the estate of the deceased shareholder. The insured's co-shareholders were required by the buy-sell agreement to pay premiums on the policy. At the insured's death, the trustee collected the policy proceeds (on behalf of the surviving shareholders), and in exchange for the stock held by the insured stockholder, paid the estate the appropriate amount of cash. Clearly, there was a transfer of a life insurance policy. But was there valuable consideration; if so, what was it? The surviving shareholders argued that they had paid nothing for the policies and therefore, absent consideration, the transfer for value rule was inapplicable. But the court held that there had in fact been a transfer of the insurance policy for consideration—the mutuality of obligations and the actual cash consideration paid by the surviving beneficiary shareholder in premiums. The court noted that the transfer did not fall within one of the exceptions to the transfer for value rule (as it would have had the transferees been partners in a partnership in which the insured was a partner), and so the proceeds were subject to ordinary income tax. Ltr. Rul. 7734048 5 reached the same result, even though the policies transferred from the insured to their co-shareholders to fund the cross-purchase arrangement had no “value” at the time of the transfer. Termination of agreement. The issue may also arise on termination of a buy-sell arrangement. For example, in Estate of Rath, 6 an insurance policy was purchased by a corporation on the life of its largest shareholder to fund a stock purchase agreement. Under that agreement, the shareholder-insured was given the right to have the policy assigned to himself or his nominee if the corporation decided to terminate the agreement. When the corporation was sold, the policy was sold by the corporation to the shareholder's wife. The IRS claimed that there had been a transfer of the policy from the corporation to the wife for valuable consideration, and that reportable income had been received by her at her husband's death. The wife argued that there had been an exercise of the shareholder's option, a constructive transfer of the policy to him (a “proper party” exception to the transfer for value rule), and a gratuitous transfer by him to her (also falling within an exception to the transfer for value rule). The court held that there had not in fact been a transfer from the corporation to the insured and a second transfer to his spouse, but that the transfer had been directly from the corporation to the spouse, for a valuable consideration, and no exception was applicable; the court in effect ignored the “step transaction” argument made by the insured's spouse. (This case arose prior to the enactment of Section 1041 , which would make similar transactions nontaxable events, and therefore exempt from the rule). Switching from stock redemption to cross-purchase. For various reasons, the parties may want to convert the form of a corporate buy-sell agreement from a stock
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redemption (where typically the insurance to fund the purchase of a deceased shareholder's stock is owned by and payable to the corporation) to a cross-purchase arrangement (where each shareholder owns insurance on the life or lives of the other shareholders). 7 For example, assume that five individuals own all the stock in a corporation as well as all the interests in a partnership. 8 They currently have a corporate life insurance funded stock redemption plan, which they have decided to switch to a cross-purchase agreement. Their corporation transfers the policies, so that each of the insureds' co-shareholders (who are also the insured's partners) owns an equal interest in the policy on his or her life. Each partner then assigns the interest he or she owns to a grantor trust of which he or she is deemed the owner. Because the grantor trust is, for income tax purposes, the alter ego of the partner, the last transferee in this series of transfers is the insured's partner. 9 S corporation issues. A client's CPA may suggest that an S corporation with accumulated earnings and profits from C corporation years transfer its life insurance contracts, if the ultimate distribution by the corporation of otherwise tax-exempt death proceeds would be taxed as a dividend when distributed to the shareholders under Section 1368 . This problem may arise because tax-exempt death proceeds do not increase an S corporation's accumulated adjustments account. When an S corporation with accumulated earnings and profits uses its life insurance proceeds to redeem the insured/decedent's stock, the recipient of the redemption proceeds might qualify for exchange (rather than dividend) treatment under Sections 302 and 303 (with no taxable gain due to the basis step-up under Section 1014 ). The corporation may in fact reap a significant benefit by having its accumulated earnings and profits reduced (pursuant to Section 1371(c)(2) ) in proportion to the percentage of stock redeemed. If this proportionate reduction in accumulated earnings and profits advantage is significant, the S corporation might be better off avoiding the transfer for value risks and simply retaining the insurance in the S corporation to fund such redemptions. 10 Purchase of insurance from estate. Frequently, surviving partners (or shareholders) want to purchase an existing policy on each others' lives from the estate of a deceased partner (or shareholder). If the transaction takes the form of a transfer of life insurance from an estate to a partner of the insured, the safe harbor for a transfer to a partner of the insured will be met. 11 On the other hand, if the transfer is to the surviving shareholders, the transfer for value rule will apply! As discussed below, potential solutions to this issue include the sale by the estate of the insurance policies back to the insureds (which wouldn't provide continued funding for their cross-purchase obligations), the formation of a legitimate partnership and ownership of the insurance by all the surviving co-shareholders as partners of the insureds, and as a last (and not necessarily viable) choice, the surrender of the policy(ies) for cash or sale to a settlement company—which would not meet the surviving owners' need for coverage on each others' lives. Use of an uninsurable's personal insurance. There are at least two reasons that caution is suggested in the knee-jerk reaction to use the personal insurance of an uninsurable shareholder to fund a cross-purchase agreement. The first is that, absent another safe harbor (e.g., the transferee shareholder is also a partner of the insured), the transfer will fail to qualify for a safe harbor and the proceeds will be ordinary income. A second reason is that the uninsurable's family will doubtlessly (and possibly desperately) need the money. Because the insured is at that point uninsurable (and consequently with a shorter than normal life expectancy), the amount his co-shareholder
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is willing to pay is likely not to equate to what the IRS may claim the policy is really worth (or if it does, the purchase would be too expensive to be practical).
Buy-sell planning More than almost any other single area, buy-sell agreement funding, modification, and termination give rise to potential transfer for value traps. For instance, if an uninsurable's individually-owned insurance were sold to a co-shareholder to help fund a cross-purchase agreement, the transaction would clearly fall within the transfer for value rule. The same result would occur if a corporation were to sell a policy to a co-shareholder of the insured, which might occur where the company wants to switch from a stock redemption plan to a cross-purchase agreement and sells its corporate-owned policies on the lives of its shareholders to their co-shareholders. 12 Can the problem be avoided by a transfer to the insured followed by a “gift” of the policy to the other shareholder? Probably not; the IRS would doubtlessly argue that the double transfer was really one transfer made directly from the corporation, 13 and it would also argue that there was no “gift,” particularly if the parties were not related. Failing that argument, the IRS could claim that the reciprocity of the arrangement—I'll “give” you the policy on my life if you “give” me the policy on yours—is sufficient consideration for the transfers. Another place where the problem is likely to occur, absent planning and client education, is at the death of a shareholder who owned policies on more than one other coshareholder. For example, assume that there are three shareholders, and each owns policies on the other shareholders' lives. If one dies, what happens to the policies he or she owns on the others' lives? There is no way for the estate to sell the policies to the non-insured shareholders to allow them to continue the agreement on a fully funded basis without triggering a transfer for value. There are several possible indirect solutions to this problem, though. The first is a sale of both policies by the estate to the corporation. Such a sale falls within a safe harbor exception to the transfer for value rule. The corporation could then establish a stock redemption plan that meshed with the existing cross-purchase agreement. 14 The result would be a hybrid plan, because the survivors continue to own policies on each other's lives. Of course, the survivors could also transfer those policies to the corporation and use a stock redemption agreement for all purchases. A second potential solution is for the estate to surrender each policy for cash or sell them to a life settlement company. A third possible answer is for the survivors to purchase the policies on their own lives and continue them as personal insurance. Another solution is for the surviving insureds to form and operate a legitimate partnership or limited liability company (“LLC”); each policy could then be transferred safely on a cross-owned basis to the insured's co-shareholder—but as a partner of the insured. Trusteed buy-sell agreements. Can the transfer for value trap be avoided if a trustee is made the owner of all the policies under the agreement? Probably not. It's true that upon the first death, there would be no physical policy transfer, and legal title to the policies on the lives of the survivors won't have changed. But the reality is that the beneficial interest in the decedent's share of the policies on his co-shareholders' lives has shifted to them. On each death, there would be some transfer of equitable ownership to the surviving co-shareholders. It would seem that there is also valuable consideration— i.e., reciprocity. No policyowner would allow the beneficial interest in a policy he or she
Copyright 2006 Larry Brody and Stephan R. Leimberg. For Most Recent Cases and Rulings, See http://www.leimbergservices.com and Tax Planning With Life Insurance (800 950 1216)
owned on another shareholder's life to pass through the legal ownership held by the trustee to the other shareholder(s), unless each of the other shareholders did the same. At best, the trustee approach on a cross-purchase agreement is clouded with tax uncertainty, and the potential risk seems to outweigh the possible benefits. The most certain and simple solution is—if appropriate and viable—to assure the existence of a valid partnership in which each shareholder owns an interest. 15 Because the trust holding the insurance could be structured to assure grantor trust status as to each co-shareholder owner, if each co-shareholder of the insured was also his or her partner, the safe harbor for transfers to partners of the insureds 16 would be met. This would make it possible to use a trusteed agreement to minimize the required number of life insurance contracts and reduce administrative costs and burdens. 17 Using group term life to fund cross-purchase agreements. Another trap exists where group term life insurance is used to fund a cross-purchase agreement. Assume that two shareholders, each insured under a corporate-owned group term life contract, name each other as beneficiaries. Although no money has changed hands and even though the policies are term insurance without cash values, there has been a transfer for valuable consideration. The reciprocity (one shareholder would not have named the other as beneficiary if he or she hadn't reciprocated) again provides the valuable consideration. Using first-to-die policies in buy-sell agreements. First-to-die (“FTD”) contracts are sometimes used as an alternative to traditional life insurance contracts. These low-cost (25% to 30% lower premiums than single life) contracts can simultaneously insure two or more (usually up to five) lives. When a first-to-die contract is used in a cross-purchase arrangement, it is essential that the transfer for value rule be considered in advance, regardless of whether the contract is owned individually by the shareholders or held in a trust arrangement. One commentator has stated that “with an FTD policy, it could be argued that the surviving stockholder is also an insured under the policy and the exception to the transfer for value rule should apply to avoid income taxation. Naturally, if the FTD policy is owned individually by the stockholders, the insured exception to the rule will have to be relied upon.” 18 It is safer to use FTD policies with stock redemption type buy-sells to avoid the transfer for value issues. Split-dollar traps in buy-sell agreements. A fourth area of danger in buy-sell planning relates to split-dollar plans. Suppose the buy-sell agreement is to be established as a cross-purchase plan, but neither shareholder can afford to pay premiums. It is decided that the corporation will assist the shareholder-employees by making split-dollar life insurance available to them as an employee benefit. A policy will be purchased on the life of each shareholder, but it will be payable to the co-shareholder (in excess of the corporation's interest). If the corporation is the original policyowner (under the endorsement method) and it names each insured's co-shareholder as beneficiary, there has been a transfer of an interest in the policy, a portion of the death proceeds. Is there valuable consideration? The IRS could argue that the corporation agrees to pay all or a substantial portion of the premiums in a split-dollar agreement and allows the naming of a personal beneficiary for a portion of the death benefit in consideration of the employee's continuing services. A further argument is that—to the extent each shareholder recognizes income based on the economic benefit of having the corporation provide the death benefit 19—it is as if term insurance was purchased on the shareholder's behalf by the corporation. Typically, that presents no problem because the term insurance purchased is on the insured's life, and if it is transferred to someone other than
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the insured, it is by gift. But in a cross-purchase endorsement split-dollar, the employer is the original owner, and the policy is on the life of a co-shareholder of the party to whom the company endorses the policy. A simple solution is to use the collateral assignment method. Each shareholder purchases a policy on the life of his or her co-shareholder and owns it from the beginning. The shareholder then collaterally assigns it to the corporation (a “proper party”) as security for the loan. Upon the death of a shareholder, the surviving shareholder would receive the pure insurance income tax-free, and the corporation would also recover its contributions income tax-free. Summary and conclusions. For the planner in the corporate or partnership buy-sell area, the cases and rulings provide the following guidance: 1. The IRS and the courts have concluded that a transfer of an insurance policy has been for valuable consideration, even if no cash consideration passes hands. The mutuality of agreement supporting the typical buy-sell arrangement will be enough consideration to invoke the transfer for value rule. Similarly, physical transfer of policy ownership is not a prerequisite to finding a transfer for value; the mere naming of a beneficiary in exchange for consideration is enough. 2. The IRS and the courts will generally look at what the parties have actually done, rather than what they might have done (or what they might have done had they recognized the tax consequences of their actions), to determine if there has or has not been a transfer of an insurance policy for a valuable consideration. Form is as important as substance. 3. The “business” exemption to the transfer for value rule is limited. Any transfer in a business situation of a life insurance policy for value (as “transfer” and “value” have been broadly determined by the IRS and the courts) must be reviewed with the “proper party” or “transferor's basis” in mind. 20
Transfer for value problems in retirement and employee benefit planning In this area, the IRS has been active in issuing rulings relating to the transfer of life insurance policies to the trustee of a qualified retirement plan. The transfer may take place as part of the corporate employer's contribution to the plan on behalf of the participant, or as part of a participant’s voluntary contribution to the plan. Alternatively, in many of the rulings, the proposed transaction had at least two steps—a transfer by one retirement plan of a policy to the insured followed by the insured's transfer of that policy to a second plan, or a transfer by a corporation of a keyman policy to the insured followed by the transfer of that policy to a plan. Purchase by retirement plan. In Rev. Rul. 73-338 , 21 the IRS discussed the transfer for value aspects of an agreement under which the employer was to purchase an existing insurance policy on the life of the participant from the participant for its cash value. 22 The employer would then transfer the policy to the trust as part of the employer's required annual contribution to the trust. The trustee would pay the premiums on the policy and at the participant's death would pay the insurance proceeds to the designee (the surviving spouse). At death, the proceeds were paid to the plan trustee who turned them over to the insured's spouse.
Copyright 2006 Larry Brody and Stephan R. Leimberg. For Most Recent Cases and Rulings, See http://www.leimbergservices.com and Tax Planning With Life Insurance (800 950 1216)
The IRS cited Haverty Realty and Investment Co. 23 for the proposition that the transfer for value rule did not apply to a transfer that did not result in a significant change in beneficial ownership. In addition, Rev. Rul. 73-338 stated that there is a transfer for value only where there is an absolute transfer for value of the right to receive all or any part of the proceeds of a life insurance policy. The Ruling concluded that since there was no absolute transfer of the right to receive all or any part of the proceeds of the policy, and since the arrangement effected no significant change in the beneficial ownership of the proceeds, the policy had not been transferred for value. Similarly, in Ltr. Rul. 7848068 , the IRS held that a proposed gift of an insurance policy from the insured's spouse to the insured who then assigned the policy for an amount equal to its cash value directly to the trustee of the corporate employer's qualified money purchase pension plan was again not a transfer for value. The ruling indicated that, with regard to the second transfer, the insured retained the right to control the beneficiary designation at all times. The trust had no right to retain the proceeds which were required to be paid to the designee of the participant upon the participant's death. 24 The key to the favorable result was that the IRS felt the “exchange effected no significant change in beneficial ownership of the proceeds” and thus did not constitute a transfer. Contribution to retirement plan. Rev. Rul. 74-76 25 reached a similar conclusion in a situation where a corporation maintained a qualified plan which permitted voluntary employee contributions and an employee participant who owned an insurance policy on his/her life wished to assign that policy directly to the plan as a voluntary contribution. Under the terms of the plan, the policy proceeds continued to be payable to the employee's beneficiary and the cash surrender value of the policy was payable to the participant upon retirement or termination of employment by other than death. Citing Rev. Rul. 73-338 , the IRS concluded that because the insurance proceeds were payable to the employee's designated beneficiary upon death and the cash surrender value was payable to the participant upon retirement or other termination of employment, there was no significant change in the beneficial ownership of the policy and therefore, it had not been transferred for value within Section 101(a)(2) . 26 Split-dollar transfers. A split-dollar life insurance arrangement is one in which two parties (in the business context, typically an employee and employer) split the premiums, cash values, and death proceeds of a life insurance policy. The creation or implementation of such plans often shifts ownership rights in either the policy or an interest in the policy. 27 For instance, if the arrangement is begun with an employer-owned policy, the cash values and death benefits would be split between the parties by an endorsement to the policy or a change of beneficiary form—in either case, an interest in a policy would have been transferred, for value (the continued employment of the employee). Similarly, with an employee-owned policy, the cash values and death benefits would be split between the parties by collaterally assigning the policy to the employer—a transfer of an interest in a policy for (the same) value. 28 On termination of the arrangement, during the insured's lifetime, a similar transfer of an interest in a policy (for value) would take place. 29
Summary and conclusions. The IRS seems to be taking a relatively liberal attitude in regard to transfers to retirement and employee benefit plans, in holding that, although there has been a transfer in each of the situations described in these rulings, the transfer will be disregarded:
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1. In the case of a transfer of a policy from an employer corporation to its qualified retirement plan, where the insured participant retains the right to designate the beneficiary of those proceeds when collected by the plan. 2. In the case of a transfer of a policy by an employee to a qualified plan as part of a voluntary contribution, where the employee not only retains the right to designate the beneficiary of those proceeds when received by the plan but also retains the right to any cash surrender value of those policies in the event of an earlier retirement or termination of employment. The arrangement under which the employer acquires the insurance policy from the employee must make it clear that the employer is obligated to transfer the policy to its qualified plan and cannot retain any part of the insurance proceeds for its own benefit. Similarly, it must be clear from the plan documents that the plan has no right to retain those proceeds, but must pay them to the participant's designated beneficiary; it is merely a conduit of the proceeds. In any of these cases, although the trustee of the retirement plan is the legal owner of the insurance policy in question, the insured participant must be the equitable owner— i.e., the policy proceeds will be paid to the beneficiary designated by the participant and any cash surrender value will be payable to the participant upon either earlier retirement or termination of employment. The IRS seems to be taking a “substance over form” position with respect to transfers of life insurance into pension plans, in effect ignoring the steps taken to achieve a result and focusing on the end result of the transaction. This should be contrasted with its position in cases like Rath, emphasizing not the end result, but focusing on each step taken to obtain that result. It can be argued that the position taken by the IRS in this area reaches the “right” result, but it is difficult to reconcile the holdings of these rulings in “looking through” the series of transactions to the end result with other cases and rulings focusing on each step in the series.
Transfer for value problems concerning general business insurance Transfer of a policy as collateral. The relationship between the transfer for value rule and the use of a life insurance policy as collateral for a debt is not clear. Reg. 1.1011(b)(4) provides that “...the pledging or assignment of a policy as collateral security is not a transfer for a valuable consideration of such policy or an interest therein, and section 101 is inapplicable to any amounts received by the pledgee or assignee.” In a series of early cases, the courts struggled with the effect of the predecessor of the current transfer for value law on amounts received by a creditor by reason of death of the insured debtor under an insurance policy that was paid to the creditor. For instance, in St. Louis Refrigerating and Cold Storage Co., 30 there was an assignment of policies on the debtor's life as collateral for his obligation to the creditor corporation. The corporation, which had charged off the indebtedness as a bad debt in a prior year, collected a portion of that indebtedness from the insurance proceeds at his death. The IRS determined that the insurance proceeds (less the premiums paid by the corporation) were income. The corporation argued that the policy proceeds were not taxable income, because no transfer for value had occurred; its argument was that it paid no valuable consideration for the assignment.
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The court held that the corporation did not receive the policy proceeds by reason of the death of the insured, but that it received them by reason of the debt. The court concluded that when the insurance contract was transferred and pledged, it lost its character as insurance and became simply collateral. Accordingly, the court taxed the corporation on the income it received from recovery of its previously charged-off debt, regardless of the fact that it represented amounts received under insurance policies at the death of the insured, in which it was named as a beneficiary. 31 The receipt of the proceeds by the corporation was considered income, not because of the transfer for value rule (since the court held that the policy lost its character as insurance and became merely collateral), but because it represented a recovery of previously charged-off debt. Similarly, in Desks, Inc., 32 as security for its debt to the supplier, and in order to obtain credit from a supplier, the taxpayer corporation agreed to pay premiums on a life insurance policy which had been assigned to the supplier by a predecessor of the taxpayer. The predecessor corporation had gone into bankruptcy and eventually paid about 20% of its debt to its creditors, including its debt to the assignee of the policy. When the assignee of the policy collected the insurance proceeds at the death of the insured, it paid a portion of them to the taxpayer. The court held that there had been an assignment for value, the consideration being a continuation of business dealings with the supplier. However, the court found as a fact that the taxpayer had paid much more in premiums than it collected from the policy proceeds. Although there had been a transfer for value of the policy, no amount was includable in the taxpayer's income. Transfer incident to business sale. The transfer of life insurance policies often is incident to the sale of the assets or stock of a business or some other business reorganization, and the transfer for value rule may well apply. For instance, in Spokane Dry Goods Co., 33 the taxpayer had purchased all the assets of a corporation in which it was a shareholder. The assets included a number of insurance policies on the life of one of the corporation's officers. The policies were subject to loans equal to their respective cash surrender values. The taxpayer subsequently paid the premiums on the policies, repaid the loans, and collected the full face amount of the policies upon the death of the insured. The taxpayer argued that it had not acquired the insurance policies for a valuable consideration, or alternatively that if it had, the consideration was its investment in the capital stock of the selling corporation. The court held that the taxpayer had in fact acquired the policies for a valuable consideration, based on the purchase of the policies as part of its purchase of the assets of the failing business. That purchase had occurred for a valuable consideration, in spite of the fact that the policies were treated as having a zero value at their acquisition date since the cash value equaled the amount of policy loans. Similarly, in Lambeth, 34 a corporation—in liquidation—transferred to the taxpayer an insurance policy on his life and one on the life of one of his co-shareholders. Upon the death of the other co-shareholder, the taxpayer received the policy proceeds. The taxpayer excluded the policy proceeds from his income for the year of receipt, on the theory that they had been received tax-free under the predecessor of Section 101(a) . The IRS argued that the contract had been acquired for a valuable consideration, including the amount for which he had originally purchased his stock in the corporation. The court specifically held that, while the taxpayer, in purchasing his stock, did not contract for the insurance policy (and most likely had no thought of acquiring it), the
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consideration paid by him for the stock constituted consideration not only for the stock but also for any distributions to which he might become entitled as a stockholder— namely the insurance policy. The court therefore held that the contract had been acquired for a valuable consideration (the full amount paid by the taxpayer for his stock in the corporation). Accordingly, although the general exclusionary rule of the predecessor of Section 101(a) was not available to the taxpayer, he nonetheless had no income from the transaction, because the price he paid for his stock (i.e., his basis) exceeded the insurance proceeds. 35 Transfers involving the addition of new partners. Ltr. Rul. 9410039 involved a law partnership which had bought a policy on the life of a key employee who was not a partner. The partnership owned and was the beneficiary of the policy. The partners were concerned that each time a new partner joined or left the partnership (e.g., through death, disability, retirement, or some other reason), the IRS would treat the partnership as terminated and a new partnership formed. Under this argument, the policy might be considered transferred from the “old firm” to the “new firm.” The safe harbor for transfers to a partnership in which the insured is a partner would not apply because the insured in this case was a non-partner. But the IRS indicated that as long as the business of the partnership continued and there was no major change in the firm's asset base, this situation would not be treated as a transfer for purposes of the transfer for value rule. Beware: If the partnership for any reason legally terminates upon the entrance or exit of a partner, the problem raised in this letter ruling might be present. This is particularly true if: (1) no part of the business is continued by a partner, or (2) there is a sale or exchange of 50% or more of partnership capital or profits within a 12-month period. 36 Summary and conclusions. In the debtor-creditor area, the provision of Reg. 1.1011(b)(4) , that assignments of policies as collateral security are not transfers of those policies for purposes of the transfer for value rule, should eliminate the concern expressed in the early cases that amounts received by the creditor at the death of the debtor were taxable income. However, the full import of this Regulation is not clear. Does it mean that the exception to the general exclusionary rule of Section 101(a) doesn't apply to such amounts or that the exclusionary rule itself doesn't apply to those amounts? It would seem to make sense that Section 101 doesn't apply at all, on the theory that the proceeds are no longer insurance, but a return of capital. With regard to the purchase of a business, care must be taken any time a policy is transferred to be sure that it wasn't transferred for value (even indirectly, when the business was acquired). If there has been such a transfer, documentation should be created showing as large as possible a consideration for the transfer in order to reduce or even eliminate the taxable amount. Alternatively, the “transferor's basis” exception can be relied on in a “sale” that can be structured as a tax-free exchange.
Transfer for value problems involving personal insurance The published Revenue Rulings in the personal area— Rev. Rul. 69-187 37 and I.T. 3212, 38 —provide some guidance relating to transfers of life insurance policies between spouses or other family members. In I.T. 3212, the insured purchased a policy on his life from his corporate employer, and then immediately named his wife as beneficiary. She collected the policy proceeds at the insured's death. The IRS concluded that the proceeds were exempt because the transfer
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was to a “proper party,” the insured. 39 This Ruling, distinguishing Hacker, 40 on the ground that the transferee there was the insured, held that the policy proceeds received by the insured's wife at his death were excludable from her income under the predecessor of Section 101(a) . The Ruling indicated that since the purchase of the policy from the corporation was made by the insured, the transfer for value rule should not apply. Accordingly, no part of the policy proceeds were taxable when received by the beneficiary. In Hacker, the taxpayer's father purchased a life insurance policy on the father's life. He designated a corporation as the beneficiary. Shortly thereafter, the corporation changed the beneficiary provision of the policy and named the insured's wife (the taxpayer's mother) as the beneficiary. Several years later, the insured assigned all his right, title, and interest in the policy to his wife in exchange for her payment to him of the cash surrender value of the policy. Then the insured's wife (the taxpayer's mother) gratuitously assigned the policy to the taxpayer. The IRS asserted that when the taxpayer collected the policy proceeds at her father's death, the excess of the policy proceeds over the consideration paid by the taxpayer's mother, plus subsequent premiums paid by the mother and by the taxpayer, constituted income to the taxpayer. The taxpayer’s argument was that the transfer for value rule should be inapplicable to someone who would be the natural object of the insured's bounty. But the Board of Tax Appeals held that the IRS's determination was correct, since there had in fact been a transfer for valuable consideration from the insured to his spouse (the taxpayer's transferor), and that such a transferee thereupon becomes an investor in the policy. 41 In Rev. Rul. 69-187 , the IRS ruled on the federal income tax consequences of an insured's transfer of an insurance policy on his life (subject to an indebtedness) to his wife. Under the facts of the Ruling, the policy had a face amount of $2,000 and a cash value of approximately $860, of which approximately $845 had been advanced to the insured as a policy loan on the security of the value of the policy (and without personal liability on the part of the insured). The insured transferred the policy, subject to the debt, to his wife. Thereafter, the insured's wife paid off the loan during the insured's lifetime and continued to pay all premiums due after the transfer. The Ruling concluded that the transferee spouse's interest in the policy was acquired in part for a valuable consideration and in part by gift, so that on the insured's death, the insurance proceeds would be received under a policy which had a basis determinable in part by reference to the basis of the policy in the transferor's hands. Accordingly, the policy proceeds when paid to the wife would be excludable from her income under Section 101(a) . Without specifically stating so, the Ruling, in holding that the transferee's interest in the policy was acquired “in part for a valuable consideration and in part by a gift” must be taking the position that the excess of the policy value over the loan was a “gift” and the portion of the policy value represented by the indebtedness shifted to the wife was a sale. Nevertheless, since the policy was acquired at least in part by gift, so that the transferee's income tax basis in the policy was determinable in part by reference to the basis of the transferor's interest in the policy, no part of the policy proceeds were taxable when received by the beneficiary at the death of the insured. In Rev. Rul. 69-187 , the policy loan was specifically stated to be less than the policy’s gross gift tax value, but the Ruling is silent on the relationship of the loan to the transferor's income tax basis in the policy. If a transferred policy is subject to a policy
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loan, the loan is treated as an “amount paid” for the policy. In many cases, the insured's basis will exceed the loan. Hence, the transferee's basis is determined by reference to the transferor's and there would be no problem. But if the amount of the policy loan (and other consideration) exceeds the transferor's basis in the policy, two results are possible. First, to the extent the loan is greater than the transferor's basis, he realizes ordinary income (just as if he had sold the policy to the transferee for the amount of the loan) at the time of the transfer. 42 Second, the transferee's basis is determined—not in whole or in part by referring to the transferor's basis—but solely by the “sale” price, the amount of the loan. This means the transferee loses the protection of the “transferor's basis” exception. 43 The solution is to limit the amount of any proposed loan to some level clearly less than the transferor's basis in the policy. This avoids both the contention that there was a taxable sale on the transfer and that the sale price determines basis. In Bean, 44 the taxpayers purchased a series of policies on the life of their father from him for cash. The taxpayers' father had reported the transaction as resulting in a taxable gain to him in the year of sale. Because the insured died in the year following the sale, the insured's gross estate had included the value of the policies (in excess of their purchase price). The taxpayers contended that the proceeds should be excluded from their income since the taxpayers were the natural objects of their father's bounty 45 and because his estate had included the excess of the face value of the policies over their cash surrender value. 46 But the Tax Court held that the taxpayers had received taxable income upon collecting the policy proceeds at their father's death. The measure of that income was the difference between those proceeds and the consideration each paid. Insured as transferee. Estate of Rath and Swanson, Jr. 47 illustrate the issues raised in intra-family transfers in identifying whether the transferee is the “insured”—(i.e., one of the “proper party” exempt transferees). In Rath, which occurred prior to the enactment of Section 1041(b) , an insurance policy on the corporation's shareholder was transferred directly from the corporation to his wife, in exchange for an amount equal to the cash value of the policy. When the wife collected the policy proceeds, the IRS took the position that the wife had received income because of the transfer for value of the policy from the corporation to her. She argued that what in fact had happened was that the policy had been (constructively) transferred to the insured who then gratuitously transferred it to her (both of which transfers would have been exempt). The court ignored this “step transaction” argument and held that although there might have been a way for the insured to have accomplished the transfer so that it would have qualified for the Section 101(a)(2)(A) exemption, the policy had not in fact been transferred to the insured, and accordingly the policy proceeds were taxable in the wife's hands. In Swanson, the Eighth Circuit held that a transfer of a policy to a trust which was a “grantor” trust for income tax purposes would be treated as a transfer to the “insured” for purposes of the transfer for value rule, since the trust was ignored for income tax purposes. The technique used in this case has proven helpful in transferring policies to irrevocable life insurance trusts which contain “defective grantor trust” provisions. 48 This holding—that the trust was the grantor/insured for transfer for value purposes—is different from the conclusions reached in the letter rulings described below, which held that the transfers were disregarded for all income tax purposes (including the transfer for value rule), under Rev. Rul. 85-13 , 49 because they were transfers to grantor trusts.
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Divorce. Although there does not appear to be a ruling or case involving the transfer for value implications of a life insurance policy transferred incident to a divorce, under the rationale of Davis 50 a transfer of a life insurance policy incident to a divorce in certain common law states probably would have triggered the transfer for value rule—until Section 1041(b) was enacted to specifically reverse the holding in Davis. In Davis, pursuant to a property settlement incident to divorce, the husband transferred to his wife appreciated stock that had been in his name alone. The issue was whether the transfer of stock to Mrs. Davis was the appropriate time to tax the gain to Mr. Davis or whether it was more appropriate to wait to tax that gain until Mrs. Davis disposed of the stock. The Supreme Court held that this transfer was not a division of property in which both spouses had interests, but was an immediately taxable transfer in exchange for a release of one spouse's inchoate rights. As noted, Section 1041(b) reversed this holding. Protection under Section 1041 is particularly useful since it provides its own carryover basis rule—a rule that is much more liberal than the carryover basis rule of Section 1015 . The Section 1041(b) carryover rule, for example, applies regardless of whether or not the transferor's basis in the policy is equal to, greater than, or even less than the policy's fair market value (“FMV”) at the time the policy is transferred. Compare this with the Section 1015 rule, which makes the transferee ineligible for carryover treatment—and therefore for a safe harbor—if the total consideration (including outstanding loans) received by the transferor exceeded the transferor's basis in the policy at the time of the loan. Beware: No Section 1041 treatment is available if the transfer was to a nonresident alien spouse or to a nonresident alien former spouse. 51 This Code section also doesn't provide any protection against the transfer for value rule for premarital transfers of life insurance. Thus, a pre-marriage transfer of life insurance would trigger sale or exchange treatment, 52 and the transferee would compute basis under Section 1012 . Summary and conclusions. For the planner in the personal insurance area, the cases and rulings suggest: 1. Many intra-family transfers will be exempt as transfers where the transferee's basis is determined by reference to the transferor's (typical gift situations). 2. If consideration is paid for the policy transfer or if the liability to which the policy is subject exceeds the transferor's income tax basis in the policy, the transfer for value rule will apply (unless the transferee is otherwise exempt). 3. Transfers of life insurance policies between spouses during marriage or incident to a divorce are no longer treated as “sales” and therefore qualify for the carryover basis safe harbor.
Transfers from trusts Perhaps the most common transfers of life insurance policies in recent years have been from an irrevocable trust to the insured, who then contributed the policy to a new trust, or from an insurance trust directly to a new irrevocable trust created by the same insured/grantor. The problem arises from the very nature of such trusts and the inevitability of life. By definition, irrevocable trusts cannot (easily or inexpensively) be changed, while at the same time the needs and circumstances of trust beneficiaries and the goals and objectives of trust grantors begin to change the moment a trust becomes
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irrevocable. This dichotomy poses the question: How can the life insurance policies be removed from a trust with terms and provisions that are no longer appropriate or desired, and transferred into a new trust with more appropriate provisions—without falling into the transfer for value trap? One answer is to give the new trust an interest in a bona fide partnership or LLC in which the insured was a partner. This would make the transferee trust a partner of the insured at the time of the transfer—so that a purchase by the new trust from the old trust would fall within the safe harbor for a transfer to a partner of the insured. 53 Ltr. Rul. 8951056 presented another solution. Step 1: Contributions to the old trust were ended. Step 2: A new trust with suitable terms and appropriate beneficiaries was created. Step 3: The insured purchased the policy from the first trust for its FMV, and contributed it to the new “better” trust. 54 Finally, Ltr. Ruls. 200228019 , 200247006 , 200229019 , and 200120007 all dealt with transfers of policies, for consideration, from the trusts that owned them to new grantor trusts. 55 In several of these rulings, the transfers of the policies for consideration (some involving a single life policy and some a survivorship contract) were held not to be transfers for value, because the transfers were from old grantor trusts to new grantor trusts created by and taxable to the same grantor(s), and such transfers are “disregarded” for income tax purposes. 56 Ltr. Ruls. 200518061 , 200514001 , and 200514002 all reached similar conclusions; because the transfers weren't recognized for income tax purposes, there was no “transfer” of the policies for purposes of the transfer for value rule. 57 Beware: What is the FMV of a policy? The question is not merely academic for two reasons. First, there is a tax risk. Suppose, for example, that the insured were terminally ill and on his deathbed at the time of the purchase. If the insured purchases the policy from the trust for, say, $20,000 when the policy's face amount is, say, $300,000, there certainly seems to be a bargain sale by the trust to the insured. 58 And what if the insured were not in imminent danger of dying, but was severely ill and the trust could have sold the policy to a life settlement company for much more than the amount paid by the insured? Second, the beneficiaries of the first trust—and their counsel—will also be concerned. To the extent the trustee of the trust sold the policy for less than its economic “value,” or if the insured died soon after the sale and the trust lost the policy proceeds, could the beneficiaries surcharge the trustee? This entire issue is clouded by valuation rules not directly applicable to trust-to-trust transfers 59—but certainly reflective of a method other than the classic “interpolated terminal reserve plus unearned premiums” measure of the gift tax Regulations 60— perhaps including the existence of an active life settlement market for existing policies. In any event, trust-to-trust transfers require a cash gift by the grantor to the transferee trust (if it isn't already adequately funded), to enable it to purchase the policy for its “fair market value.” Finally, where the sale is from the insured to a grantor trust, so long as the purchase is at full “fair market value,” the three-year transfer rule of Section 2035 shouldn't apply, since it excepts transactions for “full and adequate consideration.” 61 Given the uncertainties surrounding a policy's “fair market value,” having the purchasing trust pay something more than the policy's gift tax value, as confirmed by the insurer on a current Form 712, should be considered. 62
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Planners must treat every transfer of life insurance or an interest in life insurance as a potential transfer for value—until that danger is ruled out by careful analysis. Rather than rely on fairness or logic, neither of which will safeguard either the client or the professional, practitioners should refer to the specific safe harbor rules for protection against the draconian impact a mistake in this area will cause. Failure to do so can result in both an unanticipated tax liability and the risk of a malpractice claim.
PRACTICE NOTES With regard to the purchase of a business, care must be taken any time a life insurance policy is transferred in order to be sure that it wasn't transferred for value (even indirectly, when the business was acquired).
1
Section 101(a)(2) . 2
This article is a revision of the original article on the transfer for value rule by the authors, published in the Journal of Financial Service Professionals; L. Brody and Stephan R. Leimberg, “The Not So Tender Trap: The Transfer for Value Rule,” Journal of Financial Service Professionals 38 (May 1984): 32. Reprinted with permission from the Society of FSP. 3
See Brody and Leimberg, “Avoiding the Tax Trap of the Transfer for Value Rule,” 32 ETPL 3 (Oct. 2005) . 4
8 AFTR 2d 5142 , 197 F Supp 146 , 61-2 USTC ¶9555 (DC Ala, 1961). This is also one of the leading cases in determining what constitutes a “transfer for value.” 5
See also James F. Waters, Inc., 35 AFTR 1011 , 160 F2d 596 , 47-1 USTC ¶5909 , 47-1 USTC ¶9196 (CA-9, 1947), and Ltr. Rul. 7918022 , which involved the proposed sale by a corporation of insurance on the lives of each of its shareholders to a partnership composed of the same individuals. 6
44 AFTR 2d 79-5949 , 608 F2d 254 , 79-2 USTC ¶9654 (CA-6, 1979). 7
Ltr. Rul. 9309021 provides a good example of this planning. See The Corporate BuySell Handbook (610-924-0515), and Structuring Buy-Sell Agreements (800-950-1215). 8
Ltr. Ruls. 9328010 , 9328012 , 9328017 , 9328019 , and 9328020 . 9
See the discussion of this issue, in the text, beginning at note 55, infra. 10
Brown, “The Life Insurance Transfer for Value Rule,” The CPA Journal On-Line (June 1993).
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11
Ltr. Rul. 9727024 . 12
One reason that existing life insurance purchased to fund a stock redemption is often transferred from a C corporation is to avoid the corporate alternative minimum tax (“AMT”). As a result of the Accumulated Current Earnings adjustment of Section 56(g) , many closely held C corporations have considered substituting cross-purchase shareholder agreements in situations that were previously structured as redemptions. But see Section 55(e) , providing an exception to application of the AMT for “small” corporations. 13
See Estate of Rath, 44 AFTR 2d 79-5949 , 608 F2d 254 , 79-2 USTC ¶9654 (CA-6, 1979). 14
See Leimberg and Rosenbloom, The Wait-and-See BuySell (http://www.leimberg.com or 610-924-0515). 15
Ltr. Rul. 9511009 . 16
Section 101(a)(2)(B) . 17
A simpler solution would be to use a partnership instead of a trust as the entity to own the policies. 18
Titus, “Using FTDs in Buy-Sell Plans,” 144 Tr. & Est. 44 (May 2005). 19
Measured by the Table 2001 cost, or the insurer's alternative term rate, qualifying under Notice 2002-8, 2002-1 CB 398 . 20
Transfers to a co-shareholder or a co-officer of the insured or to a corporation in which the insured is a nonshareholder employee or a non-employee (such as a director) will not be exempt from the transfer for value rule (although it could well be argued that such transfers are business-motivated and arguably should be exempt). Again, symmetry between partnership and corporate buy-sell planning in this area would be helpful, but it doesn't (for whatever underlying policy reason) exist. 21
1973-2 CB 20. 22
Planners must now be more conscious of proper and adequate valuation in transfers of life insurance, particularly when qualified retirement plans are involved. There are not only tax and ERISA issues, but also the possibility that plan participants will sue the trustee for failure to realize sufficient cash on the sale of retirement trust property. See
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Rev. Proc. 2005-25, 2005-17 IRB 962 . See also Steve Leimberg's Employee Benefit and Retirement Planning Newsletter #300 at http://www.leimbergservices.com. 23
3 TC 161 (1944). In Haverty, the Tax Court held that a transfer of insurance policies from one corporation to another “effected no significant change in their beneficial ownership,” because the shareholders of the two corporations were substantially identical, and thus there was no transfer of the policies for a valuable consideration. 24
See also Ltr. Rul. 7752109 , to the same effect. 25
1974-1 CB 30. 26
Ltr. Rul. 8050045 reached a similar result where the policy was owned by and payable to the corporation and was sold to the participant who transferred it to his account in the retirement plan. See also Ltr. Ruls. 7906051 , 8936072 , and 9041052 . 27
See Ltr. Ruls. 7829128 , 8003094 , and 9045004 . 28
However, as discussed below, the Section 101 Regulations provide that assigning a policy as collateral, presumably including for split-dollar advances, isn't a transfer for this purpose. See the text at note 30, infra. 29
Although the Regulation provision discussed above wouldn't, by its terms, apply to a release of a collateral assignment, if the assignment weren't a transfer for this purpose, it appears the release wouldn't be either. 30
35 AFTR 1477 , 162 F2d 394 , 47-2 USTC ¶9298 (CA-8, 1947). 31
See McCamant, 32 TC 824 (1959). See also Federal Nat'l Bank of Shawnee, Okla., 16 TC 54 (1951), citing St. Louis Refrigerating and Cold Storage Co., supra, note 30, for the proposition that a pledged insurance policy is no longer insurance, but merely collateral, and that therefore the insurance provision of Section 101(a) is not applicable. 32
18 TC 674 (1952). 33
TCM Decision 13,137, (4/19/43). See also Waynesboro Knitting Co., 47 AFTR 1902 , 225 F2d 477 , 55-2 USTC ¶9631 (CA-3, 1955), holding that the death proceeds of policies acquired from an employee in satisfaction of a claim for embezzlement were taxable as income. 34
38 BTA 351 (1938). 35
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See also, e.g., King Plow Co., 24 AFTR 552 , 110 F2d 649 , 40-1 USTC ¶9330 (CA-5, 1940), aff'g 45 BTA p. 62, (1941), which held that the predecessor of Section 101(a)(2) applied to policies received in a tax-free reorganization. This specific issue has been resolved by the exemption in Section 101(a)(2)(A) . 36
Section 708(b) . 37
1969-1 CB 45. 38
1938-1 CB 65. 39
There were no statutory exemptions to the transfer for value rule at that time. 40
36 BTA 659 (1937). 41
As discussed below, under current law, the interplay between Section 1041 and the carryover basis safe harbor usually will eliminate any interspousal transfer problem. See the text at note 50, infra. 42
See Gallun, 13 AFTR 2d 660 , 327 F2d 809 , 64-1 USTC ¶9253 (CA-7, 1964); Simon, 6 AFTR 2d 6077 , 285 F2d 422 , 61-1 USTC ¶9136 (CA-3, 1960); and Malone 27 AFTR 2d 71-1565 , 326 F Supp 106 , 71-1 USTC ¶9475 (DC Miss., 1971). 43
Unless the transferee is otherwise an exempt transferee. 44
TC Memo 1955-195 , PH TCM ¶55195 , 14 CCH TCM 786 45
See Hacker, 36 BTA 659 (1937). 46
See also Pritchard, TC Memo Dec. No. 14,205(17), (10/24/44), in which the proceeds of policies which were sold for their cash surrender value by the insured within three years of his death and held to be includable in his estate for estate tax purposes were held not to be includable in the transferee's income, on the theory that the estate tax holding meant that there was no “transfer” of the policies. 47
36 AFTR 2d 75-5159 , 518 F2d 59 , 75-2 USTC ¶9528 (CA-8, 1975). 48
The trust in Swanson was an unusual irrevocable trust—one as to which the grantor had the power to interpret or amend (but not to vest the trust property in himself). 49
1985-1 CB 184.
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50
9 AFTR 2d 1625 , 370 US 65 , 8 L Ed 2d 335 , 62-2 USTC ¶9509 , 1962-2 CB 15 (S.Ct., 1962). 51
Section 1041(d) . 52
The transferor spouse would have reportable ordinary income if, at the time of the transfer, the policy's value (including any outstanding loans) exceeded his basis in the contract. See Farid-es-Sultaneh, 35 AFTR 1049 , 160 F2d 812 , 47-1 USTC ¶9218 (CA-2, 1947). 53
See Ltr. Ruls. 9347016 and 9903020 . 54
Subject to the three-year transfer rule of Section 2035 . 55
Transfers to grantor trusts are discussed at Steve Leimberg's Estate Planning Newsletters #486 and #434 at http://www.leimbergservices.com. 56
Rev. Rul. 85-13 , supra note 49. 57
See the earlier discussion of Swanson, which reached a similar conclusion, based on the unusual terms of the trust. 58
See Pritchard, supra note 46. 59
Rev. Proc. 2005-25, 2005-17 IRB 962 , which modified and supersedes Rev. Proc. 2004-16, 2004-10 IRB 559 , applicable to determining the FMV of policies under Sections 79 , 83 , and 402 . 60
Reg. 25-2512-6 ; Rev. Proc. 2005-25 warns that this method is appropriate only where the reserve reflects “the value of all of the relevant features of the policy.” 61
Transfers between trusts should also avoid application of the Section 2035 three-year transfer rule, because the transfer isn't by the insured. 62
Note the possible “step transaction” argument the IRS could make to bring such a sale within the scope of Section 2035 : Is the insured in any different economic position after a gift and sale than if he or she had just gifted the policy? If not, the transaction might be disregarded for Section 2035 purposes. To reduce the risk of such an argument, the insured could consider contributing more to the trust than is needed to purchase the policy.
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