What it means
Life insurance proceeds paid on death are generally free of income tax for the person who receives them. The transfer for value rule exists to stop people buying existing policies purely as an investment and then collecting a tax-free gain when the insured person dies.
A transfer for value happens when a policy, or an interest in it, is sold or exchanged for money, property or something else of worth. If the rule applies, the buyer is taxed on the death benefit minus what was paid for the policy and any premiums the buyer paid afterwards.
The rule has well-known exceptions. A transfer to the insured person, 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 is generally outside the rule, as is a transfer where the new owner takes over the previous owner's tax basis (the original cost used to measure gain).
In business planning the rule often catches buy-sell arrangements. If co-owners of a company hold policies on each other and later restructure the ownership of those policies, a careless transfer can create an unplanned tax bill at the worst possible moment.
Because tax law differs between countries and changes over time, anyone planning a policy transfer should confirm the position with a qualified adviser before signing anything. The cost of that advice is small compared with the tax at stake.
In practice
Real-world examples.
Example
Two partners in a design studio each own a $400,000 policy on the other to fund a buyout. One partner sells his policy to an outside investor for $50,000, which is a transfer for value and puts the later death benefit at risk of tax.
Example
An elderly policyholder sells a $1,000,000 policy to a specialist buyer for $250,000 because she no longer needs the cover. The buyer's gain on the death benefit may be taxable under the rule unless an exception applies.
Example
A company moves a key-person policy from itself to the insured executive, who is also a shareholder. Because the transfer is to the insured, it generally falls within an exception and the benefit stays tax free.
Formula
Calculation
Where the rule applies, the taxable portion is calculated as:
Taxable amount = Death benefit - (Price paid for the policy + Premiums paid afterwards by the new owner)
Take an illustrative policy with a $500,000 death benefit that an investor buys from the original owner for $60,000. The investor then pays $20,000 of further premiums over the following years. When the insured dies, the investor receives $500,000, and the taxable amount is $500,000 - ($60,000 + $20,000) = $420,000. If a valid exception had applied, the whole $500,000 would normally have been received free of income tax, so the unplanned exposure is $420,000 of taxable income.Case study
Seen in the real world.
Calder and Pryce Surveyors is an illustrative, fictional two-partner practice. Each partner held a $600,000 policy on the other, intended to let the survivor buy out the estate if one of them died.
When Mr Pryce decided to leave and sell his stake to a new partner, the firm moved the policies to a new company structure without asking an adviser. One policy ended up owned by a trust set up by the incoming partner, who paid $40,000 to take it over.
The accountant caught the problem at the next annual review and recommended restructuring so that the policy was held by a partnership in which the insured was a partner. In this illustrative case the fix cost a few thousand dollars in fees, compared with a potential taxable amount of roughly $560,000 on the death benefit had nothing been done.
Watch out
Common mistakes.
- Assuming a life insurance death benefit is always tax free, regardless of how the policy was acquired.
- Forgetting that a gift or exchange can count as a transfer for value if something of worth is given back.
- Moving business policies during a restructure or buyout without checking the exceptions first.
Questions
People also ask.
Does a free gift of a policy trigger the rule?
A pure gift is generally not a transfer for value, although gift tax and other rules may still apply.
Which transfers usually avoid the rule?
Transfers to the insured, to a partner of the insured, to the insured's partnership or to a corporation where the insured is a shareholder or officer are the standard exceptions.
Who should be consulted before a policy transfer?
A tax adviser or insurance specialist who knows the rules for the relevant country and can review the exact facts.
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