If an insurance policy is acquired for a valuable consideration, the transfer for value rule may cause the recipient of the insurance proceeds to recognize ordinary income.73With limited exceptions, the transfer for value rule applies whenever an interest in an insurance policy has been transferred, by assignment or otherwise, for a valuable consideration.74Thus, the sale of an insurance policy is often subject to the transfer for value rule. A gift of a policy would not be covered by this rule.
PRACTICE NOTE:
There are three very important exceptions to the transfer for value rule. The transfer for value rule will not apply:
(1) If the transfer is to the insured himself.75
(2) If the transfer of value is to a partner of the insured or to a partnership in which the insured is a partner, or to a corporation in which the insured is the stockholder or officer.76
70
SeeEst of Tompkins v Commr, 13 TC 1054 (1949), acq1950-1 CB 5;Bobrzensky v Commr, 34 BTA 305 (1936);Est of Mitchell v Commr, 37 BTA 1 (1938), 1938 BTA LEXIS 1100, acq1938-1 CB 20.
71
SeeIRC § 264(a)(1).
72
SeeIRC § 101(a)(1).
73
SeeIRC § 101(a)(2).
74
SeeTreas Reg § 1.101-1(b)(4).
75
SeeIRC § 101(a)(2)(B).
76
SeeIRC § 101(a)(1)(b). See Priv Ltr Ruls 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9328012, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010,PLR 9725007, 9725008, 9725009, 9701026, 9625014, 9328010, 9725007, 9725008, 9725009, 9701026, 9625014, 9328010.
(3) If the policy changes hand in a transaction in which the basis of the transferor carries over to the transferee, no transfer value will occur.77
Example:
Alice and Ben are shareholders of Gamma, Inc., a calendar year S corporation. On April 15, 2011, the parties entered into a stock redemption agreement. Gamma purchased two insurance policies, one on Alice’s life and one on Ben’s life to fund its obligations under the agreement. On July 1, 2012, the parties decide to convert to a cross-purchase agreement. If the corporation transfers the policy on Alice to Ben and the policy on Ben to Alice, the transfer for value rules would normally apply. However, if Alice and Ben then exchange policies so the insured owns the policies on their own lives, the insurance proceeds will retain their tax-free character.
Another tax trap may exist under a cross-purchase agreement if the surviving shareholders buy the policy on another shareholder from the deceased shareholder’s estate. In that case, a transfer for value has occurred.
Example:
Ann, Ben and Clark each own 1,000 shares of Brackets, Inc., a calendar year S
corporation, worth $1.5 million. Each shareholder owns $250,000 of life insurance on the other shareholders’ lives to fund the cross-purchase agreement. On May 1, 2011, Ann dies. Ben and Clark each collect $250,000 in insurance proceeds and purchase Ann’s stock from her estate. Ben and Clark also buy the remaining insurance policies from Ann’s estate. If Ben buys the policy Ann owned on Clark, it is a transfer for value and no exception applies. Later, at Clark’s death, Ben would have ordinary income measured by the excess of proceeds over Ben’s investment in the policy. The same problem would exist for Clark’s purchase of the policy on Ben’s life.
PRACTICE NOTE:
There is a solution to this problem. The corporation should purchase the policies on Ben and Clark from Ann’s estate. The transfer for value rule will not apply to a sale to a corporation in which the insured is a stockholder or an officer. The corporation should then enter into a stock redemption plan that is coordinated with the existing cross-purchase agreement. The result would be a hybrid cross-purchase/stock redemption agreement. The corporation would purchase the stock to the extent of its insurance proceeds, and the shareholders will purchase stock to the extent of their insurance proceeds.
A trust arrangement should not be used to avoid the transfer for value problem for a cross- purchase arrangement. Under a trust arrangement, all of the policies would be held by a trust whose purpose would be to hold the policies, collect the proceeds, and implement the buy-sell agreement. Upon Ann’s death, there would be no physical transfer of the policy. Legal title to the policies on the lives of Ben and Clark would remain in the trust and would not change. The beneficial ownership of Ann’s share of the policies on Ben’s and Clark’s lives have shifted to them. Some transfer of equitable ownership to the surviving co-shareholders has occurred, which
77
would constitute a transfer for value.78
Another solution to the transfer for value problem for cross-purchase agreements, which has received a lot of attention over the last few years, is the exception for partners or partnerships under Section 101(a)(2).79Under this exception, if the policy is purchased by a partnership in which the insured is a partner, the transfer for value rule does not apply. For this exception to apply, the partnership must be carrying on a bona fide business or investment activity.
Example:
Martin, Larry, and Todd each own 1,000 shares of the stock of Nubic, Inc., a calendar year S corporation. On May 1, 2011, Martin, Larry, and Todd entered into a cross-purchase agreement. The agreement obligates each shareholder to purchase the other’s stock upon death or disability. Each shareholder buys a life insurance policy on the life of the other shareholders to fund his obligation under the agreement. The parties are also in a real estate partnership. The real estate partnership purchases the insurance policies on each shareholder’s life. The partnership then holds the policies, collects the proceeds, and implements the buy-sell agreement. Since the purchase is by a partnership in which each of the insured is a partner, the transfer for value rule does not apply.
PRACTICE NOTE:
When structuring an insurance-funded cross-purchase agreement, an escrow arrangement may be advisable. Under this approach, the stockholders appoint an escrow agent to administer their cross-purchase agreement. The escrow agent holds the insurance policies and delivers the proceeds to the stockholders pursuant to the escrow agreement. The stockholders use the funds to fulfill their obligations under the cross-purchase agreement.
The escrow agent is the owner and the beneficiary of the insurance policies. Each stockholder is credited with a pro rata interest in the policies covering the lives of the other stockholders. The same agreement must specify that an insured will not be credited with any ownership interest in the policy insuring his or her life. Without this provision, the proceeds would be taxed in the insured’s estate. Each stockholder pays his or her proportionate share of the premiums on the other stockholders’ lives. The premiums are paid directly to the insurance company or, alternatively, can be transferred to the escrow agent who will make the payments. Upon a stockholder’s death, the escrow agent collects the insurance proceeds. The escrow agent pays the proceeds directly to the other stockholders who, in turn, fulfill their obligations under the buy-sell agreement. The escrow agent then credits each surviving stockholder’s account with its pro rata share of the ownership of the remaining policies.
The tax risks associated with the escrow agreement are the same transfer for value problems inherent in all cross-purchase agreements. While the escrow agent may be the initial
78
See “Grantor Trust Insured for Life Insurance Transfer for Value Purposes,” J Tax (WG&L), March 2007; “Life Insurance As A Planning Tool,” 33 NYU Inst. 793, 813 (Matthew Bender 1975) andMonroe v Patterson, 197 F Supp 146 (ND Ala 1961); C Well Hall III, “Valuation of Stock Under Buy-Sell
Agreements After Chapter 14—General Business Practice or Business as Usual?” Journal of S Corp Tax’n, Vol 7, No 3, Winter 1996.
79
owner of the policies, the beneficial interest of the decedent in the policies on the co-
shareholders’ lives automatically shifts to the survivors. This constitutes a transfer for value, even though there is no change in the legal title of the policies.80
Example:
Alex, Blane, and Karen are shareholders of Bell, Inc., a calendar year S corporation. They are not involved in any other business together. The shareholders have entered into an escrow cross-purchase buy-sell agreement, whereby an escrow agent owns a policy on each shareholder’s life. At Alex’s death, his interest in the policy on the lives of Blane and Karen are transferred to the surviving non-insured pursuant to the escrow agreement. This amounts to a transfer for value which would cause a party to the insurance proceeds to be taxable at the next death.
If the shareholders are also partners in other business ventures, an exception to the rule will likely be met if such ventures are valid partnerships, and there will be no negative income tax consequences.
Example:
Bob, Sam, and Tim are shareholders in Mellons, Inc., a calendar year S corporation. They are also partners in Real Estate, Ltd., a real estate partnership. Bob, Sam, and Tim enter into an escrow cross-purchase buy-sell agreement. At Bob’s death, his interest in the policies on the lives of Sam and Tim are transferred to the surviving non-insureds to the escrow agreement. This amounts to a transfer for value, but since Sam and Tim are partners in a partnership, there is no transfer for value. There is no requirement in the statute or accompanying regulations that the partnership, or the furtherance of the business, be involved in the transferred policies for the partner exception to apply.81
PRACTICE NOTE:
In Revenue Ruling 2007-13,82the IRS ruled that transfers of insurance policies between grantor trusts did not violate the transfer for value rule.