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The Transfer For Value Rule: What is it & How can you avoid it?

10.14.20 written by

In the law, obscure rules can sometimes provide for substantial penalties if they are violated. One such example of a situation like this is the Transfer for Value Rule involving life insurance contracts. Therefore, you should know what the Transfer for Value Rule is and how you can avoid it.

It is important to understand that generally speaking, the proceeds of life insurance contracts that are received by a beneficiary when an insured of the policy passes away are received without any income tax implication. However, that general rule changes if the life insurance contract had previously been transferred for value. In those types of situations, the proceeds received by the insurance contract beneficiary as a result of the death of the insured are taxable, and the proceeds from the life insurance policy then become subject to income taxes for the policy owner. The actual amount that is taxable is the amount of the death benefit that exceeds the amount that was actually paid as premiums for the policy. This is called the Transfer for Value Rule, and, therefore, the proceeds are taxable to the owner of the life insurance contract.

Fortunately, there are various exceptions to the Transfer for Value Rule in which the policy proceeds remain income tax-free.  Those exceptions are as follows:

  1. If the policy transfer is considered a gift;
  2. If the policy is transferred to a partner of the insured;
  3. If the policy is transferred to a partnership where the insured is a partner;
  4. If the policy is transferred to a corporation where the insured is a shareholder; or
  5. If the policy is transferred to the insured.

Therefore, whenever transferring the ownership of a life insurance contract, please make sure that the transfer qualifies for one of the exceptions to the Transfer for Value Rule, or some or all of the life insurance proceeds will be considered taxable income when received.

NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.

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