¶ 2.07 The Transfer-For-Value Rule Causing the Loss of Tax-Free Status

¶ 2.07[1] Importance of Understanding the Rule

Life insurance is an important estate planning tool for many reasons, but one of the most important is that it is the only sure way to provide that death, the event that creates a need for a large amount of cash, also creates a significant amount of cash to meet that need. 110 The importance of life insurance in meeting this need presupposes, however, that there will be a sufficient amount of insurance proceeds remaining to meet the needs for which the insurance was bought. The utility of life insurance diminishes in direct proportion to any tax burden it must bear.

While life insurance proceeds are not usually subject to income taxes, they may become taxable income under the transfer-for-value rule—a tax trap that can cause all or a major portion of the death proceeds to become subject to ordinary income tax. The stakes are high. Table 2-1 illustrates the minimum shrinkage that occurs when various beneficiaries receive taxable income.

Table 2-1


            APPROXIMATE LOSS DUE TO INCOME TAX ON PROCEEDS
                        (Assume Death in 1998)
Amount Taxable     Single     Joint      Trust     C Corp.   Service Corp.
 $  100,000      $ 24,000   $ 20,000   $ 39,000   $ 22,000     $ 35,000
    500,000       175,000    169,000    197,000    170,000      175,000
  1,000,000       372,000    367,000    395,000    340,000      350,000

¶ 2.07[2] Requirements for the Transfer-For-Value Rule

¶ 2.07[2][a] An Overview

Section 61 is the basis for understanding the entire flow of the income tax law. That section provides that “gross income includes all income from whatever source derived.…” 111 Section 101(a) , however, provides a key exception to that general rule by stating generally that gross income does not include amounts received under a life insurance contract 112 if those amounts are paid by reason of the insured's death. 113

The transfer-for-value rule is a draconian exception to that exception, applying whenever a policy is transferred in return for valuable consideration. 114 This rule does not apply to the proceeds of a policy that is bought initially by (rather than transferred to) the beneficiary. 115 It is an easily missed or misunderstood provision that can cause loss of the favorable income tax treatment afforded to life insurance proceeds.

Example  2-23

Charles Client buys a $1 million policy on the life of a co-shareholder. The insured dies and Client collects the proceeds. If Client bought the policy from the co-shareholder, the proceeds will be subject to ordinary income tax. If Client purchased the same $1 million policy on the same co-shareholder but bought the contract directly from the insurer, however, the $1 million will be income tax free, a difference that could amount to over $300,000 in savings.

The transfer-for-value rule is contained in Section 101(a)(2) and provides specifically:

In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by…[the beneficiary under § 101(a)(1)] shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee.

Example  2-24

A $1 million life insurance policy on Insured's life is transferred from Insured to Sister for $1,000. There has been a transfer of an insurance contract for value. If Sister then pays two $1,200 premiums before Insured's death, the amount excludable from Sister's gross income for amounts received under the policy will be limited to the value of the consideration paid for the policy ($1,000) plus the total premiums subsequently paid ($2,400). This means $996,600 ($1 million less $3,400) will be subject to ordinary income tax. In most cases, this will be both shocking to the beneficiary and devastating to the objectives for which the coverage was purchased. 116

Note that interest paid or accrued by the transferee for value on any policy indebtedness that is nondeductible under Section 264(c)(4) (the general rule of disallowance for interest deductions on policy loans) is treated as an amount paid for the contract by the transferee and thus increases basis.

¶ 2.07[2][b] All Types of Life Insurance Subject to Rule

The type of life insurance policy transferred is irrelevant. Every type of policy (term or permanent, universal, variable, or adjustable) is covered under the transfer-for-value rule, as are group and individually purchased contracts. The method by which the policy (or the interest in the policy) is transferred is irrelevant.

¶ 2.07[2][c] Insurable Interest Not Key to Exclusion From Rule

The ostensible congressional purpose for the transfer-for-value rule is to discourage speculation in human life through the sale of insurance policies to those who do not have an insurable interest. 117 The parties specifically exempt from the transfer-for-value rule are those who are likely to have an insurable interest in the continued life of the insured. Nonetheless, some parties who might be expected to have an insurable interest (such as the insured's spouse, children, parents, or co-shareholders in a closely held corporation) are not included in the exempt categories. 118 But the income tax exclusion has been denied in cases where there was clearly no risk or intent of speculation on the death of the insured and where the only violation was a technical one. 119 Nor will a transfer to the natural objects of the insured's bounty provide defense from the harsh imposition of the rule, no matter how close or natural the relationship is. 120 Thus, practitioners should not use mere logic as a working guideline for this rule. To avoid the transfer-for-value trap, planners must carefully follow the language of the Code and the Regulations rather than the underlying rationale of the rule.

A potential problem should be suspected under the transfer-for-value rule whenever there has been a transfer of a policy or any interest in a policy and any type of valuable consideration is (or could have been) given in return for that transfer. Every transfer should be considered suspect until scrupulously examined. Such an examination requires consideration of every element of the transfer-for-value rule.

¶ 2.07[2][d] Meaning of “Transfer”

The term “transfer for valuable consideration” is broadly defined. It encompasses any absolute transfer—for value—of a right to receive all or any part of a life insurance policy. The income tax regulations include in this definition the creation for value of an enforceable contractual right to receive all or any part of the proceeds. 121

If Insured in Example 2-24 had merely named Sister as the policy beneficiary (for valuable consideration), that alone would constitute a transfer for purposes of the rule, even though no physical transfer of the policy's ownership had occurred. The rule, therefore, extends far beyond mere outright sales of policies. Even the creation by separate contract of a right to receive all or a portion of the policy proceeds would be considered a transfer.

Conversely, specifically excluded from the scope of a transfer for valuable consideration is the pledge or assignment of a policy (or an interest in a policy) as collateral security. A pledgee or assignee who has received the pledge or assignment of a policy as collateral for a loan will be able to recover proceeds income tax free 122 (but as a repayment of capital, rather than as the proceeds of a life insurance policy). 123 So an absolute assignment of a life insurance policy should always be suspect, but a collateral assignment of a life insurance contract will almost always fall outside the rule.

With the exceptions listed following, transferees for value of life insurance policies are therefore taxable at ordinary income tax rates on receipt of the policy proceeds, less the sum of the amounts paid by them to acquire the policy and all later premiums and other payments. 124

Example  2-25

A client buys a $1 million policy on the life of his co-shareholder. Assume its value at the date of purchase is $100,000. The client pays three annual premiums of $30,000 each and then dies. An amount of $190,000 ($100,000 + (3 × $30,000)) will be income tax free when the insured dies. The $810,000 difference between $1 million and $190,000 will be taxable at ordinary income tax rates.

In Private Letter Ruling 9410039, a law partnership purchased a policy insuring the life of a key employee who was not a partner of the firm. The partnership paid all the premiums and was named as beneficiary on the employee's death. The firm was concerned that every time a new partner was admitted to the firm or a partner withdrew from the firm (because of death, disability, retirement, or for any other reason), the Service might consider the partnership to be terminated.

Were the addition of a new partner a termination of the former partnership, the Service might consider there to be a transfer of a policy or an interest in a policy from the “old firm” to the “new firm” and treat the transfer as one made for consideration. Since a transfer for value to a partnership of a policy on the life of a nonpartner does not fall within the exceptions to the transfer-for-value rule, the firm was afraid the proceeds would be subjected to ordinary income tax.

The Service held that there was no transfer as long as the business of the partnership continues and the asset base stays essentially the same. Although incoming new partners had to make a capital contribution on entering the partnership and would receive a payback of that same money when leaving, the Service said that this was not the same as a transfer of the policy to a new partnership from an old partnership.

The Service also pointed out that a termination of a partnership occurs if no part of the business is continued by any partner or if there is a sale or exchange of 50 percent or more of partnership capital or profits within twelve months, a fact not present in this situation (so the partnership is deemed to continue rather than be terminated). The partnership would continue to own the insurance both before and after partners entered or left the firm.

According to this ruling, as long as the partnership itself does not terminate when a new partner enters or another leaves, there is no transfer of a policy or interest in a policy. Since there is no transfer, there should be no transfer-for-value problem even where the coverage is on the life of a key, nonpartner employee.

In Private Letter Ruling 9852041, the Service ruled that there was no transfer for value where an individual proposed to acquire life insurance from an irrevocable life insurance trust in exchange for another life insurance policy. The ruling involved an irrevocable life insurance trust (ILIT) created by a couple for the benefit of their two children. The principal asset of the trust was life insurance on each spouse’s life. The attorney for the taxpayer represented that each policy in question met the tax law definition of “life insurance,” and none was a modified endowment contract.

For reasons not discussed in the ruling, the parties obtained a state court order terminating the trust. The trust assets were to be distributed in equal shares to the couple’s children, who then became joint owners of each of the policies. After the distribution date, the daughter, if she survived the insured, would receive one half of the proceeds. If she did not survive the insured, her one half would be paid to her estate. Likewise, the couple’s son would receive one half of the proceeds if he survived the insured. If he did not survive, his one half would be paid to his estate. Neither joint owner could make any unilateral change in the policy—neither, alone, could obtain a policy loan, exchange a policy for another policy, or surrender a policy for its cash surrender value.

To pay premiums, money was borrowed from each policy’s cash values so each policy had loans against it. The two children wanted to simplify this arrangement and separate the control element. They proposed an action for partition, that is, to change the current joint ownership of the policies in the following manner: Each life insurance contract would be transferred to the insurer. In return, for each policy received, the insurer would issue two separate new policies. Each of the new separate policies would insure the same life as that covered under the original policies, and would provide exactly one half of each original policy’s death benefit and cash value, and be subject to one half of the outstanding loan. Each child would pay equally, using his or her own funds, a nominal administrative fee to the insurer for the proposed policy split. The daughter would be named owner of one separate policy and the son would become owner of the other.

The Service ruled that the division of the policy would not be a transfer under the transfer-for-value rules. The Service looked at the form of the transaction, and stated that the proposed transaction is not in substance a “transfer” of existing policies to the daughter and the son, but rather the receipt of new policies from the insurer. Therefore, the transfer-for-value rule would not apply.

Even though the Service blessed the partition of the policy in this ruling, one must look at whether there is a deemed sale or other taxable disposition that might trigger the reporting of gain. The Service made an analogy to the division of jointly-owned property such as real estate into undivided interests, reasoning that such a transaction is nontaxable and that this transaction should also be nontaxable. The Service stated that, “although the term ‘partition’ is not generally used with reference to insurance policies, the proposed transaction is in substance similar to a partition of jointly owned property.” Since the quantity of property owned by each child did not change, the event of division of one policy into two policies of value equal to the original should be nontaxable.

A modification or restructuring of a policy issued or assumed through reinsurance by a financially troubled insurer will not be treated as a transfer, if the modifications or restructuring are an integral part of the rehabilitation plan and are approved by the state insurance commissioner, state court, or other responsible state official. 124.1

In Private Letter Ruling 200228019 (July 12, 2002), a transfer was deemed not to have occurred when a life insurance policy was sold from one irrevocable life insurance trust to another, both of which were deemed owned by the same grantor. H created Trust 2 for the benefit of H 's descendants, which then bought variable life insurance policies on the joint lives of H and W. Trust 2 allowed the trustee to use trust assets to pay premiums on insurance policies on the lives of any individuals, if any beneficiary had an insurable interest. H later created Transferee Trust, which has terms that are somewhat different from those of Trust 2, including an authority for the trustee to condition the distributions to H's lineal descendants upon their entering into a prenuptial or post-nuptial agreement.

Transferee Trust proposed to buy the three variable life insurance policies held by Trust 2, for their fair market value, as determined by the interpolated terminal reserve value, plus the proportionate part of the gross premium last paid before the date of sale. Transferee Trust would then become the beneficiary of the three transferred policies. H would make annual gifts to Transferee Trust, which would be used by Transferee Trust in part to pay the premiums on the policies.

The IRS stated that the purchase of the policies by Transferee Trust will not be a transfer for value under Section 101 , because Transferee Trust and Trust 2 are both grantor trusts deemed owned by H, so the transfers are disregarded. 124.2 It is noteworthy, however, that the IRS did not opine on whether the trusts were grantor trusts deemed owned by H. Rather, the taxpayer represented that the trusts were grantor trusts.

¶ 2.07[2][e] “Valuable Consideration” Defined

Two issues that must be resolved in every situation in which there might be a transfer for value are:

1. Whether there in fact has been a transfer of a policy (or an interest in a policy); and

2. Whether there was valuable consideration given in exchange for that transfer.

¶ 2.07[2][e][i] Creation of enforceable rights as consideration.

Although there is no definition of the terms, “transfer” or “valuable consideration” in the Code, the Regulations provide that a transfer for valuable consideration occurs whenever there is any absolute transfer for value of a right to receive all or any part of the proceeds of a life insurance policy. This includes the creation for value of an enforceable right to receive all or part of the proceeds of a policy but excludes any pledge or assignment of a policy as collateral security. 125

¶ 2.07[2][e][ii] Nominal promise without payment.

Even if there is a transfer, the transfer-for-value rule will not apply if there is no consideration given in exchange for that transfer. 126 Thus, if there is a nominal promise by the transferee to pay value and even if the policy assignment said “for one dollar,” the proceeds will be tax-free, since no consideration is ever paid. This rule applies regardless of the formal recitation of consideration in the assignment form furnished by the insurer, but the better practice, of course, is to recite in the documents of assignment that the transfer is made as a gift solely “for love and affection.”

Example  2-26

Assume the same facts as in Example 2-24, except that while the document of assignment recites that Sister will pay Insured $1,000, she never in fact pays him anything. As no consideration was ever actually paid, there is no transfer for value and all of the proceeds paid to Sister at Insured's death are received by her free of income tax.

¶ 2.07[2][e][iii] Term policies not protected.

A transfer for value occurs if, in exchange for any kind of valuable consideration, a policy beneficiary of all or any portion of the proceeds is named or changed. This rule applies even if there is no legal assignment or physical transfer of the policy, 127 even though the policy has no cash surrender value at the time of the transfer, and even if the policy is term insurance, so that it never had any cash value.

Example  2-27

Assume the same facts as in Example 2-24, except that the policy is a term policy on the life of Insured and it has no cash surrender value. Insured assigns the policy to Sister on the last day of the policy year, so the policy has not only no cash value but also no unexpired premium value. If Sister pays a valuable consideration for the policy, the mere fact that it has no cash value will not prevent the application of the transfer-for-value rule.

¶ 2.07[2][e][iv] Proceeds tax free if less than basis.

Even though the transfer is found to be in exchange for a valuable consideration and none of the exemptions under Code Section 101(a)(2) apply, insurance proceeds paid under a policy acquired in a transfer for value are still subject to income tax only to the extent that they exceed the transferee's adjusted basis in the policy.

The transferee's adjusted basis in the policy is the total of the consideration paid for the policy, plus any amounts paid subsequent to the transfer. Thus, if the transferee's adjusted basis exceeds the policy proceeds, the entire amount of the proceeds will be excludable from the transferee's gross income. 128

Example  2-28

Assume the same facts as in Example 2-24, except that the policy sold by Insured to Sister is a form of permanent insurance with a substantial cash surrender value. Sister pays Insured $600,000 for the policy (which is substantially more than its cash surrender value on the date of the sale), and thereafter she also pays nine annual premiums of $50,000 each. When Insured dies, Sister receives a $1 million death benefit. Her income tax basis in the policy is $1,050,000 ($600,000 + ($50,000 × 9)), so she realizes a $50,000 loss on the receipt of the proceeds.

¶ 2.07[2][e][v] Reciprocal promises as consideration.

The consideration given to support a transfer need not be in the form of cash or other property with a readily ascertainable value. The valuable consideration requirement is met by any consideration sufficient to support an enforceable contract right.

For example, in Monroe v. Patterson, 129 mutual shareholders' promises to buy each others' stock in the event of death was held to be enough consideration to invoke the rule. In that case, the taxpayers and the other stockholders of a closely held corporation entered into an agreement in 1936 by which the taxpayers would ultimately buy all the corporation's stock of one stockholder, Mrs. Gore, on her death. Two life insurance policies were bought on Mrs. Gore's life with the corporation named as beneficiary. The policies were assigned to Mrs. Gore and another stockholder in trust to collect and pay over the proceeds as all or part of the purchase price to be paid by taxpayers for the stock. The taxpayers agreed to pay part of the insurance premium in consideration for Mrs. Gore's (and another stockholder's) promise to assign the two policies and sell the stock at a specified price.

In 1948, the parties entered into another agreement identical to the 1936 agreement, except that the method for determining the purchase price of the stock was materially changed. When the insured died, the trust received the proceeds and the taxpayers used them to buy the stock. The Service contended that the policy was acquired in a transfer for value, and a U.S. district court agreed.

The court recited the terms of the transfer-for-value rule and held that the consideration for the transfer of the two insurance policies was the mutuality of obligations and the actual cash consideration paid by taxpayers in premiums. These amounts and obligations were, the court said, an “integral part of the consideration for the assignment of the insurance policies for the use and benefit of the taxpayers.” The court rejected the taxpayers' argument that the proceeds of the two insurance policies were used only to arrive at the purchase price of the stock, finding that the facts did not support the contention. The 1948 agreement set the purchase price for the stock at “the excess of its corporate assets…over corporate liabilities.”

In Private Letter Ruling 199903020, the Service ruled that reciprocal promises of trust beneficiaries to pay future premiums were valuable consideration for a transfer of a life insurance policy. In the ruling, a couple created an irrevocable life insurance trust to which they then made cash gifts to pay premiums on a second-to-die life insurance purchased by the trust on their lives. The couple then decided that they wished to discontinue their contributions to that trust. This would have made it impossible for the trustee to continue to pay premiums on the life insurance, because the trust lacked sufficient other assets from which to pay the premiums.

The couple’s children decided that they wanted to buy and continue to maintain the policies personally. They entered into an agreement by which they would buy a right to a portion of the insurance proceeds payable when the surviving insured died. The balance of the proceeds would be paid to the trust. The ratio of the children’s benefit and that of the trust would be determined by the ratio that the policy’s cash surrender value on a specified date bears to the cash surrender value on the day immediately preceding the death of the surviving insured. Essentially, this provided that the children would receive two thirds of the proceeds.

The Service ruled that there was clearly a transfer of an interest in the policy to the children, through their split-ownership agreement with the trust. The Service also ruled that the children’s promise to pay premiums in the future was a valuable consideration for the policy. The Service, relying on Monroe v. Patterson, stated that because of the children’s premium payments, the irrevocable trust will continue to have insurance on the grantors’ lives (by agreement, the amount passing to the trust decreases as the proportion of premiums paid by the children increases), and that this was clearly consideration in money or money’s worth.

¶ 2.07[2][e][vi] Policy loans as consideration.

The Service takes the position that a transfer of a life insurance policy subject to a loan is a transfer of the policy for value (at least to the extent of the loan). 130 Presumably, the rationale for this position is that the old policy owner transfers the policy in consideration for being relieved of an obligation to pay an amount equal to the loan. A transfer of a policy subject to a nonrecourse loan discharges the obligation of the transferor, who is viewed as having received an amount equal to the debt he or she no longer is obligated to pay. 131

The mere existence of a policy loan does not, however, ensure that the transfer-for-value rule will apply. If the transferor's adjusted basis in the policy is equal to or greater than the face amount of the loan, the transferee's adjusted basis in the policy will be determined at least partially with reference to the transferor's basis, and the transfer will not be deemed to be for value. 132 If the transferee is not sure that the facts will support a carryover basis, however, it is important that a private letter ruling be sought to avoid ordinary income treatment on the proceeds.

¶ 2.07[3] Safe-Harbor Exceptions

A beneficiary can receive insurance proceeds income tax free—even if there has been a transfer for valuable consideration—in any one of five circumstances. These five safe-harbor exceptions to the transfer-for-value rule are

1. The transferor's basis exception; 133

2. A transfer to the insured;

3. A transfer to a partner of the insured;

4. A transfer to a partnership in which the insured is a partner; and

5. A transfer to a corporation in which the insured is a shareholder or officer. 134

¶ 2.07[3][a] The Transferor's Basis Exception

Under the transferor's basis exception, the transfer-for-value rule does not apply where the transferee's basis in a policy or an interest in a policy is determined in whole or in part by reference to the transferor's basis. Such carryover of the transferor's basis to the transferee can occur in many different situations, but it comes into play most frequently in two common situations.

First, the transferor's basis rule applies in the case of outright gifts of policies that generally take the form of an absolute assignment of a policy “for love and affection.” Here, no consideration of any kind changes hands. The transferor merely gives the policy to the transferee, so that where a client makes a gift of a policy and receives no consideration of any kind in return for the transfer, the transferee carries over the transferor's basis and falls safely within the protection of the transferor's basis exception.

Second, the transferor's basis exception is typically applied where a policy is transferred from one business to another in a tax-free corporate reorganization. Thus, for example, a transfer of property during the formation of a corporation is income tax free if, immediately after the transfer, the persons who exchanged property for stock own at least 80 percent of the voting stock and own at least 80 percent of all other classes of stock in the corporation. 135

Example  2-29

Corporation X owns and is beneficiary of a policy on the life of Alice, an employee. As part of a tax-free reorganization, it transfers the policy to another corporation, Y. Because the transferee-corporation's basis is determined in whole by reference to the transferor corporation's basis (in a tax-free reorganization, the transferee carries over the transferor corporation's basis in the acquired assets), Y , the successor corporation, can exclude the entire proceeds from its gross income when Alice dies. 136

On the other hand, if Y transfers the policy to Corporation Z for valuable consideration ($600), at Alice's death, Z will be able to exclude from its gross income only the consideration it paid plus subsequent premiums it paid after the transfer of the policy to it. 137

If Z transfers the policy to Corporation M in a second tax-free reorganization, the insurance proceeds payable to M at Alice's death will be excludable from M's gross income to the extent of the consideration paid by Z plus any premiums paid by Z or M. 138

Two important restrictions in the transferor's basis exception must be noted. First, the transferor's basis exception means just that; if the transferor held a life insurance policy already subject to the transfer-for-value rule, the rule will continue to apply if the transfer is to a party whose adjusted basis is determined with reference to the transferor's basis. The carryover transfers the taint. Second, one corporation's purchase of the assets of another corporation is not a tax-free reorganization, so that if the assets purchased include a life insurance policy, that policy is not protected from the transfer-for-value rule (unless the insured is an officer or shareholder of the purchaser corporation).

In Private Letter Ruling 199940028, the Service stated that purchase of an existing life insurance contract was not a transfer for valuable consideration because no valuable consideration was paid to the policy owner and any transfer that did occur was by gift. The ruling involved a rearrangement of the parents' estate plan, under which two sisters were to buy a second-to-die (survivorship) life insurance policy on the lives of their parents. Only one of the two sisters was listed on the policy application, and she signed as both owner and beneficiary. The owner-sister allowed the policy to lapse after one year because she believed the policy was “too expensive,” and because she “did not need the full amount of coverage it provided.”

The policy provided for a thirty-one-day grace period and stated that it would be continued in force during that period of time. It also provided that if the premium had not been paid within the grace period, the insurance would cease to be in force at the end of thirty-one days after the due date of the unpaid premium, and that if the policy had a surrender value, the insurer would apply that value as a net single premium to provide insurance on an adjusted basis as of the due date of the unpaid premium. In other words, whatever cash was left in the policy at the date it lapsed would be automatically used to convert the original contract into a paid-up for-life policy for a lesser amount.

The policy also allowed reinstatement within three years after the due date of the first unpaid premium, if both insureds were alive or one insured were alive and the lapse occurred after the death of the other insured. The reinstatement also required that the surrender value had not been paid or otherwise exhausted, an application for reinstatement was filed, satisfactory evidence of incurability was received, overdue premiums were repaid together with interest at 6 percent, and any indebtedness (including interest) outstanding when the policy lapsed was paid or reinstated. The daughters reinstated the policy pursuant to these provisions.

The insurance agent for the two sisters provided them with a document, “Request With Respect to Policy or Application,” on which the sister, who had been the policy owner, requested reinstatement of the policy and its issuance with the two sisters named as owners and beneficiaries. Pursuant to that request, the insurer issued a second policy with a date of issue and policy number the same as the stated date of issue and policy number of the first contract. The two sisters received an invoice reflecting the annual premium plus an amount characterized as interest. That amount was, however, different from the amount due on the first contract.

The second sister who was added as an additional owner and beneficiary had no legal obligation to the first to pay any premium on the new contract, the first sister had no legal right to compel the second sister to pay any such premium, and the second sister made no payment of any consideration to the first sister in connection with the transfer of, or for, any right the first sister had in either policy. The Service ruled that, under these facts, there was no transfer for valuable consideration.

The Service concluded that there was no transfer for value. The Service stated that, in general, although life insurance proceeds are typically income tax free, if a life insurance contract or any interest therein is transferred for a valuable consideration, by assignment or otherwise, the exclusion from gross income is limited to an amount equal to the sum of the actual value of the consideration and the premiums and other amounts subsequently paid by the transferee.

The Service analogized to the appeals court decision in Waters v. Commissioner, 138.1 where the taxpayer acquired a life insurance policy in a merger. The transferor there had acquired the policy for valuable consideration, but after the merger, the taxpayer allowed the policy to lapse. Pursuant to its terms, the policy was converted into a paid-up policy. On the death of the insured, the taxpayer received the proceeds of that paid-up policy.

In Waters, the taxpayer argued that the predecessor of the carryover basis rule now contained in Section 101(a)(2)(A) required that it be permitted to exclude the policy proceeds from income. It argued further that even if the predecessor of that rule did not dictate such a result, the paid-up policy was a different policy from the policy it acquired in the merger, and that it did not acquire the paid-up policy for valuable consideration. The Court of Appeals held that the carryover basis rule did not apply to exempt the proceeds from tax, but stated:

As an alternative the taxpayer claims that [the predecessor of Section 101(a)(2)] is inapplicable because of the lapse of the policies…for non-payment of premiums. The argument proceeds on the assumption that the policies were not thereafter the same contracts as those transferred. The assumption is groundless. No new contracts came into existence. The changes in periods and amounts of insurance were effected by the terms of the insurance contracts as written in the first instance.

The Waters case therefore results in a “no new contract” principal. That is, if the policy owner allows a policy to lapse and the insured dies while the reissued policy is in force, the death benefit will be deemed to have been paid under the original contract for purposes of the transfer-for-value rule. Here, however, the Service ruled that even if this principle applied, and the second policy is considered merely a continuation of the first policy, there would be no transfer for value because the second sister never paid any consideration to the first sister-owner for any right to the original (or second) contract.

The sisters also had argued that something other than a mere continuation had occurred. The sisters argued that the policy on which the death benefit was paid was a new policy rather than a continuation of the original. They claimed that each agreed to buy half of that new policy at the outset and there was no transfer of either a policy or an interest in a policy. The Service appears to have accepted this analysis.

¶ 2.07[3][a][i] Part-gift/part-sale situations.

The transferor's basis exception often becomes clouded by part-gift/part-sale transactions. 139 The regulations 140 provide that in the case of a transfer that is in part a gift but in part a sale:

the unadjusted basis of the property in the hands of the transferee is the sum of

(1) Whichever of the following is greater:

(a) The amount paid by the transferee for the property, or

(b) The transferor's adjusted basis for the property at the time of the transfer, and

(2) The amount of increase, if any, in basis authorized by section 1015(d) for gift tax paid.

Example  2-30

Father sells Daughter a $100,000 policy on his life for $1,000. At the date of the sale, the policy's gift tax value is $4,000 and Father's adjusted basis for the policy is $5,000. Here, Father's $5,000 basis exceeds the $1,000 consideration he has received. Daughter's basis (for determining gain or loss on a subsequent sale) will be Father's basis (the $5,000 net premiums he has paid). 141 Daughter's basis is determined, therefore, in part by Father's $5,000 basis because, even though there is a sale of a policy worth $4,000 in exchange for a $1,000 payment from Daughter, there is also a $3,000 gift ($4,000 value less $1,000 consideration paid by Daughter). At the date of the policy transfer, Father's $5,000 basis exceeds the $1,000 consideration received. Therefore, his basis is carried over to Daughter. In spite of the consideration paid on the transfer of the policy, Daughter will receive the proceeds income tax free. 142

A part-gift, part-sale situation can also arise when a policy is transferred subject to an existing policy loan. As has been discussed, the amount of the policy loan to which the policy is taken subject is treated as valuable consideration for purposes of the transfer-for-value rule. 143 Before transferring a policy against which there is a loan, therefore, it is important to confirm that the transferor's adjusted basis in the policy equals or exceeds the loan. If basis is equal to or greater than the loan, the transferee will take a basis in the policy determined with reference to the transferor's basis, and thereby fall within a safe harbor to the transfer for value rule.

In Revenue Ruling 69-187, 144 for example, the beneficiary received $2 million in life insurance proceeds. The insured had transferred the policy to his wife at a time when it had a cash value of $860,000 and was subject to a policy loan of $845,000. The insured's wife named herself owner and beneficiary of the policy and paid off the loan the year after the transfer. The Service said that the transaction was part gift and part sale. The transfer was a sale to the extent of the loan the insured no longer was responsible for paying, and the transfer was a gift to the extent that the debt did not exceed the insured's basis in the policy. The Service ruled that there was clearly a transfer of the policy and the acceptance of the loan by the wife was a valuable consideration for the transfer. However, the transferee's basis would be determined at least in part by reference to the basis of the policy in the hands of the transferor, since the transferor's basis in the policy exceeded the loan balance on the date of the transfer. Had the loan exceeded the transferor's basis, the transaction would have been viewed as a sale and transferor's basis exception would have not applied.

However, if the sale portion of a part-sale/part-gift exceeds the gift portion, the transferor's basis exception ceases to apply. The part-sale/part-gift protective rule applies only when the transferor's basis exceeds the amount paid by the transferee including the amount the transferee is deemed to have paid by relieving the transferor of the obligation to pay any policy loan.

If the policy loan and any cash or other property received in the exchange are greater than the transferor's basis, the transaction is treated as a sale and not as a gift. That means there will be no exemption, and the transfer-for-value rule causes the proceeds to be subject to income tax. 145

Example  2-31

Assume the same facts as in Example 2-30, except that Father borrows heavily on the policy just before transferring it to Daughter. Assume that sum of the policy loan Father took plus the amount of consideration paid to him by Daughter exceeds Father's $5,000 basis in the policy. Since the amount deemed to be paid by Daughter (the sum of the debt assumed plus consideration actually paid), the transferee, exceeds Father's, the transferor's, basis, Daughter's basis will be determined not by reference to Father's basis but rather by the total “sales” price. This means there will be no protection against the transfer-for-value rule, and the proceeds will be subject to ordinary income tax.

Example  2-32

Each of two shareholders owns a policy on her own life. To fund a cross-purchase buy-sell agreement, each gives the policy on her own life to the other. These transfers will not create a carryover basis, since neither shareholder made a gift of her policy out of a detached generosity, as is required by the income tax law to create a gift; rather, each made the “gift” because the other did the same. The transfer-for-value rule applies despite the fact that no cash changed hands. The reciprocal promises, and not love and affection, prompted the gifts; there was consideration for the transfers. Each gave up something of value only because she knew she would get something of value in return. 146

¶ 2.07[3][a][ii] Transfers between spouses and ex-spouses.

There is an interplay between Code Section 1041(b) and the transferor's basis exception that makes it safe for the insured to transfer life insurance to the insured's spouse (or even an ex-spouse, if the transfer is pursuant to a divorce and meets certain tests). 147 Under Section 1041(b), no gain or loss is recognized on the transfer or the sale of property between spouses. 148 The transfer is treated as a gift to the transferee. Consequently, the transferee recognizes no gain for income tax purposes, 149 even if the policy is received in exchange for the transferee's surrender of marital rights. 150

Better yet, for purposes of the transfer-for-value rule, the transferee spouse (or ex-spouse) takes as his or her basis the transferor's basis. 151 This protection is afforded regardless of whether the transfer is cast as a gift, sale, exchange, or is of separately owned, jointly held, or even community property. 152 Because basis is carried over from the transferor to the transferee spouse, it falls cleanly into the transferor's basis exception.

Example  2-33

Husband sells a $1 million insurance policy on his life to Wife for $25,000—its cash surrender value on the date of the sale. At Husband's death, the $1 million proceeds are received tax free by Wife, because her purchase of the policy is recast as a gift for income tax purposes under Section 1041 , giving her an adjusted basis in the policy equal to Husband's basis on the date of the sale.

Example  2-34

Husband and Wife are in the process of obtaining a divorce. As part of their property settlement agreement, Husband agrees to sell a $1 million insurance policy on his life for $25,000. The sale is required under the terms of their property settlement agreement, and it occurs six months after their divorce decree is granted. Despite the fact that the transaction is cast as a sale and despite the fact that Wife pays Husband $25,000 in cash for the insurance policy, Wife receives the proceeds tax free because Section 1041 treats the transaction as a gift and gives Wife Husband's adjusted basis in the policy. Had the sale not been required by the property settlement agreement and had it taken place more than two years after the divorce, Wife would be deemed to have purchased the policy from Husband, and the proceeds (in excess of her basis) would be taxable to her as ordinary income.

The Section 1041 protection does not apply to transfers to nonresident alien spouses or nonresident alien ex-spouses, 153 nor does it apply to “spouses-to-be” incident to the marriage. 154 Also, the transferor's basis exception does not apply to a transfer to a trust of a life insurance policy against which there is an outstanding loan in excess of the owner's basis (the premiums paid by the owner less any dividends he or she received). 155

Example  2-35

Husband and Wife are in the process of obtaining a divorce. As part of their property settlement agreement, Husband agrees to transfer a $1 million insurance policy on his life to a trust for the benefit of Wife and her two children (by her previous marriage). The policy is subject to an outstanding loan of $40,000, and Husband's basis in the policy is $30,000. Husband recognizes a gain of $10,000 on the gift because the amount of the liability to which the policy is subject exceeds his basis. When Husband dies, the trust will receive the $1 million as taxable income.

The Service has ruled that a transfer to a grantor trust deemed owned by the insured's spouse was a transfer to the spouse for purposes of Section 101, and therefore exempt from the transfer-for-value rule. In Private Letter Ruling 200120007 (Feb. 2, 2001), the insured, H, created an irrevocable trust, naming two of his children and an unrelated party as co-trustees. The trust assets will be divided among H's descendants after his death. The trust instrument allows the trustee to buy insurance on the lives of H and H's wife, W, and the trust bought two second-to-die policies insuring the lives of H and W (Policies X and Y), and a small amount of cash. The trust was a grantor trust under Section 677(a)(3), because of the ownership of insurance and the ability of the trustees to buy policies on the life of H.

W then created Trust 4, naming a bank as trustee. The beneficiaries of the two trusts are the same as the beneficiaries of the first two trusts, though their relative interests are slightly different. Trust 4 is a grantor trust deemed owned by W for federal income tax purposes, under Section 677(a)(3).

H and W proposed, in part, that Trust 1 would borrow against its policies to reduce their values, and then sell the policies to Trust 3 for cash in an amount equal to the interpolated terminal reserve value of the policies on the date of the transfer, plus the unexpired premiums, and less any outstanding indebtedness on the contract.

The Service ruled that the transfers were “transfers for a valuable consideration,” as defined in Section 1.101-1(b)(4) of the regulations, but that it was exempt from taxation under the transfer-for-value rule, because the transferee was a trust deemed owned by the grantor's spouse. The IRS ruled that the spouse would be deemed to own the assets owned by the trust, under the grantor trust rules. 155.1 Therefore, a transfer of the policy owned by Trust 1 to Trust 3 would be deemed to be a transfer of the policy by H to W. The IRS stated:

Under § 1041(b)(1) of the Code, W, for federal income tax purposes, is treated as acquiring W's interest in Policy Y2 by gift, and not for value. Therefore, the “transfer-for-value” rule of § 101(a)(2) does not apply to the transfer of Trust 2's interest in Policy Y2 to Trust 4. Accordingly, the transfer of Trust 2's interest in Policy Y2 to Trust 4, will not affect the application of § 101(a)(1) of the Code to amounts that the beneficiaries of Policy Y2 will receive upon the deaths of H and W. 155.2

¶ 2.07[3][a][iii] Shoes-of-the-transferor rule.

Once a policy is tainted by the transfer-for-value rule, a subsequent transfer to a transferor's basis category of transferee will not by itself wash away the taint. The taint is carried over. The policy remains subject to the transfer-for-value rule, since the gratuitous transferee stands in the shoes of the transferor. 156

Example  2-36

XYZ Corporation transfers an insurance policy to Sam, one of its three shareholders. The policy is on the life of Insured, one of the other shareholders. Sam agrees to pay XYZ an amount equal to the policy's value at the time of transfer. Also suppose that Sam, the new policy owner, then gives the policy on Insured's life to Sam's wife, Wanda. This last transfer is a gift for “love and affection” and no consideration changes hands. Although a transfer of a policy on Sam's life to Wanda would have been protected from the transfer-for-value rule, the transfer of the policy on Insured's life is tainted. The subsequent transfer to Sam's wife does not cleanse the taint. She stands in the shoes of her husband, who was a transferee for value.

To remove the taint and to free the policy proceeds from the transfer-for-value rule, the transferor must make the final transfer to one of the exempt parties to whom a protected transfer may always be made, such as the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or an officer. Then, that party could make an untainted gift, and the proceeds would be income tax free.

¶ 2.07[3][a][iv] Last-transfer rule.

As mentioned previously, when a policy is transferred by gift, the proceeds may be received income tax free up to the sum of the amount that would have been excludable by the party making the transfer had no transfer taken place (considering the status existing at the last transfer), plus any premiums and other amounts paid after the transfer by the transferee. 157

Example  2-37

Wife applies for and names herself as owner of a $1 million policy on the life of Husband and then makes an absolute assignment of the policy to Son, as a gift. Since the policy is transferred gratuitously, the maximum tax-free amount the Son can receive is $1 million (the same amount the transferor, Wife, could have received tax free had the transfer not taken place) plus any premiums and other amounts (such as repayment of policy loans) he pays after the transfer.

If the last transfer prior to the insured's death was a gift but there were other prior transfers for value, the last owner's basis is determined in whole or in part by reference to the prior owner's basis, and the income tax exclusion is limited to the sum of the amount that the transferor could have excluded had no transfer taken place, plus any premiums and other amounts paid by the final transferee.

Example  2-38

Adam buys a policy on his own life and pays $500 in premiums. Adam then sells the policy to Betty, his sister, for $600. Betty then gives the policy to Charlie, her son. At Adam's death, Charlie, the final transferee, can exclude from gross income whatever amount his mother could have received tax free had she not made a transfer to him. Here, the tax-free amount is the $600 consideration she paid plus (1) premiums his mother paid after she received the policy and (2) any consideration and premiums he paid. 158

If the last transfer was for valuable consideration, only the actual consideration paid by that transferee (plus premiums and other amounts paid after the transfer) is excludable from the beneficiary's gross income.

Example  2-39

Insured buys a $500,000 policy on his own life and then gives it to Daughter. At this point, the proceeds are income tax free. Daughter, however, later sells the policy to Son, her brother. Son must report the entire $500,000 (less the amount he paid for the policy and any premiums he later paid) as ordinary income when Insured dies.

If the last transfer of an untainted policy was a gift (or a part-sale/part-gift), where the donee's basis is determined at least in part by reference to the donor's basis (which may not always be the case in a part-sale/part-gift situation), 159 the final transferee will be able to exclude the entire amount of the proceeds.

Example  2-40

Insured gives the policy on his life to Daughter, who in turn gives it to Wife, her mother. Wife's basis is determined by a carryover of Daughter's basis, which, in turn, is carried over from (and therefore determined by reference to) Insured's basis. Thus, the entire proceeds are excludable from the beneficiary's income when Insured dies. The same result will occur if Daughter sells the policy to Wife but receives payment that in total (including Wife's assumption of any loans to which the policy is subjected) is less than Daughter's basis.

Certainly, when an insured's family member buys an existing policy on the life of the insured from a corporation controlled by the insured, there is a transfer-for-value and the proceeds lose their income tax free status. However, there may be a way to plan such a transaction that will avoid ordinary income tax treatment.

In Private Letter Ruling 8906034, a corporation owned and was the beneficiary of a life insurance policy on the life of the company's 75 percent owner. His son, who worked in the business, owned 4 percent of the stock. The remaining stock was owned by the insured's five other children, who were not active in the business. Pursuant to a buy-sell agreement, the following transactions occurred. First, the company transferred the insurance, which was being used to fund a stock-redemption plan, to the insured father for an amount equal to the policy's value as of the date of the transfer. Second, the insured then made a gift of the policy to his son simultaneous with the son's promise (1) to keep the policy in force; (2) to use the proceeds to purchase his father's stock at his death; and (3) to make up any shortfall between purchase price and the proceeds through negotiable promissory notes to his father's estate.

The Service ruled privately that when the final transfer in a series of transfers is “for a valuable consideration, then the transferee can exclude from income the amount of proceeds that the transferor could have excluded (if no transfer had taken place), provided that the transferee's basis is determined by reference to the basis of the transferor.” Therefore, assuming the transfer from the father to the son was a gift as defined for income tax purposes, the son could exclude the same 100 percent amount of proceeds that would have been tax exempt had his father been able to receive the proceeds, since his basis was the same as his father's basis immediately before the gift.

Arguably, this shows a safe way to do indirectly that which could not be done directly. However, it is important to note the precondition of this choice: The transfer from father to son was in fact a gift, defined for income tax purposes as a transfer that is the result of a “detached and disinterested generosity.” 160 The Service could easily argue that, in fact, the transfer was made to assure a market for the father's stock and to provide cash for the father's estate and did not result from mere “love and affection.”

If the last transfer was to one of the four “protected parties,” the exempt transferee will be able to exclude the entire amount of the proceeds from gross income.

Example  2-41

Insured gives a policy of insurance on his life to Daughter, and she sells it to Son, her brother, who then sells it to ABC Corporation (in which Insured is a shareholder or officer). ABC Corporation will receive the proceeds income tax free.

Example  2-42

Corporation X owns and is beneficiary of a policy on the life of Alice, an employee. As part of a tax-free reorganization, X transfers the policy to another corporation, Y. Y then sells the policy to Corporation Z for $600. Z then transfers the policy to Corporation M in a second tax-free reorganization. Alice owns some of the stock of M. The entire proceeds are received on A's death income tax free by M . The entire proceeds are excludable, since the final transfer is to one of the four “proper parties,” a corporation in which the insured is a shareholder or officer. 161

¶ 2.07[3][b] Transfers to the Insured

Under Section 101(a)(2)(B), a transfer of a policy to the insured is never taxable under the transfer-for-value rule, regardless of whether consideration is paid by the insured and, further, regardless of the form of consideration. 162

Example  2-43

Insured buys a five-year-old $600,000 policy on his life from his brother-in-law for $8,000. Even though there is a transfer from the brother-in-law for valuable consideration, there will be no income tax under the transfer-for-value rule, since the transfer is to the insured.

Example  2-44

Adam buys a policy on his own life and pays $500 in premiums. He then transfers the policy to Betty, his wife, for $600. She then transfers the policy to Carol, her daughter, for $200. Carol then makes a gift of the policy to Adam, her father. Adam names his estate as policy beneficiary. The proceeds are entirely excludable from income tax. 163

The Service has ruled that a transfer to a grantor trust deemed owned by the insured is a transfer to the insured for purposes of the transfer-for-value rule of Section 101. In Private Letter Ruling 200120007 (Feb. 2, 2001), the insured, H, created an irrevocable trust (Trust 1), naming two of his children and an unrelated party as co-trustees. The trust assets will be divided among H's descendants after his death. The trust instrument allows the trustee to buy insurance on the lives of H and H's wife, W, and the trust bought two second-to-die policies insuring the lives of H and W (Policies X and Y), and a small amount of cash. The trust was a grantor trust under Section 677(a)(3), because of the ownership of insurance and the ability of the trustees to buy policies on the life of H.

The policies were subject to split-dollar arrangements with a corporation of which H and W were employees. Each trust pays a portion of the premium equal to the cost of the term insurance protection, and the corporation pays the premiums in excess of that amount. On the death of the survivor of the two insureds, the corporation will receive from the proceeds the amount of premiums it has paid, and the trustees will receive the balance.

H then created Trust 3, naming a bank as trustee. The beneficiaries of the two trusts are the same as the beneficiaries of the first two trusts, though their relative interests are slightly different. Trust 3 is a grantor trust deemed owned by H for federal income tax purposes, under Section 677(a)(3). H and W proposed that Trust 1 would borrow against its policies to reduce their values, and then sell the policies to Trust 3 for cash in an amount equal to the interpolated terminal reserve value of the policies on the date of the transfer, plus the unexpired premiums, and less any outstanding indebtedness on the contract.

The Service ruled that the transfers were “transfers for a valuable consideration,” as defined in Section 1.101-1(b)(4) of the regulations, but that it was exempt from taxation under the transfer-for-value rule, because the transferee was a grantor trust deemed owned by the insured, and because the transferee was a partner in a partnership in which the insured was also a partner. The IRS noted that the taxpayers had represented that both Trusts 1 and 3 are grantor trusts owned by H for federal income tax purposes. Thus, H was treated for federal income tax purposes as the owner of all of the assets of Trusts 1 and 3. Therefore, the “transfer” of Trust 1's interest in its policy to Trust 3 was disregarded for federal income tax purposes, and will not affect the application of Section 101(a)(1) to amounts that the beneficiaries of the policy held by Trust 1 would receive on the deaths of H and W . 163.1

This ruling should be contrasted with the IRS litigation position in Swanson, Jr. Trust v. Commissioner . 163.2 In Swanson, Jr. Trust, the Tax Court and Eighth Circuit both found that a sale of a life insurance policy to a grantor trust owned by the insured was exempt from the transfer-for-value rules. In the action on decision by which the IRS explained why it recommended not asking for certiorari in Swanson, Jr. Trust, the IRS indicated that it still did not agree with the reasoning or holding of the Tax Court or the Eighth Circuit. 163.3 The IRS stated:

The Eighth Circuit erred in holding that the trusts as grantor-trusts did not retain their identity as separate tax entities under Section 101(a)(2)(B).

The fact that the grantor by virtue of powers to control the beneficial enjoyment is taxed on the income of the trusts under Section 674 merely provides that a grantor who retains powers to control beneficial enjoyment is taxed on income. A contrary holding of the Eighth Circuit by looking to a statute whose only function is to prevent tax avoidance (Section 674) in effect broadens the scope of the second statute (Section 101) whose only function is to exclude from income what would be taxable under ordinary principles. It views a statute designed to affect the liability of a particular taxpayer during his lifetime (Section 674) as a gloss on another statute (Section 101) which by its term goes into play only after the death of that same taxpayer.

Apparently, this analysis no longer represents the position of the IRS.

In Private Letter Ruling 200247006, 163.4 the IRS examined the application of the transfer-for-value rule with respect to transfers of a single life policy and a survivorship contract. H and W, a married couple, created two sets of grantor trusts. The first set of grantor trusts, Old H Trust and New H Trust, was created by H. Old H trust contains a single life policy on H's life. The second set of grantor trusts, Old Couple Trust and New Couple Trust, were created by H and W Old Couple Trust contains life insurance covering the joint lives of = H and W.

H and W wanted to have the new trusts, in both cases, buy the policies from the old trusts. The life insurance on H's life will be transferred from the trustees of Old H Trust to the trustees of New H Trust. The survivorship life insurance on the couple's lives will be transferred from the trustees of Old Couple's Trust to New Couple's Trust.

The IRS stated that the transfers are “disregarded” as non-events for income tax purposes. The grantor considered owner of the entire trust under the grantor trust rules is considered to be the owner of the trust assets for federal income tax purposes—the trust is considered the alter ego of the grantor. Thus, the IRS treated the sale by one grantor trust to another grantor trust as if the grantor had switched an asset from one tax pocket to another, for income tax purposes.

The IRS also noted that intraspousal transfers are treated as gifts for income tax purposes, under Section 1041(a)(1). Thus, no gain or loss is recognized on a transfer of property from an individual to his or her spouse.

Here, for income tax purposes, the IRS considered H as the owner of all of the assets of both the Old and New H trusts. Likewise, the IRS considered H and W the owners of all of the assets of both the Old and the New Couple's trusts. Therefore, the IRS stated that the proposed transfers of life insurance contracts, even though for valuable consideration, were non-events for federal income tax purposes, and for that reason, the transfer-for-value rule will not apply.

¶ 2.07[3][c] Transfers to a Partner of the Insured

Under Section 101(a)(2)(B), a transfer of a policy to a partner of the insured is not a transfer for value. This exception would apply where, for instance, three individuals are partners in a real estate development partnership, and one partner owns a policy on another's life. If the third partner buys the policy from the initial owner, there has been a transfer for value. However, since the transfer is to a partner of the insured, the proceeds are received income tax free.

Nothing in this exception suggests that the transferee-partner must own much of an interest in the partnership in order for the proceeds to escape income taxation, as long as he or she has a legitimate share of a legitimate partnership. In Private Letter Ruling 9045004, for example, a one percent interest was sufficient to fall within the safe-harbor protection.

Furthermore, neither the Code nor the Regulations even suggest that the life insurance policy need have any connection with the partnership. Thus, a policy purchased by a partner on the life of another partner for reasons wholly unrelated to their partnership relationship should still be insulated from the transfer-for-value rule.

Example  2-45

Oscar is an employee of Insured. Oscar buys from Insured a policy of insurance on Insured's life to provide some measure of protection for Oscar in case Insured dies and in case the company that Insured owns and that employs Oscar should change hands or be dissolved. Normally, this would be a transfer for value, and Oscar would receive any proceeds on the policy on Insured as ordinary income. However, suppose that Oscar and Insured are also partners in a real estate investment partnership. Under Section 101(a)(2), the proceeds are now insulated from the transfer-for-value rule and will be tax exempt when received by Oscar.

This liberal view of the safe-harbor exception for transfers to a partner of the insured was reflected in several recent private rulings. In Private Letter Ruling 9235029 , a life insurance policy was sold to an irrevocable trust that was a partner with the insured in a preexisting family partnership. The policy was one of several whole life insurance policies owned by a corporation on the life of one of its stockholders. The insured created a new irrevocable trust to buy the policy from the corporation. The beneficiaries of the trust were the insured's two sons. The trust, the insured, and one of the two sons were also partners in a pre-existing partnership formed in 1972. Without considering the fact that the trust had only recently been formed or that the partnership had no connection with the purpose for which the insurance was obtained, the Service simply ruled that the safe-harbor exception of Section 101(a)(2)(B) for a transfer to a partner of the insured applied to this situation. 164

In Private Letter Ruling 9239033, a corporation owned a term life insurance policy insuring one of its two stockholders, A. A , the other stockholder, B, and the corporation were also general partners of a partnership. To implement a new buy-sell agreement, B proposed to buy from the corporation the policy insuring A 's life for its interpolated terminal reserve, which, in this case, was the unexpired portion of the most recent premium. The policy would then be owned by B and B's spouse as community property. B would then name himself as beneficiary, and pay all subsequent premiums. The Service ruled that while B would be acquiring the policy in a transfer for value (his transfer of cash to the corporation), the proceeds would not be taxable because B is a partner of A, the insured, under Section 101(a)(2)(B). 165

The Service did, however, include in Private Letter Ruling 9239033 a caveat that it was expressing no opinion “as to whether the Partnership qualifies as a partnership for federal income tax purposes under section 761.” This indicates that whether a particular entity is a valid partnership for purposes of Section 101(b) will be based on the tax rules of Section 761 , rather than state partnership law. In this regard, the legislative history of Section 761 indicates that the term “partnership” in the income tax law is far broader than the same term in state law. 166

Furthermore, the regulations under Section 761 indicate that a partnership for income tax purposes need not be formed or operated to conduct an active business. The regulations make it clear that “financial operations” and “ventures” constitute partnerships, as long as there is a division of the profits. 167 Furthermore, the regulations under Section 761 permit an investment partnership to elect not to be taxed as a partnership for income tax purposes, necessarily implying that in the absence of such an election, an investment partnership is a partnership for income tax purposes. 168

In Private Letter Ruling 9328012, a group of stockholders successfully used this exception from the transfer-for-value rule to convert an insurance-funded corporate redemption buy-sell agreement into an insurance-funded, trusteed cross-purchase buy-sell agreement. The five individuals owned all of the stock of Corporation and all of the interests in Partnership, neither of which was created solely for the purposes of effecting this transaction. 169

To convert from a redemption agreement to a cross-purchase agreement, Corporation assigned the policies it held on the lives of the five stockholders to Partnership, in part payment of annual rent due Partnership from Corporation for the use of certain assets held by Partnership. Partnership then transferred the policies to the five partners in a manner that the policies on the life of each partner would be jointly held by the other four partners. Thus, for example, Partnership transferred the policy on the life of A to B, C, D, and E, in equal shares.

The partners then assigned each of the jointly owned policies to an irrevocable life insurance trust (one trust was created for each of the five sets of four partners). The four grantors of each trust owned the trust under Section 671 and were the trust's sole beneficiaries. On the death of any Partner, the trust agreements directed the trustee to distribute the proceeds to the beneficiaries, for use to pay the estate of the deceased Partner for the value of his or her interest in Partnership and his or her shares in Corporation. Furthermore, on a Partner's death, the interest of his or her estate in the remaining trusts will be sold to the surviving Partners.

For example, on the death of A, the Trustee of Trust 1 distributes the proceeds from the insurance policy on A's life in equal shares to the beneficiaries of Trust 1, partners B, C , D, and E. Partners B, C, D , and E then use the proceeds to pay the estate of A for the value of A's interest in Partnership and shares in Corporation. Additionally, all of A's interests in Trusts B , C, D, and E are transferred to B , C, D, and E, pursuant to the terms of each trust agreement. In exchange, the estate of Partner A will receive a cash payment equal to the value of those interests.

The Service ruled that the transfer-for-value rule did not apply to the transfers by Corporation to Partnership and by Partnership to the Partners. The Service noted that, with respect to the transfers by Corporation to Partnership and by Partnership to its Partners, Regulation Section 1.101-1(b)(3)(ii) provided that because the last transfer of the policies was to a partner of the insured, the exclusion from income of the life insurance proceeds provided by Section 101(a)(1) applied to the series of transfers.

The Service also ruled that the transfer of the policies by the grantors to trusts owned by them under Section 671 did not change the beneficial ownership of the policies. Thus, the Partners who owned the policies prior to transfer to the Trusts continued to own them after the transfer. Thus, the final transfer in the series of transfers by which the trusts acquired the interests were treated as transfers to a partner of the insureds, and exempt from the transfer-for-value rule. 170

In Private Letter Ruling 9347016, the Service ruled that a transfer of a policy from a corporation to shareholders who are also partners falls within a safe harbor from the transfer-for-value rule. In this ruling, two brothers and their father own the stock of a closely held corporation and were equal general partners in a partnership that bought and held investments and business ventures. The corporation owned policies on the lives of all three owners.

The parties proposed to transfer the policy on the father's life to the two sons as co-owners in return for the policy's cash value at the time of the transfer, in order to facilitate a proposed cross-purchase agreement among the shareholders. The policies on each brother's life would be transferred to the other brother for its value at the date of transfer. The Service held the transfers fell within the “transfers to a partner” exception to the transfer-for-value rule.

This ruling reiterates that as long as the transferees are partners, neither the nature of the partnership nor its relationship to the corporation is relevant. Planners must note that if the purchasing partners paid merely the policy's cash value as consideration (which is what the ruling implied), the difference between the policy's interpolated terminal reserve and unearned premium and the cash value is a bargain price that translates into a taxable (dividend) distribution from the corporation to its shareholders. Furthermore, if the proposed cross-purchase arrangement contains a restriction on the use of each policy without the insured's consent or a right of the insured to veto a proposed transfer or policy substitution, such a right could be considered an incident of ownership and cause estate tax inclusion. 171

In Private Letter Rulings 9625013 through 9625019, involving life insurance purchased under a split-dollar arrangement, the Service stated that a limited liability company (LLC) that qualified for partnership status would be treated as a partnership, and its members as partners, for purposes of the safe-harbor exceptions from the transfer-for-value rules. The rulings involved employee-shareholders who were also partners in a general partnership that owned a building used by the corporation that employed them. The shareholders proposed to convert the general partnership into an LLC. Thereafter, they would enter into a buy-sell agreement relating to the stock of their corporate employer. They also created a trust to hold their stock and to buy those shares when an employee died or terminated his or her employment. The trust also held the life insurance policies that would provide the funds for a purchase at the death of an employee. The Service ruled that the LLC was taxable as a partnership, and the members would be treated as partners for purposes of the exceptions to the transfer-for-value rule. Therefore, the proceeds, when received by the trust, would be tax exempt. 172

The Service has also ruled, in Revenue Procedure 96-12, 173 that it will not issue advance rulings on whether or not a partnership, an LLC, or a limited liability partnership (LLP) holding life insurance on the life of one or more of its partners (or members in the case of an LLP) will be treated as a partnership for income tax purposes. It also will not rule on whether the transfer of life insurance to a partnership falls within a safe-harbor exception to the transfer-for-value rule. Consequently, one cannot be certain if the exceptions for transfers to a partner of the insured (or the exception for transfers to a partnership in which the insured is a partner) will apply where “substantially all of the organization's assets consist or will consist of life insurance on the lives of members.”

The issue of partnership tax status may be simplified by regulations that enable the entity to choose partnership or corporate taxation by merely “checking a box.” This “check the box” procedure eliminates the artificial machinations often used to assure the desired entity classification and should increase the probability of favorable tax treatment. 174

In Private Letter Ruling 9701026, the transfer-to-a-partner exception prevented what otherwise could have been a serious tax problem. Three shareholders, B1, B2, and B3 owned equal shares in a corporation. A collaterally assigned reverse split-dollar life insurance contract owned by that corporation on the life of B3 was transferred by the corporation to shareholders B1 and B2 to finance their obligations under a trusteed cross-purchase buy-sell agreement. All three shareholders were also equal partners in a business that owned, operated, and leased a building to their professional corporation, a law firm.

Before the transfer, premiums for the transferred policy were split. The corporation owned all incidents of ownership and paid for the cost of the death benefit. Shareholder B3 paid the remaining portion of the premium and in return was named recipient of the proceeds, up to the greater of the policy's cash value or the total premiums he paid. The balance of any proceeds were to be paid to B3's heirs. B3 owned the policy's cash value but the corporation held all other incidents of ownership.

The shareholders proposed to enter into a trusteed cross-purchase buy-sell to fund the buy-out of a deceased shareholder and use life insurance to meet their obligations under the arrangement. They proposed to have the corporation transfer the existing reverse split-dollar policy it owns on B3's life to shareholders B1 and B2 and to make the proceeds (less the cash value portion) payable to a trust that would carry out the stock purchase at B3's death. They proposed to sign a private reverse split-dollar agreement with B3 similar to the one presently existing. Under this arrangement, B1 and B2 would pay the death benefit portion of the premiums and B3 would continue to pay (and own) the cash value portion.

The Service stated that there was a transfer of a policy because of the absolute transfer of a right to receive at least a portion of the proceeds of a life insurance policy. There was also valuable consideration paid for that transfer in the form of the corporation's release from the obligation to pay premiums. The Service reiterated that no purchase price need be paid nor need money change hands for consideration to be found. However, because the transferees, shareholders B1 and B2, were partners of the insured, the exception to the transfer-for-value rule applied.

The Service took particular note of the taxpayers' representation that if the building owned by the partnership in the ruling were sold, the partners would use the proceeds to purchase other investment or business property to continue the firm's operations. This supported the view that the partnership was a bona fide entity that served purposes other than the retention of the life insurance.

In Private Letter Ruling 9727024, the principal assets of the partnership are land and an office building, which the partnership leased to two corporations. Two of the partners are shareholders in one of the corporations. All three partners own stock in the other corporation. The shareholders created a buy-sell agreement and funded it with life insurance. The agreements require each shareholder to hold insurance on the other two. If the son or daughter dies first, the survivor of the two has an option to buy the policy that the deceased owner held on the father. When the son or daughter dies, the survivor is to buy the policy held on them by the deceased. The son and daughter jointly own the policies on their father's life but each individually owns policies on the other sibling's life.

The Service stated that because the partnership qualified as a partnership for federal tax purposes, the proposed life insurance transfers will fall within safe-harbor exceptions to the transfer-for-value rule. Thus, if the surviving son or daughter buys a policy that the deceased held on their father's life, the transfer will be considered a transfer between partners. If the survivor of the two purchases a policy on his or her own life, it will fall within the safe harbor for transfers to the insured. Even though there is a transfer of a life insurance policy in return for valuable consideration, the proceeds will retain their income tax free status.

In Private Letter Ruling 9701026, the Service stated that the entry into a split-dollar arrangement was a transfer for value, but that because the shareholders were also partners in a valid partnership, the exception to the transfer-for-value rule applied. Three shareholders, B1, B2, and B3, owned equal shares in a corporation. A collaterally assigned reverse split-dollar life insurance contract owned by that corporation on the life of B3 was transferred by the corporation to shareholders B1 and B2 to finance their obligations under a trusteed cross-purchase buy-sell agreement. All three shareholders were also equal partners in a business that owned, operated, and leased a building to their professional corporation, a law firm.

The Service stated that there was a transfer of the absolute transfer of a right to receive at least a portion of the proceeds of a life insurance policy. There was also valuable consideration paid for that transfer in the form of the corporation's release from the obligation to pay premiums. The Service reiterated that no purchase price need be paid nor money need change hands for consideration to be found. However, because the transferees, shareholders B1 and B2, were partners of the insured, the exception to the transfer-for-value rule applied. The Service took particular note of the taxpayers' representation that if the building owned by the partnership in the ruling were sold, the partners would use the proceeds to purchase other investment or business property to continue the firm's operations. This supported the view that the partnership was a bona fide entity that served purposes other than the retention of the life insurance.

In Private Letter Ruling 199903020, the Service ruled that reciprocal promises of trust beneficiaries to pay future premiums were valuable consideration for a transfer of a life insurance policy. In the ruling, a couple created an irrevocable life insurance trust to which they then made cash gifts to pay premiums on a second-to-die life insurance purchased by the trust on their lives. The couple then decided that they wished to discontinue their contributions to that trust. This would have made it impossible for the trustee to continue to pay premiums on the life insurance, because the trust lacked sufficient other assets from which to pay the premiums.

The couple’s children decided that they wanted to buy and continue to maintain the policies personally. They entered into an agreement by which they would buy a right to a portion of the insurance proceeds payable when the surviving insured died. The balance of the proceeds would be paid to the trust. The ratio of the children’s benefit and that of the trust would be determined by the ratio that the policy’s cash surrender value on a specified date bears to the cash surrender value on the day immediately preceding the death of the surviving insured. Essentially, this provided that the children would receive two thirds of the proceeds.

All of the children and their parents are treated as the owners (for income tax purposes only) of a number of other grantor trusts that hold significant interests in several partnerships. The children argued that they were deemed, therefore, to own the partnership interests held by their trusts, and that they were, therefore, entitled to the protection of the statutory exception to the transfer-for-value rule afforded partners of the insured.

The Service ruled that there was clearly a transfer of an interest in the policy to the children, through their split-ownership agreement with the trust. The Service also ruled that the children’s promise to pay premiums in the future was a valuable consideration for the policy. The Service, relying on Monroe v. Patterson, stated that because of the children’s premium payments, the irrevocable trust will continue to have insurance on the grantors’ lives (by agreement, the amount passing to the trust decreases as the proportion of premiums paid by the children increases), and that this was clearly consideration in money or money’s worth.

The Service also ruled, however, that the transaction fell within the safe-harbor exception to the transfer-for-value rule since the children are partners of the insured. The Service deemed the children to own the partnership interests held by the grantor trusts. While the Service did not so state, it may have been important that the partnerships in question were not created merely to shield the transaction from the transfer-for-value rule. Specifically, the taxpayer represented that the partnerships were recognized as partnerships under state law, that they had filed their income tax returns as partnerships under federal income tax law, that they intended to continue to do so at least through and including the year in which the proposed transaction is consummated, that they were legitimate operating entities with a business purpose (real estate leasing), and that they held no life insurance and do not intend to do so. It is also important that both state law and the trust instruments allowed the parties to enter into this premium/death benefit–splitting transaction.

An equally favorable result occurred in Private Letter Ruling 199905010, in which A was an employee and the majority shareholder of Corporation. A gave stock of Corporation to A’s children, C and D. Corporation owned an adjustable whole life insurance policy on A’s life, of which Corporation is designated the beneficiary. Corporation no longer needs this contract and wishes to sell it to C and D, who want to buy the policy, believing that it would be a good investment.

A and A’s spouse, B, are also general partners and limited partners in Partnership, which was previously created to engage in investment activities. The agreement for Partnership requires that profits and losses and distributions of cash must be allocated among the partners in proportion to their respective capital contributions. Partnership has a certain level of investment assets and will dissolve and wind up its business by a certain date.

A proposed to give portions of his limited partnership interest in Partnership to C and D in the current year, and to continue giving partnership interests to C and D over the next two to three years. B will gift-split under Section 2013. A also intends to give more of the stock of Corporation to C and D. C and D propose to buy the life insurance contract for the greater of its interpolated terminal reserve value or its cash value, giving Corporation a demand note in the amount of the purchase price of the life insurance contract. Simultaneously, C and D will borrow funds from the commercial insurance carrier that issued the life insurance policy, and use the borrowed funds to pay for the demand note. Corporation will have no security interest in the life insurance contract after closing. The death benefit under the life insurance contract will be reduced by any unpaid loan amount.

The Service followed an analysis similar to that undertaken in Private Letter Ruling 199903020, and ruled that the sale of the policy from Corporation to C and D was a transfer for valuable consideration, but that because C and D were legitimate partners of a partnership in which A was also a partner, the transfer-for-value rules did not apply.

The Service also ruled that a transfer to a trust that owns an interest in an LLC taxable as a partnership, in which the insureds are also members, would be exempt from the transfer-for-value rule under Section 101. In Private Letter Ruling 200120007 (Feb. 2, 2001), H and W created a series of irrevocable life insurance trusts, each of which was deemed owned by its grantor because of the trustee's power to use principal and income to pay premiums on policies insuring the life of the grantor. Each trust owned one or more policies on the life of its grantor and the grantor's spouse.

Several of the policies were owned by a trust subject to split-dollar arrangements with a corporation of which H and W were employees. Each trust pays a portion of the premium equal to the cost of the term insurance protection, and the corporation pays the premiums in excess of that amount. On the death of the survivor of the two insureds, the corporation will receive from the proceeds the amount of premiums it has paid, and the trustees will receive the balance.

H and W then created Trust 5, naming a bank and one of their children as trustees. The assets of Trust 5 are cash and an interest in an LLC. Trust 5 is not treated as a grantor trust for federal income tax purposes, and the LLC is taxed as a partnership for federal income tax purposes.

H transferred a portion of his LLC interest to Trust 3, which he had created, and W transferred a portion of her LLC interest to Trust 4, which she had created. The current members of LLC are H, W, Trust 3, Trust 4, and Trust 5. H and W proposed, in part, that Trusts 3 and 4 would borrow against their policies to reduce their values, and then sell the policies to Trust 5 for cash in an amount equal to the interpolated terminal reserve value of the policies on the date of the transfer, plus the unexpired premiums, and less any outstanding indebtedness on the contract.

The Service ruled that the transfers were “transfers for a valuable consideration,” as defined in Section 1.101-1(b)(4) of the regulations, but that they were exempt from taxation under the transfer-for-value rule, because the transferee trust was a partner in a partnership (the LLC) in which the insureds were also partners.

¶ 2.07[3][d] Transfers to a Partnership in Which the Insured Is a Partner

Under Section 101(a)(2)(B), a transfer of a policy to a partnership in which the insured is a partner falls within a safe harbor to the transfer-for-value rule. This protection would apply, for example, if one partner who owns a policy of insurance on the life of another partner sells the policy to the partnership itself, perhaps to finance a future buyout. The transfer is made for value, but it would be excepted from the transfer-for-value rule because it was made to the insured's partnership. 175

An individual cannot establish a partnership with no purpose or function except to avoid the sting of the transfer-for-value rule. While there are no cases or rulings directly on point, in the authors' opinion, it is not wise to form a partnership with the sole purpose of avoiding the transfer-for-value trap. If it should be considered a sham transaction, it would afford no protection against the transfer-for-value rule. We suggest the entity operate as a partnership for reasons in addition to avoiding the transfer-for-value rule. Clearly, the partnership must not exist in form only. 176

It is sometimes difficult to determine when a partnership exists in form only and when it should be recognized for tax purposes under Sections 761 and 7701. In Swanson, Jr. Trust v. Commissioner, 177 the grantor's mother created certain trusts and transferred stock to the grantor as trustee for each of his three children. Thereafter, the grantor made further contributions to himself as trustee under the three trusts. The trust then became a partner in the partnership, which by its documentation was organized to engage in the business of building and operating rental properties. The trusts contributed life insurance policies. The grantor died and the Service contended that the insurance proceeds were ordinary income to the trust. The Tax Court and the Eighth Circuit both held that the parties never actually operated “as a viable partnership,” and that the grantor was not a partner of the trust. The Tax Court noted that the partnership was validly organized under state law, that there was a written partnership agreement and a bank account in the name of the partnership, and that these were clearly factors in favor of a finding that a valid partnership existed for tax purposes.

However, the court was more convinced by the contrary evidence. In particular, the court noted that the real estate that the parties said was held by the partnership for development was actually held by two of the partnerships individually. The court did note that the agreements with the building contractor were in the name of the partnership and signed by two of the individuals as partners and by the trustee of the trust partners. The two contractors testified that it was their understanding that they were dealing with the individuals in their capacities as representatives of the two partnerships.

The court noted that the dealings with the institutions providing the financing for the development evidenced a belief by those institutions that the construction was originally to be undertaken by a partnership, but that it was ultimately taken under individual ownership. The Tax Court concluded that

[t]he totality of the evidence in this case indicates that the parties did not intend to nor did they actually operate the W. Clarke Family Partnership as a viable partnership. It also indicates that W. Clarke never became a partner by virtue of his failure to contribute any property to the organization. Therefore, the transfer of the life insurance policies to the Swanson Trusts for value was not made to a partnership in which the insured (W. Clarke) is a partner nor to a partner of the insured.

It is unclear, however, what is required for a partnership to have sufficient substance to afford protection from the transfer-for-value rule and the impact of the “check the box” regulations. We suggest that the entity must first be a partnership, as defined in Section 7701. Thus, it must be a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which a business, financial operation, or venture is carried on and that meets state law requirements for a partnership. 178

Even after having established a valid partnership, Section 101(a)(2) will not protect a policy's owner from income taxation on the insurance proceeds if the partnership is deemed a sham. To be sure of the safe-harbor protection, a partnership in which the insured and the owner are both partners should have some business or investment purpose and activity, or some other assets or enterprise.

Private Letter Ruling 9309021 , 179 furthermore, suggests that a partnership, the sole business purpose of which is to “maintain ownership rights in certain transferred policies and manage a portfolio of insurance policies,” is still considered a partnership for purposes of the transfer-for-value safe-harbor exception. The ruling involved two shareholders of a corporation that owned a policy on each shareholder's life. Proceeds of the policies were to be used to fund the corporation's obligations under a buy-sell agreement. To avoid the AMT on proceeds received at the corporate level, the two shareholders formed a partnership and had the corporation sell the policies to the partnership in return for their replacement values (interpolated terminal reserve plus unearned premium). After the transfers, the partnership would own and name itself beneficiary of the policies and pay all future premiums. The intent was that the insurance would still be used to finance the corporate buy-sell should either shareholder die. In other words, the insurance would fund a corporate stock buy-out through the partnership rather than the corporation. The avowed purpose of the partnership was to engage in the purchase and acquisition of life insurance policies on the lives of its partners and manage a portfolio of insurance policies.

The Service said that the entity that held the policies was still a partnership under state law, and that even if the only reason for the partnership's existence was to hold and manage life insurance policies transferred to it, the entity will be accepted as a partnership.

Planners should keep in mind that this is only a private letter ruling and provides no assurance to anyone other than the taxpayer to whom it was issued and even to that party it provides protection only in the specific set of facts it covers and for the issues discussed. If at all possible, the authors recommend that a legitimate business or investment purpose other than the mere holding and management of life insurance policies be employed.

If the Service continues to accept the position espoused in the ruling, the Service indicated that at the death of a partner, the life insurance proceeds would first be reflected in each partner's distributive share as tax-exempt income. Next, the partner's basis in each respective partnership interest will increase in relation to his or her distributive share of tax-exempt income. Finally, the distributions from the partnership to a partner will be nontaxable to the extent the money distributed does not exceed the adjusted basis of the partner's interest in the partnership immediately prior to the distribution. In other words, the life insurance proceeds will be income tax free to the surviving partner to the extent that the distribution does not exceed the survivor's adjusted basis immediately before the distribution. If a partner's basis in his or her interest would otherwise be too low to take advantage of this treatment, it may be advisable to obtain a short-term loan from a bank or other third party, borrowing sufficient money to pay for the decedent's stock, contribute this money to the partnership, increase basis, and then take the life insurance proceeds from the partnership. 180

This ruling, however, still leaves some unanswered questions and lingering doubts. While the ruling suggests that a partnership, the sole purpose of which is to “maintain ownership rights in certain transferred policies and manage a portfolio of insurance policies,” should be considered a partnership for purposes of the transfer-for-value safe-harbor exception, caution is still suggested.

Furthermore, there is an unstated, but potentially serious estate tax problem in this technique. Under the facts of the ruling, the death proceeds will be received by the partnership that owns the policies. Those proceeds will then be distributed to the surviving partners, who will use the money to buy stock from the estate of the decedent shareholder/partner. It is quite possible that both the value of the stock interest and the value of the decedent's partnership interest will be included in his gross estate. In other words, without care, the deceased partner's share of the death proceeds will be included in ascertaining the value of his partnership interest and result in double taxation to the extent the decedent's estate is taxed on the value of part of the insurance proceeds used to purchase his stock. 181

The Service will no longer rule on whether or not a partnership (or LLC or LLP) holding life insurance on the life of one or more of its partners (or members in the case of an LLC) will be treated as a partnership for income tax purposes. 182 The Service also will not rule on whether the transfer of life insurance to a partnership falls within a safe harbor to the transfer-for-value rule. The Service states that it will no longer issue advance rulings on the status of an LLC or partnership substantially all of the assets of which are life insurance policies on the lives of the members or partners. Consequently, the Service will not rule on whether the transfer-for-value exception for transfers to a partnership in which the insured is a partner applies.

Private Letter Rulings 9725007, 9725008 , and 9725009 all dealt with the transfer of life insurance from a trust to a partnership. Each held that proceeds of life insurance policies contributed by a trust to a partnership fell within a safe harbor to the transfer-for-value rule, and that neither the trust's grantor nor his spouse held incidents of ownership in the policies.

In these rulings, a family created three trusts. Trust 1 held only a last-to-die insurance policy on the joint lives of the grantor and the grantor's spouse. The adult daughter of grantor and the adult daughter of the spouse are trustees. Trust 2 held cash and stock in a corporation controlled by the grantor's family. The grantor's spouse was named trustee. Trust 3 holds only one asset, an insurance policy on the life of the grantor. The grantor's spouse was named trustee.

The family formed a family limited partnership (FLP) and the client and his spouse retained a limited partnership interest. Then, the trustees of each of these three trusts transferred the trust's assets to the FLP. In return, each trust received an interest in the partnership: Trust 1 became a general partner in the FLP, and Trusts 2 and 3 became limited partners in the FLP.

According to the three identical rulings, each transfer fell safely into the exception for transfers to a partnership in which the insured is a partner, even though they were only limited partners. Therefore, the death proceeds of each will be received income tax free. Because neither the grantor nor his spouse were general partners in the partnership (into which all of the insurance proceeds will be paid), the Service held that neither will hold an incident of ownership and therefore the proceeds should not be included in either spouse's estate.

It may have been important in establishing the legitimacy of the partnership that the parties represented to the Service that, at all times, the cash values of all insurance policies represent less than 50 percent of the assets in the FLP and that the proceeds of the life insurance will be paid to it. Although the Service does not typically rule on whether a transfer of life insurance to a partnership is exempt from the transfer-for-value rule, it probably decided to do so here because the insurance contracts constituted less than half of the firm's assets.

The trustees in all three trusts were given discretionary authority to retain any real or personal property, to carry on any business in which they may have an interest, and to invest and reinvest in any real or personal property, including general and limited partnerships. This specific language is extremely useful in assuring the success of the technique used in these rulings.

Similarly, in Private Letter Ruling 9843024, the taxpayer, T, created an ILIT, for the benefit of T’s issue. The ILIT instrument authorizes the trustees to sell or assign any insurance policies owned by the ILIT and generally deal with the policies in the same manner that they deal with other trust property. T represented that T was treated as the owner of the ILIT for federal income tax purposes, under the grantor trust rules.

The ILIT owned insurance policies on the life of T, subject to a split-dollar arrangement between the ILIT and Corporation 1, under which the premiums are paid by Corporation 1 and the ILIT. T contributed funds to the ILIT to enable the trustee to pay its share of the premiums. Corporation 1 has a right to recover its contributions if the policy is surrendered or canceled. The ILIT would receive the balance of the death benefits.

T and two other trusts (Trust A and Trust B) are the partners in an investment limited partnership, LP, the principal asset of which was a limited partnership interest in another limited partnership, which owns a factory and land. The factory and half of the land is leased to Corporation 1. The general partner of LP is an S corporation owned equally by Trust A and Trust B. Trust A and Trust B were established by T for the benefit of T’s two adult children. T holds a power to substitute property of Trust A and Trust B of an equivalent value for assets held by each trust, provided that the possession or enjoyment of the trust property or income by the beneficiaries is not affected. T had no power to amend, alter, or revoke either trust, nor is T a trustee of either trust.

Under the LP partnership agreement, for each taxable year of the partnership, all taxable income and losses of the partnership and all partnership distributions will be made proportionately, based on the partnership interests. The general partner of LP has exclusive control over the management and investment decisions of the partnership.

T represented that the parties to the split-dollar arrangement wished to terminate it, but that the ILIT lacked sufficient funds with which to pay Corporation 1 for its interests in the policy. Therefore, the trustees of the ILIT proposed to sell its interest in the insurance policies to LP , in several separate sales over a period of time. Each policy would be sold for an amount equal to the interpolated terminal reserve value of each policy on the date of the sale, plus the unearned premium, that is, the proportionate amount of the premium last paid before the sale that covers the period extending beyond the date of the sale, reduced by the amount of Corporation 1’s interest in the policy.

T represented that as the new owner of each policy, LP will name itself as the beneficiary, and thus be entitled to the policy proceeds on T’s death, subject to any rights held by Corporation 1 under the split-dollar arrangement. After buying each policy, LP will pay all policy premiums, and over time, will repay Corporation 1 the full amount owed it under the split-dollar arrangement.

The Service ruled that the transfer by the ILIT to LP was a transfer for valuable consideration, but that it fell outside the transfer-for-value rule because of the Section 101(a)(2)(B) exception for a transfer to a partnership in which the insured (T) was also a partner.

The Service considered whether LP was a partnership for purposes of Section 101. It noted that Sections 761(a) and 7701(a)(2) define “partnership” as including “a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of the Code, a trust, estate, or corporation.” It also noted that Regulations Section 301.7701-3(b)(1) states that, unless it elects otherwise, a domestic eligible entity formed after January 1, 1997, with two or more members is treated as a partnership for federal tax purposes.

The Service limited the scope of this ruling (and perhaps telegraphed the limits of the safe harbors) by specifically refusing to rule on whether the transfer-for-value rule will apply if, at the time of the sale, T’s percentage interest in LP is less than its present percentage, or on whether the transfer-for-value rule will apply if LP disposes of all of its assets other than life insurance policies. Nonetheless, this provides a good road map for one means of removing a life insurance policy from an unsatisfactory life insurance trust, without violating the transfer-for-value rule.

In Private Letter Ruling 200111038, the Service applied this safe-harbor exception to protect from the transfer-for-value rule a transfer of a policy by a life insurance trust. The grantors, H and W, created two trusts. Trust One held substantial non-insurance assets and three second-to-die life insurance policies on the lives of H and W , for the benefit of H's parents, H and W's three adult children, and any further issue that H and W might have.

Trust One provides that, after the death of the survivor of H and W, the trustee will have broad authority to distribute income and principal to and among the beneficiaries of the trust. On the death of the latest to die of the grantors and H's parents, the trust will be divided into separate shares for the grantors' then-living children and the descendants of any deceased children. The trustees will have broad discretion to distribute income to these beneficiaries in the amounts they determine, but the trustees will distribute principal to the children and other beneficiaries only at specified ages and in specified amounts or shares.

Trust Two was a generation-skipping trust with a zero inclusion ratio for GST tax purposes, and it held cash and marketable securities. 182.1 The trustees of Trust Two were to divide the trust into two shares, if more assets were transferred to Trust Two than could be held with a zero inclusion ratio for GST tax purposes. One share would be held with a zero inclusion ratio, and the other would represent that portion to which no GST exemption had been allocated. The latter, Nonexempt Trust, would have an inclusion ratio of one for GST tax purposes. The trustees of Trust Two have broad authority to distribute income and principal to or among the grantors' children or any issue of these children.

The grantors and the two trusts proposed to form a limited partnership under applicable state law. Trust One would contribute the two second-to-die policies it held on the lives of the grantors, in exchange for units of limited partnership interests. Trust Two would contribute cash to the partnership, in exchange for units of limited and general partnership interests. The grantors would each contribute cash to the partnership, in exchange for units of limited partnership interest.

The purpose of the partnership will be “to acquire, hold, trade, sell, and otherwise deal in any real and personal property, tangible or intangible, including insurance policies.” The partnership agreement allocates all taxable income and losses to and among the partners pro rata, in accordance with their percentage partnership interests, and all distributions will be made in the same manner.

The partnership will become the beneficiary of the policies it will acquire from Trust One, upon their transfer to the partnership. The partnership will thereafter pay all premiums on those policies from its own assets or from loans that it would secure with its own assets. At all times, the Service noted, the aggregate net surrender value of the policies will represent less than 50 percent of partnership's total assets.

The Service ruled that the limited partnership was a valid partnership for federal income tax purposes, and that the grantors would be treated as valid partners for federal income tax purposes. The proposed transfer of life insurance policies by Trust One to the partnership, therefore, would be a “transfer for valuable consideration,” as defined in Regulations Section 1.101-1(b)(4), and the transferee would be the partnership. The proceeds of these policies would not be taxable income, however, because the transferee is a partnership in which the insured is a partner, under Section 101(a)(2)(B).

¶ 2.07[3][e] Transfers to a Corporation in Which Insured Is Either an Officer or a Shareholder

Under Section 101(a)(2)(B), a transfer of a policy to a corporation in which the insured is either an officer or a shareholder is not a transfer for value. If, for instance, an individually owned policy is transferred to the insured's corporate employer to be used as key-employee coverage or to fund a redemption-type buy-sell agreement, the transfer-for-value rule will not apply if the insured is an officer or a shareholder in the corporation at the time of the transfer.

It is important to note that the law does not require that the transferor be an officer or a shareholder; it requires only that the insured be an officer or a shareholder.

Example  2-46

Insured is the president and majority stockholder of ABC Corporation. Oscar is an executive recruiter who works as an independent contractor and whose primary client is ABC. Oscar has a close personal relationship with Insured, which is one of the bases of his business relationship with ABC. In 1998, Oscar buys a $1 million life insurance policy on Insured's life to protect his future earnings in case Insured's death should jeopardize Oscar's business relationship with ABC. In 2002, ABC gives Oscar a long-term contract. Oscar then agrees to sell the policy to ABC, so that it can use it to fund a buyout of Insured's stock at her later retirement. Although ABC pays Oscar $20,000 for the policy, the $1 million in proceeds are excludable from ABC's gross income because ABC, the transferee, is a corporation in which Insured is an officer or a shareholder.

This exception to the transfer-for-value rule does not extend to transfers to co-shareholders of the insured, nor does it extend to transfers to a corporation in which the insured is an employee other than an officer or a shareholder, no matter how important the employee may be to the continuing financial success of the enterprise. Thus, this exception can protect from adverse income tax results the exchanges of life insurance policies when stockholders convert from a cross-purchase buy-sell agreement to a stock redemption–type buy-sell agreement, but it provides no protection in the converse situation.

Example  2-47

Rob, Max, and Charles are the stockholders of ABC Corporation. For several years, they have maintained a cross-purchase buy-sell agreement under which each of them agrees to buy the stock of the others at death. Each owns a life insurance policy on the life of the others. In 1999, they decide to change to a redemption buy-sell agreement, under which ABC will buy the stock of any shareholder who dies, retires, or becomes disabled. Each of them sells his or her life insurance policies to the corporation for their cash surrender values. Section 101(a)(2)(B) protects all of these sales from the transfer-for-value rule.

In 2002, they change their minds and decide to convert back to a cross-purchase buy-sell agreement. Each shareholder buys from the corporation the policies on the life of the other shareholders. When Rob dies in 2003, the proceeds received by Max and Charles are ordinary income under the transfer-for-value rule. There is no exception from the transfer-for-value rule for transfers to a stockholder in a corporation in which the insured is also a stockholder or an officer.

The transfer-to-a-corporation exception should apply even if the transferee is the holder of only a few shares that qualify. 183 However, the sham-transaction rule should assure that no protection from the transfer-for-value rule should be afforded if the insured is only an officer in name and has no real executive-level duties or authority or if the transferee holds shares in name only but really is not an owner.

Example  2-48

Adam is the president of ABC Corporation. Beth, another stockholder, owns a $1 million policy on Adam's life. If Beth sells her policy to ABC, ABC will not have to include the proceeds in gross income because of the exception from the transfer-for-value rule for transfers to a corporation in which the insured is an officer.

Assume, however, that Adam owns no stock. Before Beth's sale of her policy to ABC, Adam resigns the company's presidency and becomes chairman of the board of directors. Beth then sells the policy to ABC. As Adam is a director, and a director is neither an officer nor a shareholder, the $1 million should be includable in ABC's gross income at Adam's death, except to the extent of the amount it has paid for the policy.

¶ 2.07[4] Summary of Safe Harbors

Table 2-2 summarizes the transfer-for-value rule safe harbors:

Table 2-2


Transferee for Value                        Tax Result
Anyone whose basis is determined by         Excepted
reference to transferor's basis             
Insured                                     Excepted
Partner of insured                          Excepted
Partnership in which insured is a partner   Excepted
Corporation in which insured is a           Excepted
shareholder or officer                      
Co-stockholder of insured                   Problem
Spouse of insured (interspousal transfer)   Excepted
Any other person or entity                  Problem

¶ 2.07[5] Transfer-For-Value Traps in Buy-Sell Agreements

More than almost any other single area, buy-sell agreement funding and termination give rise to potential transfer-for-value traps. In corporate or partnership buy-sell agreements funded with life insurance, as in the other areas that will be discussed, the planner must scrutinize any transfer of a life insurance policy funding the buy-sell arrangement to be sure that it is not a transfer for valuable consideration or that, if it is, that it will meet one of the safe-harbor exemptions of Section 101(a)(2). Then, in either case, the proceeds will retain their income tax excludability when collected by the transferee.

¶ 2.07[5][a] Agreement to Assume Responsibility

The leading case involving transfers for value in the buy-sell planning area is Monroe v. Patterson. 184 The issue in Monroe 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. Here, a key-employee policy was transferred to fund a cross-purchase arrangement. A policy on the key employee's life had been owned by and payable to the corporation.

A cross-purchase buy-sell agreement was established and a trust was created to facilitate the transaction and to assure an orderly transfer of the corporate stock. The corporate life insurance policy on the shareholder's life was then transferred to the trustee, who was to collect the proceeds and pay them to the shareholder's estate. 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 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, and if so, what was it? The surviving shareholders argued that they had paid nothing for the policies and that therefore, absent consideration, the transfer-for-value rule did not apply. The district court held, however, that there had 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. In other words, the court found two forms of consideration: first, their agreement to continue making premium payments (and in essence relieve the transferor corporation of that obligation), and second, their agreement to use the proceeds to buy the insured's stock at his death. 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 therefore was subject to tax.

Example  2-49

A father gives a policy on his life to his son, and the father pays the gift tax. Can there be a transfer for value if no value changed hands? Assume that after the gift of the policy, the father and son enter into a cross-purchase agreement for the purchase of the father's stock in a corporation at the father's death. The father dies, and the son, in fact, uses the policy proceeds to purchase the stock. Does the son take the insurance income tax free?

At first glance, the answer appears positive: The father meant for the transfer of the policy to be a gift to his son (even though the father entered into a buy-sell agreement), and he even filed a gift tax return on the transaction and paid a gift tax. Cautious practitioners, however, will look further. 185 They should consider whether the transfer of the policy and the execution of the agreement occurred contemporaneously and, if not, how far apart the two transactions did occur. In other words, one should look for signs that the two events were part of the same transaction. If they were, the Service could argue that the son paid a price (“I'll keep the policy in force”) as part of his agreement to buy the father's stock.

The practitioner should also consider whether there is further evidence (such as continued gifts from the father) of an intent to make the life insurance transfer a gift rather than part of a business transaction. Also, the practitioner should consider whether there was an explicit agreement between the parties that the son would use the insurance proceeds to buy the father's stock at his death.

In this situation, the Service would try to prove that, although the transaction was cast as a gift, it was really part of a larger arrangement in which the transfer of the policy was bargained for by the son. However, the practitioner would argue that even if the Son's agreement constituted consideration for the transfer of the policy, as long as any gift element can be found in the transaction, the rule would not apply, since the son's basis would be determined at least partially by reference to his father's basis. 186

¶ 2.07[5][b] Reciprocity Triggers Trap

In Private Letter Ruling 7734048, the Service reached a result adverse to the taxpayer, even though the policies transferred from the insureds to their co-shareholders to fund the cross-purchase arrangement had no value at the time of the transfer. In the ruling, two shareholders each owned a policy on their own lives. After the establishment of a cross-purchase buy-sell agreement, they transferred the policies to each other in order to fund the purchase of stock from a decedent's estate. Since the policies were in their first year, there was no cash value or interpolated terminal reserve on the day the policies were transferred.

The Service said that the issue was whether there could be consideration if no cash changed hands in the transfer. The Service concluded that the transfer-for-value rule was operative, even if there was no outright sale of a policy. The reciprocity that occurred where one shareholder transferred a policy on his life to the other in return for the other doing the same was valuable consideration for the two absolute assignments.

It made no difference that the policies themselves had no value at the time of the transfer. (Even if the policies are term insurance, they would be subject to the transfer-for-value rule.) According to the Service, none of the exceptions to the transfer-for-value rule applied. The death proceeds were exempt, therefore, only to the extent of the net premiums paid after the transfer; the balance of the proceeds were taxable as ordinary income.

¶ 2.07[5][c] Partnership Buy-Sell Agreements

Private Letter Ruling 7918022 involved a corporation's proposed sale of insurance on the lives of each of its five shareholders to a partnership composed of the same individuals. The partnership proposed to buy the policies for their fair market value (FMV) on the date of the transfer. The policies originally had been purchased to fund a corporate buy-sell agreement and were to be transferred (possibly to avoid an attribution problem, since the shareholders were related) to fund a partnership buy-sell agreement. The Service pointed out that there was a transfer and that it was for valuable consideration. The Service noted, however, that the transfer was to one of the “protected parties” (i.e., a partnership in which the insured of each policy was a partner). Thus, the proceeds would be received income tax free by the partnership. This illustrates an important and relatively certain way to avoid the penalty of the transfer-for-value rule: Transfer the policy to a partner or partnership of which the insured is a partner. The Service will, however, scrutinize the bona fides of the partnership, so it must meet any state law requirements for partnerships. The more active the firm is, the more likely the Service will recognize it as a partnership. It is also important that the firm utilize a “check the box” election.

¶ 2.07[5][d] Termination of a Buy-Sell Agreement

The transfer-for-value issue may also arise on termination of a buy-sell arrangement. For instance, in Estate of Rath v. United States, 187 a corporation bought a life insurance policy 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 to his nominee if the corporation decided to terminate the agreement. When the corporation was sold, the buy-sell agreement was no longer necessary, and so the policy funding the corporation's obligation under the redemption agreement was sold by the corporation to the shareholder's wife.

The Service claimed that there was a transfer of the policy from the corporation to the wife for valuable consideration and that reportable income was received by her at her husband's death. The wife argued that there was an exercise of the shareholder's option, a constructive transfer of the policy to him (a “protected party”), and that he then made a gratuitous transfer to her that fell within an exception to the transfer-for-value rule.

The court held that there was no transfer from the corporation to the insured and no second transfer to his spouse. Instead, the transfer was directly from the corporation to the spouse, for a valuable consideration, and no exemption applied. The court, in effect, ignored the step-transaction argument made by the insured's spouse. It concluded that the fact that the insured could have acquired the policy himself from the corporation and then transferred it to his spouse, thereby retaining the exclusion for the proceeds at his death, did not warrant the court recharacterizing what actually occurred. The court examined each step of the transaction and concluded that each was to stand on its own and therefore neither step was an exempt transfer.

Finally, the court distinguished between the estate and income tax consequences of what happened, indicating that if the insured had acquired the policy directly and then transferred it to his spouse and died within three years of the transfer, the proceeds would have been includable in his estate for estate tax purposes, but there would not have been a transfer for value for income tax purposes.

¶ 2.07[5][e] Transfer of Uninsurable's Personal Insurance

If a personally owned life insurance policy on the life of a co-shareholder who is presently uninsurable is sold to a co-shareholder to help fund a cross-purchase agreement, the transaction will clearly fall within the transfer-for-value rule. At the death of the insured, the co-shareholder will receive all or a large portion of the proceeds as ordinary income rather than tax-free income.

¶ 2.07[5][f] Direct Sale of Policy to Co-Shareholder of Insured

If a corporation converts from a stock-redemption buy-sell agreement to a cross-purchase agreement, the other shareholders may want to buy the policies then held by the corporation. 188 A sale of a corporation's policy to a shareholder will constitute a transfer for value and will not fall within any of the safe-harbor exceptions under Section 101(a)(2) .

If two shareholders want to change an insured stock-redemption agreement to a cross-purchase agreement and want merely to have the corporation give each shareholder the policy on the life of the insured, the transfer-for-value rule may still apply. Although the shareholders may call this transaction a gift to each other, there is no donative intent, and the Service is highly unlikely to treat the transaction as a gift. Rather, the Service will probably treat the distribution from the corporation as a constructive dividend or as compensation to the distributee. In either case, the policy will be acquired in a transfer for value.

The transfer-for-value problem cannot be avoided by a purchase of the policy from the corporation by the insured followed by a gift of the policy from the insured to the other shareholder. Again, while there are no precedents, the Service can argue that the two transfers should be treated as a single transfer by the corporation. 189 If that argument fails, the Service can claim that the reciprocal promises (the promise by each shareholder to acquire the policy on his or her life and then to give it away) constituted consideration for the transfers.

¶ 2.07[5][g] Sale by Estate to Co-Shareholders

Another place where a transfer-for-value problem is likely to occur, absent careful planning, is at the death of a shareholder who owns policies on more than one other co-shareholder. The deceased shareholder's personal representative has a fiduciary duty to the beneficiaries of the estate and cannot merely give away the policies. Rather, the personal representative must attempt to sell them for the best possible price.

Example  2-50

XYZ Corporation has three shareholders, Xavier, Yvonne, and Z.B. Each shareholder owns a policy of insurance on the life of each other shareholder. If Xavier dies, what happens to the policies he owned on the other shareholders' lives? There is no way for his estate to sell the policy it owns on Yvonne's life to Z.B. and sell the policy on Z.B.'s life to Yvonne without triggering a transfer for value.

There are several possible indirect solutions to this problem. First, the estate can sell both policies to the corporation, which can then establish a stock-redemption plan or a hybrid buy-sell agreement that integrates properly with the existing cross-purchase agreement. 190

Second, the estate can surrender each policy to the insurer for cash, and the surviving shareholders can buy more life insurance on each other's life. The primary disadvantage of this approach is that the surviving shareholders may be uninsurable (or insurable only at a high premium cost) and replacement policies may be unavailable.

Third, the survivors can buy the policies on their own lives and continue them as personal insurance. The proceeds will be received by the insured's beneficiaries without income tax because a purchase of a policy by the insured is never a transfer for value.

¶ 2.07[5][h] Trusteed Buy-Sell Agreements

Some buy-sell agreements use a trust to hold the stock of the various shareholders and the life insurance policies on the lives of each of them. In theory, this permits the trustee to buy one policy on the life of each shareholder, rather than requiring each shareholder to own a policy on the life of each other shareholder. However, at the death of a shareholder, the interest he or she has in the policy on the lives of the other shareholders terminates, and then, magically, the surviving shareholders end up with an interest (through the trust) in the policies on the other surviving shareholders' lives.

This one trust–one policy per shareholder cross-purchase technique for corporate shareholders is highly suspect under the transfer-for-value rule and is almost certain to attract expensive litigation with the Service. Even though there will be no physical transfer within the trust on the first shareholder's death, and legal title to the policies on the lives of the survivors will not change, the beneficial interest in the decedent's share of the policies on his co-shareholders' lives shifts to them. On each shareholder's death, there will be some transfer of equitable ownership within the trust to the surviving co-shareholders.

This arrangement seems to involve valuable consideration (i.e., reciprocal promises). No policy owner would allow the beneficial interest in a policy he or she owned on another shareholder's life to pass through the legal ownership held by the trustee to the other shareholders 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.

One solution to the potential problem of the trusteed buy-sell agreement is to avoid transfers altogether by having the insurer divide each contract into separate policies.

Example  2-51

Adam, Bob, and Carol are the three equal stockholders of ABC Corporation. They enter into a trusteed buy-sell agreement. The trustee holds a $300,000 policy on the life of each of the stockholders. Adam dies first, and the proceeds of the policy on his life would be paid to the trust. There are now two surviving stockholders and the trust owns a total of $600,000 of insurance, two $300,000 policies. However, three parties would have an equitable interest in those two policies, Adam's estate (because Adam had held an equitable interest during life) and the two surviving stockholders. The trustee would request that the insurer exchange each of the two remaining $300,000 contracts for three $100,000 contracts and return the new policies to the trust. The following situation would then exist:

Insured        Before                      After
 Adam         $300,000        No policy/proceeds held by trust
 Bob          $300,000        $100,000 (equitably owned by Adam's estate)
                              $100,000 (equitably owned by Carol)
                              $100,000 (equitably owned by Bob)
 Carol        $300,000        $100,000 (equitably owned by Adam's estate)
                              $100,000 (equitably owned by Bob)
                              $100,000 (equitably owned by Carol)

Next, the trustee would surrender the interest of Adam's estate in the policies on the two surviving stockholders and distribute the cash proceeds to Adam's estate. Alternatively, the trustee could distribute the two policies beneficially owned by Adam's estate to its personal representative, who could then sell the contracts to the two insureds. The policy on Bob's life would be sold to Bob, and the policy on Carol's life would be sold to Carol. In both cases, the transfers would fall within a safe harbor under the transfer-for-value rule (a transfer to the insured) and the estate would realize cash on the sale.

The problem with this approach, unfortunately, is that it leaves the survivor stockholders underinsured. Even if they could buy new coverage at standard rates, their older ages (and possibly deteriorated health or change in occupation or avocation) would cause premiums to be higher than under the previous arrangement.

A second alternative is for the trustee to sell to the corporation the policies equitably owned by the estate of the first stockholder to die. 191 This gives the trust cash that can be paid to the estate of the first stockholder to die, and it gives the insurance to the corporation for use in funding a separate stock redemption agreement. Because the transfer to the corporation would fall within a safe harbor (i.e., a transfer to a corporation in which the insured is an officer or shareholder), there would be no transfer-for-value problem at the death of either of the other stockholders. Even though each surviving stockholder's interest is worth much more after the trust's acquisition of the stock of the first stockholder to die, keeping the old insurance in force in this way significantly reduces the new coverage that must be purchased.

However, while the transfer-for-value problem seems to make the use of trusteed buy-sell agreements inappropriate for agreements with more than two participating business owners, one way to safely avoid this problem is for the stockholders who are beneficiaries of the trust to also be partners in a partnership. This would cause all deemed transfers of beneficial interests in the policies to be made to partners of the insured and, therefore, within a safe harbor from the transfer-for-value rule. This exemption should apply even if the partnership has no connection to the business whose stock is restricted by the buy-sell agreement, and perhaps even if the partnership is created solely to facilitate the use of the trusteed buy-sell agreement, as long as it is a valid partnership in which the insured is truly a partner. 192 Thus, the trusteed agreement could be used to reduce the number of required life insurance policies and to simplify policy ownership, without creating a risk of ordinary income classification under the transfer-for-value rule.

Example  2-52

Adam, Beth, and Charles own all of the stock of the Acme corporation. They enter into a cross-purchase buy-sell agreement restricting lifetime and testamentary transfers. Under the agreement, the corporation is worth approximately $4.5 million. The purchase of a deceased stockholder's shares at death will be financed, in whole or in part, by life insurance.

Concurrently with the execution of the stock purchase agreement, Adam, Beth, and Charles create a trust to buy and maintain the life insurance policies. A local bank serves as trustee. The trustee buys a $1.5 million insurance policy on the life of each of the stockholders. Adam dies in 1997 and Beth dies in 1999.

At Adam's death, Beth and Charles are obligated to buy Adam's shares for $1.5 million (one third of $4.5 million). The trustee receives $1.5 million in insurance proceeds and distributes $750,000 each to Beth and Charles, who use the cash to buy Adam's stock.

In 1999, when Beth dies, Charles is obligated to buy her stock for $2.25 million (one half of $4.5 million). The trustee distributes the $1.5 million proceeds to Charles, who uses the proceeds to pay for part of Beth's shares, giving his personal promissory note for the balance. At Beth's death, the trustee also distributes the remaining insurance policy to Charles and the trust terminates.

Adam, Beth, and Charles are also partners in the ABC general partnership that holds $30,000 in marketable securities. The change in the interests of Beth and Charles in the policies on their lives on account of the death of Adam is not a transfer for value, because Adam, Beth, and Charles, the insureds, are all partners in the ABC partnership.

Alternatively, Adam, Beth, and Charles could each have bought a $1.5 million life insurance policy on the life of the other stockholders. Adam would have had to own two policies (one on the life of Beth and one on the life of Charles), Beth would have had to own two policies (one on the life of Adam and one on the life of Charles), and Charles would have had to own two policies (one on the life of Adam and one on the life of Beth). This would have forced the purchase of six policies, rather than three, increasing both premiums and administrative costs. The use of the trusteed policy avoids this problem.

Given that a trusteed buy-sell agreement can thus be used, some practitioners prefer that the trustee holds both the life insurance policies and the stock certificates. The theory is that the trustee's possession of both the source of purchase funds and the assets to be bought assures that the closing of the sale of a deceased stockholder's shares will occur easily, even over the objections of a dissenting stockholder. The trustee in such cases owns the insurance policies, but has mere custody of the endorsed stock certificates, so that the stockholders of record can still vote their shares and the trustee need not be treated as the stockholder for S corporation purposes.

This type of arrangement is sometimes thought to provide a greater assurance of security and equity in the implementation of the buy-sell agreement. However, it is more complicated than having the trustee hold only the life insurance policies, and the trustee's custody of the stock certificates adds little or nothing to an agreement that is otherwise self-enforcing. Furthermore, the trustee's ownership of the life insurance policies is more important than the custody of the stock certificates, because the life insurance policies require active payment of premiums to remain in effect, while the stock certificates are merely documents of record that can be reissued by the corporation if necessary. Still, if the parties are in a slightly antagonistic position and there is a significant risk of dissention when the agreement is to be enforced, the trustee may be given custody of the endorsed stock certificates in order to expedite the transfer of share ownership.

Private Letter Ruling 9511009 dealt with an unusual type of trusteed buy-sell agreement. Two individuals who owned all the stock of a corporation also owned several bona fide partnerships. The corporation owned policies on their lives. The corporation proposed to distribute the insurance to the partners. Each partner would receive the policy on the other shareholder's life. After receipt of the policy, each shareholder would establish a revocable trust and transfer the policy to that trust. The trust, managed by an unrelated third-party trustee, would then be the owner and beneficiary of the policy on the life of the other shareholder. Premiums to carry the coverage would come from each former policy owner. At the death of a partner, the trustee would receive the proceeds.

The Service ruled that the direct transfer of the policies from the corporation, in which neither insured owned more than 50 percent of the shares, to the trust, never gave either insured any incidents of ownership over the policy. Because neither insured ever held incidents of ownership, no portion of the proceeds would be included in the estate of either insured, even if the insured died within three years of the corporation's transfer of the policies to the trust.

The Service declined to rule on whether the transfer by the corporation to the trust was a transfer for value under Section 101. The Service stated that it would not rule on these issues because of their “factual nature.” It also refused to rule on whether the trust was a grantor trust because of its long-standing no-rulings position on this issue. 193 Presumably, the taxpayers wanted assurance that the trust's status as a grantor trust owned by the insureds would prevent the application of the transfer-for-value rule.

While the Service would not so rule, if the trusts were grantor trusts, the transfer of the policies to the trustee should properly be treated as transfers to the insureds themselves, which are automatically exempt from the transfer-for-value rules. 194 The ruling does not indicate why the taxpayers did not simply transfer a partnership interest to the trusts, which would have made the trusts partners of the insureds and brought them within the transfer-for-value exception under Section 101(a)(2)(B). 195

¶ 2.07[5][i] Use of Group-Term Life to Fund a Buy-Sell Agreement

Another transfer-for-value trap exists where group-term life insurance is used to fund a cross-purchase agreement. Assume, for example, that two shareholders are each insured under a corporate-owned group-term life insurance program. Each names the other as beneficiary of the coverage on his or her own life. Although no money changes hands, and even though the policies are term insurance, there is a transfer of an interest in life insurance for valuable consideration. The reciprocal promises (one would not have named the other beneficiary if he or she had not reciprocated) again provide the valuable consideration.

¶ 2.07[5][j] Use of Endorsement-Type Split-Dollar Insurance to Fund a Buy-Sell Agreement

Yet another area of danger relates to endorsement-type split-dollar buy-sell 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. The corporation will buy policies on each shareholder's life and will name itself owner. The amount of proceeds in excess of the corporation's interest will be endorsed over to (i.e., made payable to) the insured's co-shareholders. This means there will be a transfer (naming of one shareholder beneficiary of the policy on the life of another shareholder) of an interest in a life insurance contract (policy proceeds in excess of the amount payable to the corporation to reimburse it for its cumulative outlays).

The Service can argue that there is valuable consideration in the employee's continuing services for the corporation in exchange for the corporation's paying all or a substantial portion of the premiums in a split-dollar agreement and allowing the naming of a personal beneficiary. The Service can also argue that—to the extent each shareholder recognizes income (equal to the P.S. 58 cost)—it is as if term insurance were purchased on his behalf by the corporation. Typically, that presents no problem, since the term insurance purchased is usually on the insured's life and, if it is transferred to someone other than the insured, it is by gift. In a cross-purchase endorsement split-dollar plan, however, the employer is the original owner. The policy is on the life of a co-shareholder of the party to whom the company endorses a portion of the policy proceeds. So there has been a transfer for value but no safe-harbor protection.

A simple solution to this problem is to use the collateral assignment method of split-dollar. In this arrangement, each shareholder buys a policy on the life of his or her co-shareholder and owns it from inception. He or she then collaterally assigns it to the corporation (a protected party under the safe-harbor rules) as security for the loan. On the death of a shareholder, the surviving shareholder receives the pure insurance income tax free, and the corporation recovers its contributions, also income tax free.

For the planner in the corporate or partnership buy-sell area, these cases and rulings indicate that the mutuality of agreement supporting the typical buy-sell arrangement may be sufficient consideration to invoke the transfer-for-value rules. Physical transfer of policy ownership is not a prerequisite to finding a transfer for value; the mere naming of a party as beneficiary in exchange for consideration is enough. Thus, the planner must observe 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) or what they said they have done, to determine if there has been a transfer of an insurance policy for a valuable consideration. Both form and substance must be examined.

¶ 2.07[5][k] First-To-Die Life Insurance for Funding Buy-Sell Agreements

One favorite type of life insurance for funding buy-sell agreements is the first-to-die (FTD) policy, which insures the lives of more than one business owner but pays a death benefit at the death of the first insured to die. Neither the purchase of an FTD policy nor the payment of the proceeds to the surviving shareholders should be a transfer for value.

In these situations, each owner-insured typically buys the right to receive all (or a portion) of the proceeds at the death of the first insured to die. Thus, there should be no transfer of an interest in a policy (for value or otherwise) where two (or more) individuals buy an FTD policy jointly and one (or more) receives proceeds at the first death.

However, a later change in the allocation of the FTD proceeds between the insureds, as might occur if there is a change in the percentages of ownership of the business, could result in a transfer for value to the extent that the right to proceeds is transferred. Of course, if the business owners are also partners (even in a totally separate business venture), the transfer-for-value rule does not apply, because of the exception for transfers to a partner of the insured. Therefore, even if the policy is used to fund the purchase of stock of a shareholder, it may be advisable to create a partnership in which all of the insureds are also partners, so that subsequent adjustments in stock ownership do not create a transfer for value.

¶ 2.07[6] Transfer-For-Value Problems in Employee Benefit Planning

¶ 2.07[6][a] Qualified Retirement Plans in General

The Service has made its position quite clear regarding application of the transfer-for-value rule to the transfer of life insurance policies to the trustee of a qualified retirement plan. The Service has repeatedly indicated that these transfers fall outside the transfer-for-value rule.

The transfer of a life insurance policy to a qualified retirement plan may take place as part of the corporate employer's contribution to the plan on behalf of the participant, or it may be part of a participant's voluntary contribution to the plan. Often, such transfers have at least two steps—a transfer of a policy by one retirement plan to the insured, and the insured's transfer of that policy to a second plan (or a transfer by a corporation of a key-person policy to the insured, followed by his or her transfer of that policy to a plan).

¶ 2.07[6][b] Purchase by Retirement Plan

The rulings in this area focus on the defensive argument that there has been “no significant change in beneficial ownership” when a retirement plan buys an insurance policy on the life of its participant. The proceeds should retain their income tax free status because, in essence, there has been no transfer, and, therefore, the transfer-for-value rule cannot apply. For example, Revenue Ruling 73-338 196 dealt with an agreement between an employee, his employer, and a trust, under which the employer bought an existing life insurance policy from the employee for its cash value. The employer then transferred the policy to the trust as a part of the employer's required annual contribution to the trust. The trustee paid the premiums on the policy. At the participant's death, the trustee would pay the insurance proceeds to the participant's designee (in this case, his widow). The proceeds were in fact paid to the plan trustee, who turned them over to the insured's wife. The Service concluded that the various steps resulted in no substantial change in beneficial ownership of the policy and that, therefore, no transfer (and, of course, no transfer for value) had occurred.

In Private Letter Ruling 9109018, the employers, members of an affiliated group of corporations that maintained a nonqualified deferred compensation plan for the benefit of their officers, assigned certain individual life insurance policies to a trust established under a qualified retirement plan. The insureds were all officers participating in the plan. The employers were the owners and beneficiaries of the policies, and the officers had no rights or interests in the policies nor did they receive any current economic benefit from the policies. The Service, noting that the employers' beneficial interests never changed, held that the assignment of the policies would not be treated as a transfer and that, therefore, the transfer-for-value rule could not apply.

The Service reached this result relying on Haverty Realty & Investment Co. v. Commissioner 197 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, the ruling 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 and since the arrangement affected no significant change in the beneficial ownership of the proceeds, the policy had not been transferred for value. The favorable result is predicated on the fact that the right to change the beneficiary was never given to the employer or trustee.

Similarly, in Private Letter Ruling 7848068, the Service held that a proposed gift of an insurance policy to the insured's spouse, who then assigned the policy for an amount equal to its cash value directly to the trustee of the qualified money purchase pension plan created by the insured's employer and in which the insured was a participant, was 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. Further, the trust had no right to retain the proceeds that were required to be paid to the participant's designee on his death. 198 Once again, the key to the favorable result was that the Service felt the “exchange effected no significant change in beneficial ownership of the proceeds” and therefore did not constitute a transfer.

¶ 2.07[6][c] Purchase From Retirement Plan

In Private Letter Ruling 8430102, the Service dealt with the flipside of the issues just discussed—a purchase of life insurance contracts from a retirement plan. In this ruling, a successor corporation's retirement plan bought life insurance contracts from a predecessor employer's Keogh plan. The Service ruled that the purchase of the insurance by the new trustee from the old trustee for the policy's cash value at the date of purchase was not a transfer for value because no significant change in the beneficial interest of the contract occurred. 199

¶ 2.07[6][d] Contribution to Qualified or Nonqualified Retirement Plan

In Revenue Ruling 74-76, 200 an employee-participant in a qualified retirement plan owned a life insurance contract with a cash value. The employee-participant transferred that policy as a voluntary employee contribution to a profit-sharing trust of which he was a participant. Under the plan terms, the proceeds continued to be payable to the employee's beneficiary, and the policy's cash surrender value was payable to the employee-participant on his retirement or termination of employment resulting from other than death. Relying on Revenue Ruling 73-338, the Service ruled that since the proceeds were payable to the employee's designated beneficiary on his death and since the cash surrender value was payable to the participant on his retirement or other termination of employment, there was no significant change in the policy's beneficial ownership. Therefore, the policy had not been transferred for value within the meaning of Section 101(a)(2). 201

Private Letter Ruling 8936072 concerned similar facts, but instead of a qualified retirement plan, the transferee was an irrevocable rabbi trust—a trust established by a corporation with a third-party trustee to finance the employer's obligation under a nonqualified deferred compensation agreement. Trust assets remained subject to the claims of the corporation's creditors in the case of insolvency or bankruptcy, and participants received only an unsecured right to the assets in the trust. In addition to making cash contributions to the trust, the employer proposed to transfer certain life insurance contracts to the trust. The employer or the trust was to pay the premiums, and the trust was to become the nominal owner and beneficiary of the contracts on their transfer to the trust.

The Service ruled that the proceeds were excludable from the trust's and the employer's gross incomes because there never was the requisite transfer; the trust was not viewed as a trust, but rather as an agent of the employer. The ownership of the policies did not change in a meaningful way. 202 Distribution of the proceeds of the life insurance contracts from the trust to the employer therefore would not be included in the income of the employer.

In Private Letter Ruling 9041052, a company created a “step-up anti-takeover rabbi trust” to finance its obligations under a nonqualified deferred compensation plan. The trust was initially revocable, but it became irrevocable at the earlier of the occurrence of a change in control or sixty days after the receipt of a favorable ruling. When the trust became irrevocable, the company could not regain any trust income or corpus until all payments to plan participants were made, until there were excess assets in the trust, or until the company became insolvent. All assets held by the trust, however, at all times were subject to the claims of the company's general creditors.

Among the assets to be transferred to the trust either before or after the trust became irrevocable were certain life insurance policies on the lives of company employees. The Service looked to Section 83, involving the income tax treatment of property distributed to an employee as compensation, to see if there was a transfer of the life insurance for income tax purposes. It concluded that there was no transfer because the plan was unfunded and because general creditors had continuing access to policies contributed to the trust. It also concluded that there was no transfer for purposes of Section 83 and that there were no changes in (1) the insureds; (2) the terms; (3) the conditions; (4) benefits; or (5) the nominal owner of the policies. Therefore, the proceeds were not subject to the transfer-for-value trap. 203 On the other hand, this ruling indicates that the Service may resort to Section 83 to deem that a transfer of a life insurance policy has occurred.

The Service seems to be taking a relatively liberal attitude concerning policy transfers to retirement plans in holding that although there has been a physical transfer in each of the situations described in these rulings, that transfer will be disregarded. 204 This seems to indicate 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 the Service's position in cases like Estate of Rath v. United States, 205 which emphasized not the end result but each step taken to obtain that result. It can be argued that the Service is reaching the right result, but it is difficult to reconcile how the Service looks through the series of transactions to the end result in these rulings with its position in other cases and rulings focusing on each step in the series.

Still, for the planner in the employee benefit and retirement planning areas, these cases and rulings provide the following guidance:

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, the Service will generally hold that no transfer has occurred for purposes of the transfer-for-value rule.

2. In the case of a transfer of a policy by an employee to a qualified plan as a part of his or her 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 his or her earlier retirement or termination of employment, the Service will generally hold that no transfer has occurred for purposes of the transfer-for-value rule.

3. A favorable IRS ruling is predicated on two facts: (a) the arrangement under which the employer acquires the insurance policy from the employee makes it clear that the employer is obligated to transfer the policy to its qualified retirement plan, and the corporation cannot retain any part of the insurance proceeds for its own benefit; and (b) it is clear from the plan documents that the plan itself has no right to retain those proceeds but must pay them over to the participant's designated beneficiary.

4. Although the plan trustee is the legal owner of the insurance policy, it is important that the insured participant continue to be the equitable owner (that is, the policy proceeds will be paid to the beneficiary designated by the participant and any cash surrender value will be payable to the participant on his or her earlier retirement or termination of employment).

¶ 2.07[7] Transfers for Value Under Split-Dollar Life Insurance Arrangements

A split-dollar life insurance arrangement, under which an employee and an employer share the cost of life insurance coverage under some prearranged formula, is often used as a form of nonqualified, selective employee benefit plan. 206 The Service has often ruled on whether a transfer-for-value occurs in common split-dollar arrangements, where a life insurance policy is bought by the employer. 207

Private Letter Rulings 7829128 and 8003094 dealt with the transfer-for-value aspects of insurance policies transferred in connection with the establishment of split-dollar plans. In Private Letter Ruling 7829128, the insured's wife originally owned a policy on his life. The policy was assigned to the insured's solely owned corporation to fund a split-dollar arrangement. Thereafter, the insured's wife transferred her interest in the policy, subject to the corporation's rights under the split-dollar arrangement, to the insured.

The insured and the corporation proposed to enter into a new split-dollar agreement. The insured intended to assign his interest in the policy to his wife. She would then name herself as beneficiary of the proceeds in excess of the amount due the corporation under the split-dollar plan. The Service ruled that the transfer of rights in the policy to the corporation qualified for the protected-party exemption provided for transfers to a corporation in which the insured was either an officer or shareholder. Thus, any amounts received under the policy on the death of the insured would be entirely income tax–exempt. The transfer of any rights in the policy to the insured was ruled to be similarly exempt. The final transfer, a gratuitous transfer of the insured's policy rights to his wife, was also held to be exempt because she would have a basis in the contract determined in whole or in part by reference to the insured's basis.

Similarly, Private Letter Ruling 8003094 dealt with an insured who owned all of the stock of a professional corporation that owned a permanent life insurance policy on his life. The corporation was to transfer ownership of the policy to the insured in exchange for its then-current cash surrender value. The insured would then transfer the policy to his wife as a gift. It was intended that she would then enter into a split-dollar arrangement with the insured's corporation and would collaterally assign the policy to the corporation as security for its payment of premiums. Without discussion of the transfer-for-value issues, the ruling concluded that the insured's wife would collect the proceeds free of income tax under Section 101(a)(1). 208

In Private Letter Ruling 9045004, there were four shareholders, A, B , C, and D, involved in an arrangement sometimes known as late-start split-dollar (splitting of premium dollars of an existing contract between the corporation and its shareholders). A and B each owned about 43 percent of the corporation. C and D each owned about 7 percent. All four shareholders were also partners in a separate business partnership. A and B were the major partners, each owning about 49 percent. C and D each owned only about one percent of the partnership.

The corporation was the owner and the beneficiary of, and paid premiums on, two life insurance policies on the lives of A and B. The corporation, however, was concerned about the corporate AMT that might be imposed on life insurance proceeds. The firm's attorney wanted to set up a cross-purchase buy-out of the corporate stock. He also wanted to move the life insurance out of the corporation in order to fund the cross-purchase buy-sell, and yet he also wanted to have the corporation pick up most or all of the premium burden without subjecting the shareholders to massive income taxes.

To accomplish this goal, the attorney used a form of late-start split-dollar, involving three steps:

1. The corporation kept the cash value portion of the policies on the lives of A and B and continued paying premiums for the portion of the premium represented by the annual increase in policy cash values.

2. The corporation retained the portion of the policy proceeds equal to the total cash value of the policy to secure its interest.

3. The corporation assigned all other rights of ownership on the lives of A and B (the two principal shareholders) to C and D. Each policy named one of the minor shareholder-partners as primary beneficiary. The other principal shareholder and the other minority shareholder would be named as contingent beneficiaries, so that they would become primary beneficiaries if the policy owner predeceased the insured. (This is the way it was done in the ruling, but it probably could have been accomplished more easily and effectively by splitting each of the policies into two separate contracts and assigning them to the smaller shareholder-partners.)

The Service noted that there has been valuable consideration for a transfer of a policy (or an interest in a policy) if either the new policy owner (transferee) promises to relieve the old policy owner (transferor) of the obligation to make premium payments or the transferee promises to use the policy proceeds to purchase the transferor's stock at death.

The Service indicated that the mutuality of the shareholders' agreements to purchase the others' stock in the event of death is valuable consideration (as is the change of policy beneficiary). In the facts in this ruling, the Service noted that:

Each insured will be entitled to receive the proceeds from the other's policy in exchange for allowing the other to acquire a beneficial interest in his policy. The transfer to either a primary or secondary beneficiary will be a transfer of an interest in each policy to a partner of the insured.

Because the transferees were partners in the partnership and partners of the insured, the proceeds were excludable.

This ruling has two particularly important features. First, the Service seemed unconcerned about the purpose of the transfer (to avoid the corporate AMT and to fund the cross-purchase buy-sell), instead focusing solely on whether the transfer fell within a safe-harbor exception. Second, the fact that two of the partners (C and D) owned minuscule one percent interests in the partnership seemed to be irrelevant. They were partners in a legitimate profit-seeking partnership, and that appears to be all that matters to the Service with respect to the protection.

For the planner in the employee-benefit and retirement-planning areas, these cases and rulings provide significant guidance. First, any proposed transfer of an existing policy or any interest in a policy to be used to split premium dollars between two or more parties must be reviewed to determine whether there has been a transfer for a valuable consideration and, if so, whether any of the exemptions will apply to allow the employer or the beneficiary to receive the proceeds income tax free.

Second, in many situations in this area, no physical transfer of a policy may be involved, yet a potential transfer-for-value problem may exist because some part of the proceeds may be paid to parties other than the insured.

Third, in some situations involving a transfer of an interest in a policy, it may seem as though consideration were absent. The Service, however, may argue that the employee is receiving an interest in return for his implied promise to continue working for the corporation. In other situations, there is an actual transfer of a policy to fund the benefits, which might be viewed as a transfer for valuable consideration. In those cases, an analysis of the exemptions to the transfer-for-value rule will be necessary to determine the consequences of the transfer at the death of the insured.

In Private Letter Ruling 9701026, the Service reaffirmed its view that the entry into a split-dollar arrangement can be a transfer for value. Three shareholders, B1, B2, and B3, owned equal shares in a corporation. A collaterally assigned reverse split-dollar life insurance contract owned by that corporation on the life of B3 was transferred by the corporation to shareholders B1 and B2 to finance their obligations under a trusteed cross-purchase buy-sell agreement. All three shareholders were also equal partners in a business which owned, operated, and leased a building to their professional corporation, a law firm.

Before the transfer, premiums for the transferred policy were split. The corporation owned all incidents of ownership and paid for the cost of the death benefit. Shareholder B3 paid the remaining portion of the premium and in return was named recipient of the proceeds, up to the greater of the policy's cash value or the total premiums he paid. The balance of any proceeds were to be paid to B3's heirs. B3 owned the policy's cash value but the corporation held all other incidents of ownership.

The shareholders proposed to enter into a trusteed cross-purchase buy-sell to fund the buy-out of a deceased shareholder and use life insurance to meet their obligations under the arrangement. They proposed to have the corporation transfer the existing reverse split-dollar policy it owns on B3's life to shareholders B1 and B2 and to make the proceeds (less the cash value portion) payable to a trust that would carry out the stock purchase at B3's death. They proposed to sign a private reverse split-dollar agreement with B3 similar to the one presently existing. Under this arrangement, B1 and B2 would pay the death benefit portion of the premiums and B3 would continue to pay (and own) the cash value portion.

The Service stated that there was a transfer of a policy in the absolute transfer of a right to receive at least a portion of the proceeds of a life insurance policy. There was also valuable consideration paid for that transfer, in the corporation's release from the obligation to pay premiums. The Service stated that neither the purchase price need be paid nor that money had to change hands for consideration to be found. However, because the transferees, shareholders B1 and B2, were partners of the insured, the exception to the transfer-for-value rule applied.The Service took particular note of the taxpayer's representation that if the building owned by the partnership in the ruling were sold, the partners would use the proceeds to purchase other investment or business property to continue the firm's operations. This supported the view that the partnership was a bona fide entity that served business or investment purposes beyond merely holding of the life insurance. 209

¶ 2.07[8] Transfers for Value in Other Business Insurance Transactions

¶ 2.07[8][a] Key-Employee Coverage Conversions

A corporation often buys insurance on the life of a key employee. In some cases, such purchases can create transfer-for-value problems.

Example  2-53

ABC Corporation is owned equally by two individuals, both of whom own 50 percent of the stock. ABC owns $1 million life insurance policies on both of their lives. Should either person die, the corporation would receive the proceeds income tax free but would face an AMT liability equal to 75 percent of the excess of its adjusted current earnings over its AMT income. Stated more simply, the business would lose (in a worst-case scenario) about 15 percent of the value of the life insurance, since policy proceeds payable to or for the benefit of the corporation are included in computing the corporation's AMT. 210 To avoid this loss, ABC proposes to transfer the policies to an affiliated general partnership in which the two stockholders of ABC are equal general partners. This partnership owns real estate that is leased to ABC. The policy is to be transferred as partial payment for rent the corporation owes the partnership on buildings the corporation leases. The partnership, as policy owner, can then change the beneficiary designation on both policies. It would name each respective partner the beneficiary of the policy on the other partner.

In the first transaction in Example 2-53, the transfer to the partnership is clearly a transfer and clearly a transfer for value, but because the partnership is an excepted party, no taint attaches to the policies. Likewise, the change of beneficiaries from the partnership that owns the policies to the co-shareholder of the insured is a transfer—of an interest in a policy. The reciprocal promises were the consideration. Once again, however, the transferees, the partners of the insured, fall into a safe-harbor category. 211 This technique is a safe way of turning key-employee coverage (or stock-redemption funding) into cross-purchase or “wait and see” buy-sell. 212

¶ 2.07[8][b] Transfer as Collateral

The relationship between the transfer-for-value rules and the use of a life insurance policy as collateral for a debt is far from clear. Regulation Section 1.101-1(b)(4) provides that “the pledging or assigning of a policy as collateral security is not a transfer for a valuable consideration of such policy or an interest therein, and Code § 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 proceeds paid to a creditor by reason of death of the insured debtor. For instance, in Durr Drug Co. v. United States, 213 a corporation that was owed money by an employee requested the employee take out policies on his life, naming the corporation as the owner and beneficiary. At the employee's death, the corporation received the death benefits and excluded them as having been received by the corporation at the death of the insured (under the predecessor to Section 101(a)). The Service argued that the proceeds were not excludable, since the policy had been transferred for a valuable consideration. The Service also argued that although there was not an actual transfer of the policy from the insured to the corporate debtor, there was a transfer “in legal effect” since the transaction had the same effect as if the policy had originally been issued with the employee debtor as the owner who had transferred the policy to the corporate creditor.

The court had no problem in dismissing the IRS argument that a transfer for value had taken place. The court refused to substitute a possible series of transactions for the transactions that actually occurred and held that the policy was not transferred within the meaning of the Code and that therefore the collection of the proceeds by the creditor corporation was income tax–exempt.

On the other hand, in St. Louis Refrigerating & Cold Storage Co. v. United States, 214 there was an assignment of policies on the debtor's life as collateral security for his obligation to the creditor corporation. The corporation, which had charged off the indebtedness as a bad debt in a prior fiscal year, collected a portion of that indebtedness from the insurance proceeds at his death.

The Service determined that the proceeds, less the premiums paid by the corporation, were income to the corporation. The corporation maintained that the proceeds were not taxable income, since no transfer for value had occurred, arguing that it paid no valuable consideration for the assignment.

The U.S. Court of Appeals for the Fifth Circuit, however, held that the corporation did not receive the proceeds by reason of the death of the insured. Rather, it received them by reason of a repayment 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 security. Accordingly, the court taxed the corporation on the income it received from the 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. 215 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 security), but because it represented a recovery of previously charged-off debt.

Similarly, in Desks, Inc. v. Commissioner, 216 the taxpayer-corporation agreed to pay premiums on a life insurance policy that had been assigned to the supplier by a predecessor of the taxpayer in order to provide security for its debt to the supplier and to obtain credit from a supplier. The predecessor corporation had gone into bankruptcy and eventually paid about 20 percent of its debt to its creditors, including its debt to the assignee of the policy. When the assignee 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. The court found, however, that since the taxpayer had paid in premiums much more than the amount 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.

¶ 2.07[8][c] 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 rules may apply.

In Lambeth v. Commissioner, 217 a corporation in liquidation transferred an insurance policy on his life to the taxpayer and also named the taxpayer as owner of a policy on the life of one of his co-shareholders. On the death of the older co-shareholder, the taxpayer received the policy proceeds. He then excluded the proceeds from his gross income for the year of receipt on the theory that they had been received tax-free under the predecessor to Section 101(a). The Service argued that the contract had been acquired for valuable consideration. That consideration consisted at least partially of the price the taxpayer had paid for his stock when it was first purchased.

The Tax 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 consideration that he paid for the stock constituted consideration not only for the stock but also for any distributions to which he might become entitled as a stockholder, including the insurance policy. The court therefore found 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 to Section 101(a) was not available to the taxpayer, he nonetheless had no income from the transaction, since the price he paid for his stock exceeded the insurance policy proceeds. 218

For the business planner, these cases and rulings provide several useful guidelines. First, in the debtor-creditor area, the present position of the regulations 219 is that assignments of policies as collateral security are not transfers of those policies for purposes of the transfer-for-value rule. This should eliminate the concern expressed in the early cases that amounts received by the creditor at the death of the debtor were taxable income.

Second, in the purchase of a business, planners must be careful to make sure any time a policy is transferred that it was not 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 the taxable amount. Alternatively, the transferor's basis exception may be relied on in a sale that can be structured as a tax-free exchange.

¶ 2.07[8][d] Coverage in Partnership of Non-Partner

Not all key persons are stockholders or partners in a business, and key person life insurance coverage on the life of a nonowner is often used as a business stabilization technique. The income tax consequences of such coverage were examined in Private Letter Ruling 9410039, involving a general partnership operated by a managing director who was not a partner.

The partnership in the ruling bought a key-person insurance policy on the manager's life. The partnership paid all the premiums and was named as beneficiary on the manager's death. The partnership asked whether, each time a new partner was admitted to the partnership or an existing partner withdrew, the Service would consider the partnership to be terminated and reformed. If the partnership were deemed terminated and reformed, the partnership worried that the Service would deem there to have been a transfer for value of an interest in the policy from the old partnership to the new one.

These fears were largely unfounded. The Service stated that it would not treat such a change in partners as a transfer for value, if the partnership's business continued and its assets were not significantly changed. Although a new partner was required to make a capital contribution and a departing partner would receive a return of his or her contributions, the Service stated that this was not the same as a transfer of the policy to a new partnership from an old partnership. The Service noted that a termination of a partnership occurred if no part of the business were continued by any partner or if there were a sale or exchange of 50 percent or more of partnership capital and profits within twelve months. Because neither of those events occurred, the partnership in question was deemed to continue rather than treated as terminated. Therefore, the same partnership continued to own the life insurance both before and after partners entered or left the firm.

¶ 2.07[9] Personal Insurance Planning Problems Under the Transfer-For-Value Rule

¶ 2.07[9][a] In General

Transfers for value can also arise in intrafamily transfers of a life insurance policy, as indicated by the early IRS pronouncement in Income Tax Ruling 3212, 220 in which the insured bought a policy of insurance on his life from his corporate employer and then immediately named his wife as beneficiary. She collected the policy proceeds on the insured's death. The Service held that the proceeds were exempt because the transfer was to a “proper party,” the insured. In this ruling, the Service distinguished the facts of the ruling from those in Hacker v. Commissioner, 221 on the grounds that the transferee in Hacker was the insured. The Service ruled that the proceeds received by the insured's wife at his death were excludable from her gross income under the predecessor to 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 rules should not apply. Accordingly, no part of the proceeds was taxable when received by the beneficiary. 222

In Hacker, the taxpayer's father bought an insurance policy on his own life and 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 policy's cash surrender value. The insured's wife (the taxpayer's mother) then gratuitously assigned the policy to the taxpayer.

The Service asserted that when the taxpayer collected the proceeds at her father's death, the excess of the proceeds over the consideration paid by the taxpayer's mother, plus subsequent premiums paid by the mother and the taxpayer, constituted income to the taxpayer. The taxpayer argued that the transfer-for-value rules should not apply to someone who would be the natural object of the insured's bounty. The Board of Tax Appeals, however, dismissed this argument and held that the IRS determination was correct, since there had been a transfer for valuable consideration from the insured to his spouse (the taxpayer's transferor), and such a transferee thereon becomes an investor in the policy.

¶ 2.07[9][b] Part-Gift/Part-Sale Situations

The typical part-sale/part-gift transfer of a life insurance policy and its moral equivalent, the transfer of an encumbered policy, can create significant transfer-for-value problems. In Revenue Ruling 69-187, 223 the Service 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 Service said 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 proceeds would be received under a policy that had a basis determinable in part by reference to the policy's basis in the transferor's hands. Accordingly, the proceeds, when paid to the wife, would be excludable from her gross income under Section 101(a).

Without specifically so stating, the ruling's holding that the transferee's interest in the policy was acquired “in part for a valuable consideration and in part by a gift” suggests that the Service believed 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. 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 proceeds was taxable when received by the beneficiary at the death of the insured.

In Private Letter Ruling 6712155050 , the Service ruled on a proposed transfer of a life insurance policy by an insured to his wife, subject to a loan that was made by the insured on the security of the policy and without personal liability. Here, the interpolated terminal reserve value of the policy exceeded the indebtedness. The spouse did not intend to assume any personal liability with respect to the indebtedness. The ruling held that the policy proceeds would be collectible by the spouse free from income tax, since her basis in the policy would be determined at least in part by reference to the insured's basis.

In Private Letter Ruling 8027113, the Service reached the same result, with the proviso that “the District Director concurs that there was in fact a gift of the life insurance policy.” In Revenue Ruling 69-187, the policy loan was specifically stated to be less than the policy's gross gift tax value. The letter ruling, however, is silent on the relationship of the loan to the transferor's income tax basis. If a transferred policy is subject to a policy loan, the amount of that loan can be treated as an “amount paid” for the policy. In most cases, the insured's basis (net premiums paid) will exceed the amount of the loan. Therefore, the transferee's basis is determined by reference to the transferor's basis, and there would be no problem.

As previously stated, if the amount of the policy loan exceeds the transferor's basis, however, two results are possible:

1. To the extent the loan is greater than the transferor's net cost, he or she realizes ordinary income (just as if he or she had sold the policy to the transferee for the amount of the loan). 224

2. The transferee's basis is not determined in whole or in part by reference to the transferor's. Rather, it is determined solely by the sales price—the amount of the loan. This means the transferor loses the protection of the transferor's basis exception.

The better planning approach in this situation is to limit the amount of any proposed loan to some level that is clearly less than the transferor's basis. This avoids both the contention that there is a taxable sale on the transfer and that the sales price determines basis.

In Bean v. Commissioner, 225 the taxpayers bought a series of existing policies on the life of their father from him for a cash consideration. The insured-father had reported the transaction as resulting in a taxable gain to him in the year of sale. Since 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 because they were the natural objects of their father's bounty 226 and because his estate had included the excess of the face value of the policies over their cash surrender value. 227 The Tax Court held, however, that the taxpayers had received taxable income on collecting the policy proceeds at their father's death. The amount of that income was the difference between those proceeds and the consideration each had paid. The facts that they were the natural objects of their parent's bounty and that the proceeds were includable in their father's gross estate were irrelevant.

¶ 2.07[9][c] Possible Last Resort—“No Double Dipping” Defense

There is a possible no-double-dipping or last-resort defense that practitioners may want to keep in mind in many transfer-for-value situations. If the insured, within three years of his or her death, transfers a policy on his or her life for less than full and adequate consideration, the value of the proceeds in excess of that inadequate consideration will be included in his or her gross estate under Sections 2035(d) and 2042. For estate tax purposes, the insured will be treated as though the policy were never transferred. It is difficult, then, for the Service to argue, for income tax purposes, that there has been a transfer. 228 However, there is no requirement that the income tax law and estate tax law be parallel and there are many instances where it is not.

¶ 2.07[9][d] The Insured as Transferee

Both Estate of Rath v. United States 229 and Swanson, Jr. Trust v. Commissioner 230 illustrate the issues raised in intrafamily transfers in identifying whether the transferee is the insured so as to avoid the transfer-for-value rule. In Rath, an insurance policy on the corporation's shareholder was transferred directly from the corporation to the shareholder's wife in exchange for the policy's cash value. When the wife collected the policy proceeds, the Service took the position that she had received income because of the transfer from the corporation to her. The wife argued that the policy had been transferred to the insured, who then gratuitously transferred it to her (both of which transfers would have been exempt).

The court ignored the wife's step-transaction argument and held that although the insured might have structured the transfer in a manner that would have qualified it for the Section 101(a)(2)(A) exemption, the policy had not in fact been transferred to the insured and, accordingly, the proceeds were taxable to the wife. In Swanson, Jr. Trust v. Commissioner, the Eighth Circuit held that a transfer of a policy to a grantor trust would be treated as a transfer to the insured for purposes of the transfer-for-value rules, since the trust was ignored for income tax purposes.

¶ 2.07[9][e] Transfers to and From Irrevocable Trusts

Transfers of life insurance policies to and from irrevocable life insurance trusts are common. However, they are dangerous unless planned carefully. One practical problem often facing planners is how to get out of an irrevocable trust. More to the point, how can life insurance policies be safely transferred from one irrevocable trust to another without running afoul of the transfer-for-value trap?

Private Letter Ruling 8951056 seems to provide an answer. There, the insured decided that the beneficiary designations in an irrevocable trust were no longer suitable. He wanted to change the trust's beneficiaries, and he did so in four steps. First, he terminated contributions to the old irrevocable life insurance trust. Second, he created a new irrevocable trust with the desired terms and beneficiaries. Third, he bought the life insurance from the first trust in return for its value as of the date of the transfer. Fourth, he contributed (made a gift of) the life insurance to the new trust.

The policy had a nonrecourse policy loan against it. The Service ruled that the transfer to the insured was a transfer-for-value because he paid for it. Of course, at that point there was no problem because the transfer fell within the “transfers to the insured” safe harbor. He then made a gift to the new trust but was relieved of a burden; the new irrevocable trust took the policy, subject to a loan. The assumption of a policy loan, as mentioned previously, is tantamount to consideration paid by the new trustee to the insured seller since the trust is relieving the insured of an obligation according to the Service. 231 Therefore, the Service cast the fourth step as part-sale/part-gift. Thus, the new trust's basis would be the greater of the amount paid by the trust for the property (i.e., the policy loan debt it assumed) or the insured transferor's adjusted basis for the policy at the time it was transferred to the trust. 232 The insured transferor's basis is the amount he paid the first trustee for the policy plus the amount of any outstanding loan debt he assumed when he purchased the policy from the first trust. The new trust could also add the amount of any gift tax paid on any appreciation in the policy to its basis. 233

The final transfer in this series of transfers was for valuable consideration, but since the new trust determined its basis at least in part in reference to the insured transferor's basis, the trust can exclude from income the same percentage of the proceeds the transferor could have excluded (because the transfer to him, in this instance, was to the insured). 234 So the proceeds were received income tax free.


110

  Feldman, The Feldman Method (Dearborne Financial Publishing, Inc., 1991).


111

  IRC § 61.


112

  This exclusion presupposes that the contract in question meets the tests of Section 7702. If the policy fails to meet these tests, only the net amount at risk (i.e., the pure death benefit) would be income tax free.


113

  IRC § 101(a)(1).


114

  The transfer-for-value exception to the general exclusion from gross income of life insurance proceeds receivable by reason of death of the insured has been in existence since enactment of the Revenue Act of 1926 in one form or another. In 1954, the House Ways and Means Committee proposed an amendment to what was to become Section 101 to grant full exemption to life insurance proceeds payable at death, even where the contract was transferred for a valuable consideration. The Senate Finance Committee, however, believed that the House proposal might result in “encouraging speculation on the death of the insured” and reinstated prior law with respect to transfers for value. However, it did add the “proper party” provisions to what was to become Section 101 to exempt certain transfers for value that, in its view, would be carried out for legitimate business reasons, rather than for speculation. See also S. Leimberg & R. Doyle, The Tools and Techniques of Life Insurance Planning (Nat'l Underwriter Co., 2d ed. 1999); Brody & Leimberg, “The Not So Tender Trap—The Transfer for Value Rule,” 38 CLU J. 32 (May 1994); Brody & Leimberg, “Transfer for Value—A Working Guide,” 9 Tax Mgmt. Est., Gifts & Tr. J. 112 (July/Aug. 1984); Commito, “Transfer for Value Rulings Offer Planning Opportunities,” 45 J. Am. Soc'y CLU & ChFC 38 (1991); Fiore, “Transfers for Value,” 175 J. Acct. 34 (June 1993); Rattiner, “Insurance Tax Traps,” 32 Fin. Plan. 59 (July 2002); Simmons, “The Partnership Exception to the Transfer-For-Value Rule,” 7 Ins. Tax Rev. 699 (July 1993); Slavutin, “Tax Traps to Avoid in the Ownership and Transfer of Life Insurance Policies,” 74 Taxes 26 (Jan. 1996).


115

  B. Bittker & M. McMahon, Federal Income Taxation of Individuals ¶ 6.2 (Warren, Gorham & Lamont 1988).


116

  It may also be expensive to those professionals who should have advised the client of the tax trap that could have and should have been avoided.


117

  “Insurable interest” is a term covered in more detail in Chapter 6. Essentially, it means the policy owner has a stronger preference for the continued existence of the insured than for receipt of the insurance proceeds and would suffer a financial loss at the death of the insured.


118

  These categories are described infra ¶ 2.07[3].


119

  Compare the transfer by the insured to a pension plan beneficiary in Revenue Ruling 74-76, 1974-1 CB 30 , which was held by the Service not to be subject to the transfer-for-value rule, with Waters v. United States, 160 F2d 596 (9th Cir. 1946), cert. denied, 332 US 767 (1947)

.


120

   Hacker v. Comm'r, 36 BTA 659 (1937) . See also Bean v. Comm'r, TC Mem. 1955-295 (1955) .


121

  Reg. § 1.101-1(b)(4).


122

  In Private Letter Ruling 8628007 , A, B , and C are the children of D. A currently owns and is beneficiary of a policy on D's life purchased by A. A borrows money from the insurer under the contract's policy loan provision and assigns an interest in the policy equal to the amount of that loan to the insurer. Any unpaid policy loans will be deducted from policy proceeds. A then makes a second assignment. A's siblings, B and C, will become the contract owners and beneficiaries of the policy through a gratuitous assignment that A makes to them. The Service concludes that (on the condition that the transaction constitutes a gratuitous transfer within the meaning of Regulation Section 1.101-1(b)(2)) there would be no transfer-for-value problem. This result seems to ignore totally the implications of the loan and the liability accepted by the donees. It would appear that the transaction should be examined more under part-gift/part-sale analysis than as a collateral assignment issue, since the assignment made to the siblings was absolute, not collateral (although it is true that the collateral assignment to the insurer itself would not taint the proceeds).


123

  Priv. Ltr. Rul. 8628007. It is unclear whether the Section 101(a)(1) general exclusionary rule applies to amounts received by the pledgee or assignee or whether the Section 101(a)(2) exception for transfers for value to that exclusionary rule applies to amounts received by the pledgee or assignee. Presumably, the interpretation is correct, so the assignee receives the proceeds tax free as a return of capital.


124

  IRC § 101(a)(2).


124.1

  Rev. Proc. 92-57, 1992-2 CB 410; see also Priv. Ltr. Rul. 199912022.


124.2

  Citing Rev. Rul. 85-13, 1985-1 CB 184.


125

  Reg. § 1.101-2(b)(4).


126

   Haverty Realty & Inv. Co. v. Comm'r, 3 TC 161 (1944) .


127

  Reg. § 1.101-1(b).


128

  See, e.g., Desks, Inc. v. Comm'r, 18 TC 674 (1952) ; Lambeth v. Comm'r, 38 BTA 351 (1938) . See also Haverty Realty & Inv. Co. v. Comm'r, 3 TC 161 (1944) , for a discussion of the valuable consideration issue where the insurance-transfer documents and corporate minutes reflected the fact that the transfer was for a valuable consideration.


129

   Monroe v. Patterson, 197 F. Supp. 146 (ND Ala. 1961) ; see also Priv. Ltr. Rul. 7734048.


130

  See Rev. Rul. 69-187, 1969-1 CB 45 .


131

  Reg. § 1.1001-2(a). The Service's position on insurance policy loans, while firmly held by the Service, is contradicted by its position that policy loans are not actual loans for estate tax purposes and are not deductible against an insured's estate. Instead they are treated as a mere advancement against the proceeds. See Reg. §§ 20.2042-1(a)(3) , 20.2053-4. Of course, only the net amount of the proceeds over the policy loan is included in the insured's gross estate.


132

  See infra ¶ 2.07[3][a] .


133

  IRC § 101(a)(2)(A) (the “transferor's basis” exception).


134

  IRC § 101(a)(2)(B) (containing the four “proper party” exceptions).


135

  IRC § 351. Somewhat less common illustrations would include tax-free reorganizations (such as a corporate merger, consolidation, or the transfer of substantially all the property of one corporation solely in exchange for the voting stock of another corporation) under Section 368. These are all examples of tax-free transfers in which it is generally safe to transfer life insurance along with other assets. This is because the basis for the insurance will not change, and, therefore, the exclusion for proceeds will be allowed.


136

  Reg. § 1.101-1(b)(5) (Ex. 2).


137

  Reg. § 1.101-1(b)(5) (Ex. 3).


138

  Reg. § 1.101-1(b)(5) (Ex. 4).


138.1

   Waters v. Comm'r, 160 F2d 596 (9th Cir. 1947) .


139

  See Breen, “Rearranging the Ownership of Life Insurance: The Part Gift, Part Sale Exception to the Transfer for Value Rule,” 12 Keeping Current (1981); Christensen, “Careless Financial Planning by Violating the Transfer for Value Rule Can Transform Tax-Free Life Insurance Proceeds Into Taxable Income,” 56 Tr. & Est. 56 (1989); McAneney, Jr., “Obeying the Transfer for Value Rule,” 24 Fin. Plan. 94 (Dec. 1994).


140

  Reg. § 1.1015-4.


141

  Daughter's basis is Father's adjusted basis, increased by the gift taxes paid on the net appreciation. In this case, as Father's basis in the policy exceeds the present value of the contract, there is no net appreciation and any gift taxes paid by Father will not be added to Daughter's basis.


142

  See Private Letter Ruling 8951056 , where the “gift” of a policy subject to a nonrecourse loan was held to be only in part a gift. But because the transferor's basis exceeded the “amount received” (the loan assumed by the transferee), the transferee's basis was carried over from the transferor and the proceeds were income tax free. But see also Priv. Ltr. Rul. 8628007.


143

  See supra ¶ 2.07[2][e][vi].


144

  Rev. Rul. 69-187, 1969-1 CB 45.


145

  See Priv. Ltr. Rul. 8951056; Reg. §§ 1.101-1(b) , 1.1001-2 , 1.1015; Rev. Rul. 69-187, 1969-1 CB 45 .


146

  Christensen, “Careless Financial Planning by Violating the Transfer for Value Rule Can Transform Tax-Free Life Insurance Proceeds Into Taxable Income,” 56 Tr. & Est. 56 (1989).


147

  This protection applies only to transfers of life insurance policies after July 18, 1984, or after December 31, 1983, if both spouses so elect. A transfer is “incident to a divorce” if the transfer occurs within one year after the date the marriage ends or is related to the termination of the marriage. A transfer of a policy is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ends. See Temp. Reg. § 1.1041-1T , A.7.


148

  This section was intended to reverse the holding of United States v. Davis, 370 US 65 (1962) . That case held that gain must be recognized on the transfer of property incident to a divorce settlement.


149

  IRC § 102.


150

  Temp. Reg. § 1.1041-1T(c), Q.11.


151

  The carryover basis rule under Section 1041(b) applies whether the transferor's basis is less than, equal to, or greater than the FMV of the policy at the time of transfer. Practitioners should recognize that this makes interspousal transfers protected by the basis exception to the transfer-for-value rule different from other transfers by gift. Basis in all other transfers by gift is determined by Section 1015. The difference could be significant if, for example, a client gives his son a policy on the client's life. Assume the policy is subject to a loan. If the cash value in the policy exceeded the net premiums paid by the transferring policy owner (i.e., if the policy had a build in gain at the time of the transfer) and the policy owner has taken out a loan in excess of basis, the Service will argue that the transferee son assumed the transferor father's obligation. That assumption of debt is equivalent to consideration paid and it would be an amount in excess of the father's basis. So the son's basis is not determined by reference to his father's basis. The Section 101(a)(2)(A) safe-harbor exemption would not be available.


152

  See Temp. Reg. § 1.1041-T(b), A.6.


153

  IRC § 1041(d).


154

  This should mean that Section 1041 would not apply in the case of a prenuptial transfer of a life insurance policy in exchange for the surrender of marital property rights. The Service is likely to cast such a transaction as a taxable sale or exchange. See Farid-es-Sultaneh v. Comm'r, 160 F2d 812 (2d Cir. 1947) . The recipient spouse would be treated as a purchaser taking a basis under Section 1012 rather than Section 1041 , and the transferring spouse would have a taxable gain if the value of the policy on the transfer date exceeded his basis.


155

  The exception of Section 1041 does not apply because the transferee's basis is not carried over. If a policy is transferred in trust for the benefit of a spouse or former spouse, gain will be recognized to the extent that the sum of (1) liabilities assumed and (2) liabilities to which the policy is subject at the time of transfer exceed the total of the transferor's adjusted basis.


155.1

  Rev. Rul. 85-13, 1985-1 CB 184.


155.2

  See also, generally, Gopman & McCawley, “PLR 200212007 Gives Boost to Estate Planning With Life Insurance,” 27 Tax Mgmt. Est., Gifts, & Tr. J. 257 (Sept./Oct. 2002) (explaining how this ruling provides additional guidance and comfort when the insured wants to transfer ownership of a life insurance policy from an existing to a new trust).


156

  Reg. §§ 1.101-1(b)(3), 1.101-1(b)(5) (Ex. 6). See also James F. Waters, Inc. v. Comm'r, 160 F2d 596 (9th Cir. 1947), cert. denied, 332 US 767 (1947) .


157

  Reg. § 1.101-1(b)(2). In either case, where the transfer is made to one of the “proper party” individuals or entities described in Section 101(a)(2)(B) , the entire amount of the proceeds will be excludable from the transferee's gross income.


158

  Reg. § 1.101-1(b)(5) (Ex.1).


159

  Where the donee makes any payment for the policy or assumes the donor's liability with respect to a loan against the policy, there are two implications. First, the donor is treated as if he or she sold the policy for the sum of (1) any cash or other property received plus (2) any debt of which he was relieved. Second, the donee is treated as having paid for the policy and therefore takes as his basis the sum of (1) any cash or other payment actually made plus (2) any debt assumed from the donor. However, if the donor's basis at the time of the transfer was higher than this amount, the donee may use the donor's basis. In either case, the donee may also increase basis by the amount of any gift tax paid on the appreciation in property under Section 1015(d)(6). Particular caution must be exercised, because if one party transfers a policy subject to a loan in excess of basis to a nonexempt person or party, such as a client's child or an irrevocable trust, the donee determines basis as though he had purchased the policy for valuable consideration and may not be protected by the carryover basis exemption from the transfer-for-value rule.


160

   Comm'r v. Duberstein, 363 US 278 (1960) .


161

  Reg. § 1.101-1(b)(5) (Ex.5).


162

  The same protection applies if the transfer is to a trust that is treated as owned by the insured under the grantor trust rules of Sections 671 through 679. A transfer to such a trust is protected and it cleanses the taint from any previous transfers for value. Of course, if the insured is considered owner of only a fraction of the trust, only that same portion of the policy proceeds would be protected. See Swanson, Jr. Trust v. Comm'r, 518 F2d 59 (8th Cir. 1975) ; also Ltr. Rul. 200228019.


163

  Reg. § 1.101-1(b)(5) (Ex. 7).


163.1

  Citing Rev. Rul. 85-13, 1985-1 CB 184; see also Pvt. Ltr. Rul. 200228019.


163.2

   Swanson, Jr. Trust v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-61 (1974)

.


163.3

  AOD 38042 (July 23, 1975).


163.4

  See also Priv. Ltr. Rul. 200228019.


164

  Teasingly, the Service said that it expressed no opinion about the effect of the transaction under Section 2035 or Section 2042. If the insured stockholder owned more than 50 percent of the voting stock of the corporation, the transfer of the policy could arguably trigger a new three-year waiting period to remove the proceeds from the insured's gross estate. Rev. Rul. 90-21, 1990-1 CB 172 ; Rev. Rul. 82-141, 1982-2 CB 209 . However, if the insured did not own more than 50 percent of the stock, the transaction should have no adverse estate tax consequences under Sections 2035 and 2042 Also, see generally Commito, “Transfer for Value Rulings Offer = Planning Opportunities,” 45 J. Am. Soc'y CLU & ChFC 38 (Nov. 1991).


165

  The Service also noted that the change of beneficiary from the corporation to B, at the order of new owner B, would be a transfer, but as there would be no consideration for this transfer, it would not raise any issues under Section 101.


166

  See S. Rep. No. 655, 72d Cong., 1st Sess. 59 (1932); HR Rep. No. 708, 72d Cong., 1st Sess. 53 (1932).


167

  Reg. § 1.761-1. See also Comm'r v. Tower, 327 US 280 (1946) ; and Comm'r v. Culbertson, 337 US 733 (1949) , indicating that the business purpose for a partnership may be met by including such a purpose in the agreement, even if the business is never actually conducted.


168

  Reg. § 1.761-2.


169

  See also companion rulings Priv. Ltr. Ruls. 9328010 , 9328017 , 9328019, 9328020.


170

  The IRS recognition of the grantor trust rules as applicable with respect to Section 101 seems inconsistent with the position of the Service in their Action on Decision relating to Swanson, Jr. Trust v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-61 (1974) In that case, the Tax Court and Eighth Circuit both found that a sale = of a life insurance policy to a grantor trust owned by the insured was exempt from the transfer-for-value rules. In the Action on Decision by which the Service explained why it recommended not asking for certiorari in Swanson, Jr., the Service indicated that it still did not agree with the reasoning or holding of the Tax Court or the Eighth Circuit. A.O.D. (July 23, 1975). The Service said:

The Eighth Circuit erred in holding that the trusts as grantor-trusts did not retain their identity as separate tax entities under Section 101(a)(2)(B) .

The fact that the grantor by virtue of powers to control the beneficial enjoyment is taxed on the income of the trusts under Section 674 merely provides that a grantor who retains powers to control beneficial enjoyment is taxed on income. A contrary holding of the Eighth Circuit by looking to a statute whose only function is to prevent tax avoidance (Section 674) in effect broadens the scope of the second statute (Section 101) whose only function is to exclude from income what would be taxable under ordinary principles. It views a statute designed to affect the liability of a particular taxpayer during his lifetime (Section 674 ) as a gloss on another statute (Section 101) which by its term goes into play only after the death of that same taxpayer. A.O.D. (July 23, 1975).

Apparently, this analysis no longer represents the position of the Service.


171

  See Simmons, “IRS Rules Favorably on Partner Exception to Transfer for Value Rule,” 57 Tax Notes 1601 (Dec. 27, 1993).


172

  See also Priv. Ltr. Ruls. 9525022, 9525023

.


173

  Rev. Proc. 96-12, 1996-1 CB 616, amplifying Rev. Proc. 96-3, 1996-1 CB 456 .


174

  See Prop. Reg. 301.7701-2, 61 Fed. Reg. 21,989 (May 13, 1996).


175

  See also Banoff, Eisenberg & Kanter, “Avoiding Minimum Tax Problems From Life Insurance,” 73 J. Tax'n 271 (Oct. 1990) ; Banoff, Eisenberg & Kanter, “IRS Ruling Approves Life Insurance Partnerships,” 78 J. Tax'n 318 (May 1993) ; Eastland, “Using Partnerships to Plan for Life Insurance,” 7 Prac. Tax Law. (Spring (Part I) and Summer (Part II) 1993); Kupferberg & Wolf, “Transferring Life Insurance Policies to a New Partnership,” 20 Est. Plan. 340 (Nov./Dec. 1993); Mittelman, “Partnerships and Life Insurance,” 47 J. Am. Soc'y CLU & ChFC 84 (Nov. 1993).


176

   Swanson, Jr. Trust v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-61 .


177

   Swanson, Jr. Trust v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-61 (1974) See also discussion in Price, “Transfers of Life Insurance:. Opportunities and Pitfalls,” 27th U. Miami Est. Plan. Inst. ch. 3 (1993).


178

  This also assumes that the entity is not a trust or estate. See IRC § 7701(a)(2).


179

  See also similar ruling in Priv. Ltr. Rul. 9012063 .


180

  It is unclear how a partnership should treat the cash value of the policy on the insured's death when the partnership took the cash value into income when the policy was first acquired (as would be true under Priv. Ltr. Ruls. 9012063 and 9309021, where the partnership acquired the policy as partial rent payment). For a discussion of the various alternatives, see Banoff, Eisenberg & Kanter, “Can Life Insurance Partnerships Deduct Cash Value?” 77 J. Tax'n 190 (Sept. 1993) .


181

  See Simmons, “The Partnership Exception to the Transfer-For-Value Rule,” 7 Ins. Tax Rev. 699 (July 1993). If the proceeds are payable to or for the benefit of anyone other than the partnership or its creditors, the Service is likely to claim that the insured partner possessed an incident of ownership and will include the value of all the proceeds in his estate. See Rev. Rul. 83-147, 1983-2 CB 158 ; Reg. § 20.2042-1(c)(6).


182

  Rev. Proc. 2003-3, § 3.01(5), 2003-1 IRB 113 (Jan. 9, 2003); Rev. Proc. 96-12, 1996-1 CB 616. See also Priv. Ltr. Ruls. 9511009, 9309021 , 9328010, 9328012 , 9328017, 9328019 , 9012063.


182.1

  See discussion of the GST tax at ¶ 3.04; also see Harrington, Plaine & Zaritsky, Generation-Skipping Transfer Tax (Warren, Gorham & Lamont, 2d ed. 2001).


183

  See, e.g., Priv. Ltr. Rul. 9045004.


184

   Monroe v. Patterson, 197 F. Supp. 146 (ND Ala. 1961) . This case is also one of the leading cases in determining what constitutes a transfer for value. See also Private Letter Ruling 8906034, where a father bought an existing policy on his own life from his corporation and then made a gift of the policy to his son, contingent on the son's promise to keep the policy in force and use the proceeds to purchase his father's stock from the father's estate. The gift was held to be consideration. Note that in this ruling, the Service held that the proceeds were nevertheless excludable because in a series of transfers, if the final transferee takes his basis by gift and his basis is determined by reference to the transferor's basis under Section 1015 (assumed in the IRS holding but not ruled on), his ability to exclude the proceeds is dependent on the previous policy owner's ability to do the same. Since the transfer to his father was protected by the “transfers to the insured” safe harbor, the proceeds would be excludable by the son. Planners should note the precondition of safety: that the transfer from father to son was in fact the result of a “detached and disinterested generosity” as defined in Comm'r v. Duberstein, 363 US 278 (1960) . It appears the Service could easily argue that, in fact, the transfer was made to ensure a market for the father's stock and provide cash for the father's estate and did not result from mere “love and affection.”


185

  See discussion at Adams, “Questions and Answers on Estate Planning and Administration,” 124 Tr. & Est. 63 (1985).


186

  See IRC § 101(a)(2)(A); Rev. Rul. 69-187, 1969-1 CB 45 .


187

   Estate of Rath v. United States, 608 F2d 254 (6th Cir. 1979) .


188

  See Apfel & Wolfe, “AMT Increases Advantages of Cross-Purchase Arrangements Over Redemption Agreements,” 43 Tax'n for Acct. 364–368 (Dec. 1989); Wolfe & Kupferberg, “What Is the Best Form For Structuring Corporate Buy-Out Agreements Now?” 16 Est. Plan. 2–6 (Jan/Feb. 1989); Gorfinkle, “Should Redemption Agreement Be Changed When S Corporation Status Is Elected?” 69 J. Tax'n 220–224 (Oct. 1988) .


189

  But see Private Letter Ruling 8906034 , where a corporation transferred insurance that had been used to fund a stock-redemption plan to the insured father for an amount equal to the policy's value as of the date of the transfer. The insured then made a gift of the policy to his son (simultaneous with the son's promise to (1) keep the policy in force; (2) use the proceeds to purchase his father's stock at his death; and (3) make up any shortfall between the purchase price and the proceeds through negotiable promissory notes to his father's estate). The Service ruled that the proceeds were excludable “provided that the transferee's basis is determined by reference to the basis of the transferor.” This favorable conclusion was based on an assumption that the Service did not rule on, namely, that the transfer from the father to the son was a gift as defined for income tax purposes. Again, however, planners should be careful to make sure that what are intended to be gifts are, for income tax purposes, gifts. Comm'r v. Duberstein, 363 US 278 (1960) , requires that a gift be made because of “detached and disinterested generosity.” The Service could still argue in this case that there was no gift; the transfer was made to assure the transferor-father that his estate would have (1) a market for the father's stock; (2) cash for the father's estate to pay taxes and other expenses; and (3) assets to distribute to the children who were not working in the business. Unfortunately, the father may never be sure of the outcome, since the Service can choose to wait until the father's death to rule on the “gift” issue.


190

  See discussion of buy-sell agreements funded with insurance in Chapter 8.


191

  The Service is likely to take the position that the basis of the estate of Adam in the policies it owns and then sells is the basis Adam had in the policies. The Service is likely to view the excess of its cash value over the premiums paid as income in respect of a decedent, for which no basis increase is allowed on the death of the insured. IRC § 1014(c). There is, however, no precedent on this point, and a reasonable argument could be made that the policy should be treated like any other asset and a basis increase allowed.


192

  See, e.g., Priv. Ltr. Ruls. 9328012, 9012063

.


193

  Rev. Proc. 2003-3, §§ 3.01(4), 3.01(42), 2003-1 IRB 113 (Jan. 9, 2003).


194

  IRC § 101(a)(2)(B); see also Swanson, Jr. v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-061 (1974) .


195

  See, e.g., Priv. Ltr. Ruls. 9309021 (insurance to fund cross-purchase buy-sell agreement held by a partnership formed exclusively to manage the life insurance policies); 9235029 (corporation sold insurance policy on the life of stockholder to an irrevocable trust that was established for stockholder's two sons, and that was a partner with insured in a pre-existing partnership).


196

  Rev. Rul. 73-338, 1973-2 CB 20.


197

   Haverty Realty & Inv. Co. v. Comm'r, 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, therefore, there was no transfer of the policies for a valuable consideration.


198

  See also Priv. Ltr. Rul. 7752109, reaching the same result.


199

  The Service cited both Rev. Rul. 74-76, 1974-1 CB 30, and Rev. Rul. 73-338, 1973-2 CB 20 .


200

  Rev. Rul. 74-76, 1974-1 CB 30.


201

  See also Private Letter Ruling 8050045, which reached a similar result, where the policy was owned by and payable to the corporation and was sold to the participant, who then transferred it to his account in the retirement plan. Also see Private Letter Ruling 7906051 , involving a rollover from one qualified plan to another.


202

  The Service noted that the adoption of the plan, the creation of the trust, and the contribution of funds to the trust would not be a transfer of property under Section 83 or a contribution to a nonexempt employee's trust under Section 402(b), nor was there a transfer under the constructive receipt theory or economic benefit doctrine. The favorable transfer-for-value result is therefore conditioned on the plan being an unsecured, unfunded promise by the employer.


203

  Planners should note that the Service pointed out in this ruling that since there was no absolute transfer of the insurance and, in essence, the company remained the owner and beneficiary, on an insured's death, the proceeds would remain subject to the corporate-level AMT.


204

  See also Private Letter Ruling 9109018 , which involved a transfer of life insurance policies to a trust used to finance the nonqualified deferred compensation liabilities of employers who were members of an affiliated group. The Service ruled that there would be no transfer-for-value problem assuming: (1) the beneficial interests of the individual employers did not change; (2) an employer's interest cannot be used to satisfy a plan obligation for which another employer is liable; (3) a policy can be used to satisfy the claims of creditors; and (4) the trust remains a grantor trust.


205

   Estate of Rath v. United States, 608 F2d 254 (6th Cir. 1979) .


206

  See Chapter 6 for more details on split-dollar life insurance.


207

  See also Private Letter Ruling 7910064, in which the Service ruled that a corporation owning ordinary life insurance contracts on the lives of participating employees and retirees under a retired lives reserve program would not be subject to the transfer-for-value rules, despite the intended use of the proceeds of those policies to pay premiums under the plan for other retired employees. Similarly, in Private Letter Ruling 7730037, the Service ruled that a nonqualified deferred compensation arrangement, under which the corporation would own and be the beneficiary of life insurance policies on the lives of participants in the plan, which would be used, along with other corporate assets, to fund the death and retirement provisions of the plan, would not be subject to Section 101(a)(2). Although it cannot be said that either of these rulings focused on the transfer-for-value issue directly, they are included here because they both implicitly ruled on the issue.


208

  Presumably, the ruling was based on the theory that the first transfer from the corporation to the insured was covered by the exemption for transfers to the insured and the second transfer was similarly covered by the exemption for transfers, in which the transferee has a carryover basis from the transferor. The ruling did not deal with the tax consequences to the corporate employer of its receipt of a part of the policy proceeds after the transfer, but, again, that transfer would presumably be exempt, since the corporation was one in which the insured was both an owner and a shareholder.


209

  Also see Private Letter Ruling 9701026, where the Service stated that the entry into a split-dollar agreement was a transfer for value but fell into a safe harbor where the parties were also partners in a bona fide partnership.


210

  See Apfel & Wolfe, “AMT Increases Advantages of Cross-Purchase Arrangements Over Redemption Agreements,” 43 Tax'n for Acct. 364 (Dec. 1989); Wolfe & Kupferberg, “What Is the Best Form For Structuring Corporate Buy-Out Agreements Now?” 16 Est. Plan. 2 (Jan./Feb. 1989).


211

  Priv. Ltr. Rul. 9012063; see also Kanter & Banoff, “Avoiding Minimum Tax Problems From Life Insurance,” 73 J. Tax'n 271–272 (Oct. 1990) .


212

  On the different types of buy-sell agreement, see discussion at ¶ 7.04.


213

   Durr Drug Co. v. United States, 99 F2d 757 (5th Cir. 1938) .


214

   St. Louis Refrigerating & Cold Storage Co. v. United States, 162 F2d 394 (8th Cir. 1947) .


215

  See McCamant v. Comm'r, 32 TC 824 (1959) , which held that where a debtor, without notifying his creditor, purchased insurance on his life, naming the creditor as beneficiary to the extent of any indebtedness that he might owe at the time of his death, the amount received by the creditor was not excludable under Section 101(a), since the amounts had been previously deducted in prior years and the proceeds were collected by the creditor not by reason of the death of the insured but only by reason of the debt. See also Federal Nat'l Bank, v. Comm'r, 16 TC 54 (1951) , citing St. Louis Refrigerating & Cold Storage Co. v. United States, 162 F2d 394 (8th Cir. 1947) , for the proposition that a pledged insurance policy is no longer insurance but is merely collateral, and that, therefore, the insurance provision of Section 101(a) does not apply.


216

   Desks, Inc. v. Comm'r, 18 TC 674 (1952) .


217

   Lambeth v. Comm'r, 38 BTA 351 (1938) .


218

  See also, e.g., King Plow Co. v. Comm'r, 110 F2d 649 (5th Cir. 1940), aff'g 40 BTA 1348 (1941) , as an example of a case holding that the predecessor of Section 101(a)(2) applied to the acquisition of policies received in a tax-free reorganization. Note that this specific issue has been resolved by the exemption contained in Section 101(a)(2)(A) .


219

  Reg. § 1.101-1(b)(4). Note, however, that the full import of that regulation section is not clear. Does it mean that the exception to the general exclusionary rule of Section 101(a) does not apply to such amounts, or that the exclusionary rule itself does not apply to those amounts? It would seem to make sense that Section 101 does not apply at all, on the theory that the proceeds are no longer insurance, but a return of capital.


220

  1938-2 CB 65.


221

   Hacker v. Comm'r, 36 BTA 659 (1937) .


222

  Note that there were no statutory exemptions to the transfer-for-value rule at that time.


223

  Rev. Rul. 69-187, 1969-1 CB 45.


224

  See Gallun v. Comm'r, 327 F2d 809 (7th Cir. 1964) ; Simon v. Comm'r, 285 F2d 422 (3d Cir. 1961) ; and Malone v. United States, 326 F. Supp. 106 (ND Miss. 1971) .


225

   Bean v. Comm'r, TC Mem. 1955-240 (1955) .


226

  See Hacker v. Comm'r, 36 BTA 659 (1937) .


227

  See also Pritchard v. Comm'r, 4 TC 204 (1944) , in which the proceeds of policies 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.


228

  See Pritchard v. Comm'r, 4 TC 204 (1944) . But also see Bean v. Comm'r, TC Mem. 1955-240 (1955) , where there was no court decision holding that the proceeds were estate tax includable, even though the Service contended they were. In this case, the Tax Court held that the taxpayer had not proved the proceeds were includable in the estate, and so the “never transferred” (for estate tax purposes) defense against the transfer-for-value rule could not be used.


229

   Estate of Rath v. United States, 608 F2d 254 (6th Cir. 1979) .


230

   Swanson, Jr. v. Comm'r, 518 F2d 59 (8th Cir. 1975), aff'g TC Memo. 1974-061 (1974) .


231

  This argument is specious. The loan is not one that the insured ever has to pay off nor is it one for which the insured is personally liable in any way; it merely reduces the amount payable at death. Yet the Service treats the transfer to the trust as part sale and part gift.


232

  Reg. § 1.1015-4. See also Rev. Rul. 69-187, 1969-1 CB 45.


233

  IRC § 1015(d).


234

  Reg. § 1.101-1(b)(3).

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