Revenue Ruling 59-31: Transfer for Value Rule Explained

Revenue Ruling 59-31 is an interpretation by the Internal Revenue Service (IRS) concerning the tax implications of transferring ownership of a life insurance policy. This ruling is relevant for business owners, individuals engaged in estate planning, and their financial advisors. It clarifies an exception to a broader tax rule, ensuring that certain common transactions do not result in unintended tax consequences for policy beneficiaries.

The Transfer for Value Rule

The “transfer for value” rule is established in Internal Revenue Code Section 101. While the death benefit from a life insurance policy is normally received by beneficiaries free of income tax, the transfer for value rule creates an exception. The rule’s purpose is to discourage the trading of life insurance policies as speculative investments.

The rule is triggered when a life insurance policy is transferred to a new owner for valuable consideration, which can include cash, property, or services. When this happens, the tax-free status of the death benefit is lost. The new owner’s beneficiaries must include in their gross income the portion of the death benefit that exceeds the new owner’s basis in the policy. This basis is the amount paid for the policy plus any subsequent premiums paid by the new owner.

Consider a scenario where an individual sells a policy on their own life to an unrelated third party for $50,000. The third party then pays an additional $10,000 in premiums before the insured individual passes away. If the policy pays a $500,000 death benefit, the transfer for value rule would apply. The new owner’s beneficiary would have to report $440,000 of taxable income, which is the $500,000 death benefit minus the $60,000 total investment ($50,000 purchase price + $10,000 premiums).

This tax treatment can reduce the net amount received by beneficiaries and create an unexpected liability. The rule applies to any transfer of an interest in the policy for value. There are several statutory exceptions, such as transfers to a partner of the insured or a corporation in which the insured is an officer.

How the Ruling Modifies the Rule

Revenue Ruling 59-31 provides an interpretation that impacts the transfer for value rule. The ruling clarifies that when a life insurance policy is transferred to the insured person, it is not considered a transfer for value. This holds true even if the insured pays a fair market price to acquire the policy from its previous owner, creating a safe-harbor exception.

The IRS’s logic is that a transfer to the insured is substantially the same as the insured purchasing a new policy on their own life. Since an individual buying a policy on their own life does not trigger the rule, allowing the insured to reacquire a policy aligns with the tax code’s principles.

This interpretation is a planning tool that neutralizes the transfer for value rule in this specific circumstance. By transferring the policy back to the insured, any prior transfer for value issues are cleansed. The death benefit payable to the insured’s beneficiaries will then be fully income tax-free.

Common Applications of the Ruling

The guidance from Revenue Ruling 59-31 is frequently applied in business and personal financial planning. It allows for the tax-efficient unwinding of insurance arrangements that are no longer needed or have become inappropriate due to changed circumstances.

One common use involves corporate-owned life insurance. A business might purchase a “key person” policy on an employee or shareholder to protect the company against financial loss from that person’s death. If that individual later terminates their employment or sells their ownership stake, the company no longer needs the policy.

The company can then sell the policy to the departing individual for its fair market value. Because the transfer is to the insured, Revenue Ruling 59-31 ensures the transaction is exempt from the transfer for value rule. The individual can then hold the policy for their own estate planning, and their beneficiaries will receive the death benefit without income tax liability.

Another application arises in buy-sell agreements between business partners. In a “cross-purchase” agreement, partners buy life insurance policies on each other. The death benefit provides the surviving partner with cash to purchase the deceased partner’s share of the business from their estate.

If the partnership dissolves or the agreement is terminated, the partners are left holding policies on individuals with whom they no longer have a business relationship. The ruling provides a solution where each partner can sell the policy they own back to the partner who is insured. This transfer to the insured preserves the tax-free nature of the death benefit for the new owner’s family.