Tax Consequences of Transferring a Life Insurance Policy

Transferring ownership of a life insurance policy is a significant financial decision. This action, which involves formally changing the policy owner with the insurance carrier, carries a range of tax implications. Failing to understand these consequences before a transfer can lead to unexpected tax liabilities for the original owner, the new owner, or the policy’s beneficiaries. The complexities of the tax code require careful consideration to ensure the intended financial benefits are not undermined.

Gift Tax Implications of a Transfer

When a life insurance policy is transferred to another person for less than its full value, the transaction is considered a gift and may be subject to federal gift tax. This applies primarily to permanent life insurance policies that have an accumulated cash value, as term policies typically have no value to gift. The donor is responsible for filing a gift tax return, Form 709, if the policy’s value exceeds the annual gift tax exclusion amount.

Determining the policy’s value for gift tax purposes is a specific calculation and not simply its cash surrender value. The IRS requires the value to be its fair market value, which for an in-force policy is its “interpolated terminal reserve” value plus any unearned premium. This value can be obtained from the insurance company and is generally higher than the cash surrender value.

Once the policy’s value is determined, the annual gift tax exclusion can be applied. For 2025, an individual can gift up to $19,000 to any number of individuals without incurring gift tax. If the policy’s value is above this amount, the excess is a taxable gift. This taxable amount is then applied against the donor’s lifetime gift and estate tax exemption of $13.99 million for 2025.

The Transfer-for-Value Rule

An often misunderstood aspect of transferring a life insurance policy is the transfer-for-value rule, detailed in Internal Revenue Code Section 101. Generally, death benefits from a life insurance policy are received by the beneficiary free of income tax. This rule, however, creates an exception where if a policy is transferred for any form of valuable consideration, the tax-free status of the death benefit is lost.

When the transfer-for-value rule is triggered, the death benefit becomes taxable as ordinary income to the beneficiary. The taxable amount is the total death benefit minus the new owner’s basis in the policy. The new owner’s basis includes the consideration paid for the policy, plus all subsequent premiums paid to keep the policy in force. This can result in a significant tax liability.

The IRS interprets “valuable consideration” broadly, and it is not limited to a simple cash payment. It can include the reciprocal transfer of policies between business partners to fund a buy-sell agreement. Another example is the transfer of a policy subject to an outstanding loan; the new owner taking over the loan is considered to have provided valuable consideration. This broad definition means many transactions can inadvertently trigger the rule.

Exceptions to the Transfer-for-Value Rule

The tax code provides specific safe-harbor exceptions that allow a policy to be transferred for value without jeopardizing the income-tax-free status of the death benefit. These exceptions are narrowly defined and apply only to certain classes of transferees. Proper structuring of the transfer to fall within one of these categories can prevent adverse tax outcomes.

These business-related exceptions are designed to facilitate common business succession and continuity planning. Exempt transfers include those to:

• The insured person
• A partner of the insured
• A partnership in which the insured is a partner
• A corporation in which the insured is a shareholder or officer

Another exception covers transfers where the new owner’s basis in the policy is determined by the original owner’s basis. This occurs in transactions structured as a pure gift, where no consideration is exchanged. If a policy is gifted, the transfer-for-value rule does not apply, and the death benefit retains its income-tax-free character. This exception also extends to certain corporate reorganizations.

Estate Tax Considerations

A primary motivation for transferring ownership of a life insurance policy is to remove the proceeds from the original owner’s gross estate. If an individual owns a policy on their own life at death, the full death benefit is included in their taxable estate. This can subject the estate to federal estate tax if its total value exceeds the lifetime exemption amount. Transferring the policy to another person or an irrevocable life insurance trust (ILIT) is a common strategy to avoid this.

The effectiveness of this strategy is governed by the three-year look-back rule, found in IRC Section 2035. This rule states that if a policy is gifted and the original owner dies within three years of the transfer, the IRS will disregard the transfer for estate tax purposes. Consequently, the full value of the death benefit is pulled back into the deceased’s gross estate, negating the intended tax savings.

To successfully remove the policy from the estate, the original owner must survive for more than three years after the transfer is legally completed. The three-year clock starts on the date the transfer is completed. This rule applies even if the transfer was a bona fide gift for which a gift tax return was filed. This timing issue requires careful planning, particularly for individuals in poor health.