Transferring a Life Insurance Policy
4 Items to Consider
An existing life insurance policy may be transferred to an irrevocable life insurance trust via gift or sale. Given the type of transfer, potential tax consequences should be considered.
(1) Avoiding the 3 Year Rule Under Code Section 2035, the insured must survive for three years after the life insurance policy is transferred, beginning on the date of the transfer. Otherwise, the policy proceeds will be included in the client’s estate and taxed at the client’s highest federal estate tax bracket. Thus, the client’s effort and expense to establish the life insurance trust would be wasted.
The most favored option to avoid application of Section 2035 is to sell an existing policy to a life insurance trust. Because the transfer is by sale rather than by gift, Section 2035 does not apply.
(2) Transfer for Value Rule Life insurance death benefit proceeds are generally excluded from income. However, there is an exception known as the Transfer for Value rule. The IRS will disregard a grantor trust for income tax purposes and basically treat the client as the owner.
If the client sells an existing policy to a life insurance trust, which is designed as a grantor trust, the transfer is treated as a sale from the client to the client. For income tax purposes, the buyer and seller of the insurance policy are the same and the Transfer for Value rule is avoided.
(3) Valuation of a Life Insurance Policy When a transfer is initiated by gift or sale, the client’s accountant will require the fair market value (FMV) of the life insurance policy. The form 712, “Life Insurance Statement” should be requested from the insurance company. The value is generally determined to be the policy’s “interpolated terminal reserve” at the date of the gift plus any unused premium plus dividends minus policy loans. Essentially, the value is approximately equal to the policy’s cash surrender value.
(4) Gifting a Life Insurance Policy An individual may transfer $14,000 per year to any number of donees without using any of the donor’s lifetime estate and gift tax credits. Many then infer that the donor may contribute $14,000 for every withdrawal right beneficiary of an irrevocable trust.
Gifts to a life insurance trust are gifts of a future interest and do not qualify for the gift tax annual exclusion. Thus, gifts are usually accompanied by a 30 day withdraw right for each beneficiary of the trust. The beneficiary may withdraw his or her portion of the gift. This Crummey power qualifies the gift as a present interest.
The simpler option is to gift the policy to the life insurance trust. However, this will trigger the 3 year rule under Section 2035. If the client is not concerned about the 3 year rule, then a gift of the life insurance policy is a simpler choice.
The other option is to sell the policy into the life insurance trust. This process involves gifting cash from another source to the life insurance trust. The trustee utilizes the cash to buy the policy from the client. The client may have to use a portion of his or her lifetime gift exemption to make the initial gift. In addition, the client may be unwilling to temporarily part with a large cash amount.