Transferring Ownership of a Life Insurance Policy: The Taxable Distribution Trap


Most people own their own life insurance policy and name the appropriate individual or trust as a beneficiary.  However, there are situations where the insured wants  someone else – or some other entity – to own his life insurance policy.  Can ownership of life insurance be transferred?  Sure!  But there is a serious tax trap for the unaware – if transferred improperly, the policy proceeds may constitute taxable income to policy beneficiaries (this is called the “transfer for value” rule).

The insured may have any one of a number of reasons for wanting the ownership of a life insurance policy to change.  The most typical reasons are either for estate tax savings or in a business situation.  Many time, especially for estate tax reasons, life insurance policies are owned by trusts.  This allows for flexible estate planning because the policy proceeds are not subject to estate tax, and the trust can be structured so that distributions to beneficiaries can be contingent on a number of factors, like age.  It can also provide liquidity to an estate when estate taxes come due.  What happens if an individual’s estate planning goals change?

When the policy is placed in an irrevocable trust (meaning, a trust which the person who created the trust (“grantor” or “settlor”) generally cannot alter), it may be possible to sell the life insurance policy to another trust with different terms reflecting a person’s change in circumstances.  But the sale must be carefully constructed, because when a life insurance policy is sold for value, the policy proceeds will be subject to income tax.  Income tax will apply to any amount over and above an amount equal to that which was paid to transfer ownership of the policy (plus any money the transferee subsequently pays on the policy itself).

There are some exceptions to this transfer for value rule.  In other words, a sale or transfer of a life insurance policy from the original owner to a new owner (or from one Irrevocable Life Insurance Trust to another Irrevocable Life Insurance Trust) can be structured to avoid the future income tax on the life insurance proceeds.

For years Altman & Associates has  been successfully updating estate plans, that include life insurance policies owned by someone other than the insured – and clients do not lose the benefit of income-tax-free policy proceeds.  To make this work, the transfer must fall within the Tax Code’s “safe harbor.”  To name just a few examples, the life insurance policy can be transferred for value to a trust owned by the insured, to a partner of the insured, or to the spouse of the insured.  It is also possible to transfer a survivorship life insurance policy (which is insuring two individuals), but even more careful planning may be required.

Don’t fall into a trap!  Life insurance planning can be complex. For more information, contact us at (301)468-3220 or liz@www.altmanassociates.net.

–  Gary Altman, Esq. and Coryn Rosenstock, J.D.

RELATED:  The Irrevocable Life Insurance Trust:  Irrevocable for Good?

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