Journal of Financial Planning: September 2015
David M. Cordell, Ph.D., CFP®, CFA, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island
Planners and clients often take for granted that life insurance proceeds paid by reason of the death of the insured are exempt from federal income tax. That exclusion of life insurance death benefits from the definition of income is found in I.R.C. Section 101(a)(1).
Similar to most tax code sections, however, the exclusion of life insurance death benefits from income has its exceptions. In the case of life insurance, the exception—called the transfer for value rule—states that if a life insurance policy is transferred for valuable consideration, the death benefit becomes taxable to the extent it exceeds the purchaser’s basis in the policy.
Exceptions to the Transfer for Value Rule
The transfer for value rule itself has some exceptions, reviving the tax-free nature of life insurance death benefits even if there has been a transfer for valuable consideration. I.R.C. Sec. 101(a)(2) states that death benefits on life insurance transferred for valuable consideration to the insured, to a corporation in which the insured is a shareholder, to a partner of the insured, to a partnership in which the insured is a partner, or to a transferee who takes the transferor’s basis, will be excluded from income when determining the income tax liability of the beneficiary. These exceptions to the transfer for value rule have been relied on by planners and clients seeking to retain the tax-free nature of life insurance death benefits.
Although these principles of life insurance taxation have, so far, stood the test of time, statutory exclusions from the definition of income, including the exclusion for life insurance, can be taken away at the whim of the government. That is exactly what President Obama has proposed to do in his 2016 fiscal year budget, referred to as the Green Book.
The Green Book proposal asks Congress to subject the death benefit of life insurance to income tax when it is transferred for valuable consideration to the insured, and proposes a new requirement on transfers for value associated with partnerships and corporations to retain the death benefit income tax exemption.
Under the President’s Green Book proposal, the death benefit on life insurance transferred for valuable consideration to a corporation or to a partnership in which the insured is a 20 percent or greater owner would be subject to income tax. These proposals, if adopted, would result in more revenue for the government at the expense of planning flexibility for clients.
The Key Person Case
Key person life insurance is often purchased by companies to protect their interest in their human capital. Employees who possess special skills essential to the success of a business, and are either directors of the company or are highly compensated employees or individuals as defined by the code, are referred to as key employees.
If one of those key employees were to die unexpectedly, business revenue and profits may decline, and the business may incur significant costs to attract and retain a new employee with a similar skillset. To hedge against these potential losses, businesses often purchase life insurance on the life of the key employee. Under current law, if a business receives a death benefit from a life insurance policy on the life of a key employee who was an employee of the company at any time within 12 months of death, that death benefit is exempt from income tax.
If a key employee lives throughout his or her work life expectancy and retires, however, the business no longer needs to maintain a key person life insurance policy on that employee’s life to hedge against potential losses. Presumably, the employee’s skillset will have already been replaced by the new employees. As such, continuing to pay premiums no longer serves a business purpose, and as a consequence, I.R.C. Sec. 101(j) requires the life insurance death benefit in excess of the employer’s basis in the policy (basis would equal the cumulative premium payments) to be subject to income tax if the insured was not an employee or director of the company within 12 months of his or her death.
How can the life insurance death benefit be protected from income taxation after a key employee retires? Simply stated, the business sells the life insurance policy on the key employee to that employee upon retirement. While the sale of the policy is a transfer for valuable consideration, because the policy was sold to the insured (an exception to the transfer for value rule), the death benefit is exempt from income taxation. This is an optimal solution for both the business and the key employee. The business no longer has a need to maintain the life insurance because the insured no longer poses a risk of loss to the business, and will be subject to death benefit taxation if the death benefit is received more than a year after the employee retires. The employee who purchases the policy now has life insurance that can be used for a variety of planning purposes, and the beneficiary of the policy will receive the proceeds income tax free.
Should Congress choose to adopt the President’s Green Book proposal to repeal the transfer for value exception for transfers to the insured, key employees who purchase life insurance policies on their lives from former employers would no longer qualify for the death benefit exemption from income tax.
The impact of the proposal is likely to be either: (1) the employee does not purchase the policy from the employer and the employer surrenders the policy subjecting the policy gain to income tax; or (2) the employee purchases the policy and the beneficiary pays income tax on the death benefit. This outcome is a win-win for the government, but a lose-lose from the perspective of the taxpayer.
The Buy-Sell Case
Individuals who create small businesses jointly owned with others typically enter into buy-sell agreements requiring surviving owners to purchase their interest at death. Buy-sell agreements protect the interest of the deceased owner by creating a market for an otherwise illiquid asset and by ensuring that the deceased owner’s family will receive a fair value for the business interest. Buy-sell agreements protect the interest of the surviving owners by ensuring that control of the company is maintained. Because buy-sell agreements are often triggered at death, life insurance is an ideal source of funding for the required buyout called for in the agreement.
An entity-type buy-sell agreement requires the company (a corporation or partnership) to purchase the interest of a deceased owner. Sometimes, individuals may have purchased life insurance policies when they were younger that are no longer needed for planning purposes. Examples include life insurance purchased to send children to college, to pay off the mortgage, and to secure retirement income for a surviving spouse that is still in force when all of these financial obligations have been satisfied. A common solution to this problem is for the business owner to sell the life insurance policy on his or her life to the business so the business will have the funds to purchase their interest upon death.
While this is a transfer for valuable consideration, because the policy was sold to a corporation or partnership in which the insured was an owner (an exception to the transfer for value rule) the death benefit on the policy will not be subject to income taxation. This transaction is mutually beneficial for the parties, because the insured can dispose of a policy that is no longer needed and the business can obtain a policy that can be used to satisfy its obligations under the buy-sell agreement without subjecting the death benefit to income tax.
The President’s Green Book proposal would change this result by subjecting the life insurance death benefit to income tax if the insured is a 20 percent or greater owner in the business. This proposal would raise additional tax revenue for the government, but it would limit planning flexibility for small business owners seeking to protect their investment though the use of entity-type buy-sell agreements.
Tax law is only as permanent as Congress wants it to be. Planners have been able to rely on the techniques described here to protect their clients through the use of life insurance. As the federal government needs to raise revenue to offset its debt, many of the tax rules we have come to take for granted are under attack. For life insurance planning, the President’s Green Book proposals that erode the exceptions to the transfer for value rule may well be the foot in the door leading to additional attempts to subject life insurance death benefits to income tax.