Transfer-for-Value & Reportable Policy Sale Concerns in Buy-Sell Arrangements

Situation: Using life insurance as a funding vehicle for a buy-sell arrangement gives rise to a number of potential tax traps, especially in out-of-the-ordinary owner/ beneficiary structures. To this author, it seems that more than almost any other area, buy-sell agreement funding, modification, and termination give rise to potential transfer-for-value traps. This Counselor’s Corner discusses some of the most frequent buy-sell situations that result in adverse taxation under the transfer-for-value rule.

Solution: Let’s first review how the transfer-for-value rule works and why it can be so detrimental to a buy-sell situation.

Life insurance proceeds are generally excluded from the income of the beneficiary, even if the policy is used to fund a buy-sell agreement and even if the buyer uses the proceeds to complete the buyout.1 However, IRC § 101(a) provides that all or part of the death benefit proceeds under a policy transferred for valuable consideration will be taxed as ordinary income – unless the transfer falls within an exception to this general rule. Death benefit proceeds from life insurance policies transferred for valuable consideration are generally income taxable to the extent that the proceeds exceed the policy owner’s cost basis (basis).

Consideration is defined broadly and does not need to be cash or property. A mutual or reciprocal promise can trigger the transfer-for-value rule. Herein lies the problem for many buy-sell scenarios.