Advanced Underwriting Consultants

Question of the Day – October 18

Ask the Experts!

Here’s the question of the day.

Question: What are the tax consequences of making a gift of a life insurance policy subject to a loan?

Answer:   The gift of a policy in which the outstanding loan exceeds the owner’s basis may create an income tax liability not only to the donor upon transfer of the policy, but also to the donee upon the death of the insured.

The reason for this disastrous turn of events is the transfer of a policy with a loan exceeding basis is treated not as a gift, but as part-gift, part-sale.  The consideration, or sale price, is the donee’s assumption of the outstanding loan.  Code Section 1001(b) states amount received from a sale consists of the sum of cash plus the fair market value of property received other than cash.  Regulation 1.1001-2(a) says that amount received includes “the amount of liabilities from which the transferor is discharged as a result of the sale or other transfer.”

Let’s assume the owner of the $1 million death benefit policy in the following example decides to gift it to a child or an irrevocable trust.

Cash surrender value $  8,353.00
Total loans $66,466.00
Basis ( $ 3,802 premium x 10 years ) $ 38,020.00

The cash value, $8,353, is considered to be a gift.  An amount equal to the outstanding loan is considered to be a sale.  Thus, the owner receives $66,466 (assumption of the outstanding loan by the new owner) for property with a basis of $38,020.  The owner must report ordinary income of $28,446 on the transaction.

Furthermore, the donee will be taxed at the insured’s death.  Code Section 101 provides any transfer for a valuable consideration of a right to receive all or part of the proceeds of a life insurance policy is a transfer for value.  The donee’s assumption of the policy loan is considered to be valuable consideration.

Where a life policy is transferred for value, the amount of its death proceeds excludable from income is limited to consideration paid for the policy by the transferee plus any further premiums.  Unless the transaction falls under one of the exceptions to the transfer for value rule, the donee will owe income tax on the death benefit to the extent it exceeds her basis in the policy.

The donee’s basis in the policy is determined according to the rules set out in Regulation 1.1015.  In a part sale, part gift transaction, the donee’s unadjusted basis in the transferred property is equal to the gift tax paid by the donor plus the greater of (1) the consideration paid or deemed to have been paid by the donee, or (2) the donor’s adjusted basis in the property.

In our example, the donor paid no gift tax, therefore the donee’s unadjusted basis in the policy is $66,466 (the greater of $66,466 or $38,020).  Suppose the donee continues the policy and pays $50,000 in premiums prior to the insured’s death.  To the extent the donee receives death proceeds exceeding $116,466 ($66,466 plus $50,000), she must pay income tax on the excess.  In this example, that means $883,534 of the death benefit that’s taxable.

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