Income Taxation of Life Insurance
As a general principle, the proceeds of a life insurance policy paid by reason of the insured's death are received income tax free by the beneficiary. This exclusion from income taxation applies regardless of whether the proceeds are paid to an individual, a partnership, corporation, or trust.
Death benefit payments which have the characteristics of life insurance proceeds payable by reason of death, such as workmen's compensation or accident and health contracts, are also are received income tax free by the beneficiary.
An important exception exists to the general rule that life insurance proceeds are excluded from the gross income of the beneficiary. This exception is known as the “transfer for value rule,” and it works like this: after the initial issuance of a policy, if it is subsequently transferred for “valuable consideration,” the income tax exclusion under Internal Revenue Code Section 101(a) is lost, and the beneficiary must include in gross income the proceeds received to the extent that they exceed both the consideration paid by the transferee of the policy and any subsequent premium payments or other costs of maintaining the policy after the transfer.
John purchases a $750,000 life insurance policy on his own life, naming his brother Tom as the beneficiary. Subsequently, John transfers the ownership of the policy to Tom for $5,000. This is a transfer for value . During the succeeding four years Tom pays annual premiums of $2,000 per year. Thereafter, John dies and Tom receives the $750,000 death benefit under the policy. Because of the transfer for value rule, Tom realizes taxable income in the amount of $737,000 (the $750,000 proceeds, less the $13,000 which he paid to acquire and maintain the policy).
See: The Transfer for Value Tax Trap for a detailed discussion.
Estate Taxation of Life Insurance
Life insurance death benefits receivable by named beneficiaries will be subject to estate tax and included in the gross estate of the insured, if the insured, at the time of his or her death, held any incidents of ownership in the policies on his or her life. Also, if life insurance death benefits are payable to the estate, or are used to discharge a legal obligation of the estate, those proceeds will be subject to estate tax.
The term "incidents of ownership" is not limited in its meaning of ownership of the policy in the technical legal sense. It generally means the right of the insured or the estate of the insured to the "economic benefits" of the policy.
Attorney Adler focuses his practice on estate planning, wills, trusts and estates. He can be reached at 212-843-4059 or 646-946-8327.