Life insurance typically is a key component of an estate plan. To keep the value of a life insurance policy you already own out of your taxable estate, or to achieve other planning goals, it may make sense to transfer the policy. But income tax traps exist. One is the transfer-for-value rule. So before making a transfer, it pays to become familiar with this rule.
CONCEPT AND EXCEPTIONS
Normally, life insurance proceeds payable by reason of death (that is, death benefits) are not subject to income tax. However, when the transfer-for-value rule applies, the transferee – the person receiving the policy – will be subject to ordinary income taxes on the policy’s death proceeds, excluding the consideration paid for the policy and any premiums or other charges he or she pays after the transfer.
The transfer-for-value rule is intended to discourage speculation in life insurance policies by people who lack and insurable interest. An insurable interest is a legitimate reason for someone