Generally, when an insured under a life insurance contract dies, the recipient of the policy proceeds is not subject to federal income tax. However, if the contract was previously sold for money or other consideration, this exemption from tax may be lost (except as to the sum of the consideration paid and the premiums subsequently paid by the buyer). This is referred to as the "transfer-for-value" rule.
There are exceptions to the transfer-for-value rule that will allow a policy to be sold but not expose the policy proceeds to income tax. One of these exceptions is for a transfer of the life insurance contract to the insured.
If the grantor trust rules apply to a trust, a life insurance contract (or other asset) held in a trust will be treated as owned by the grantor of the trust. In a recent Revenue Ruling, the IRS addressed two fact patterns involving grantor trusts to determine whether a transfer of a life insurance contract between the two trusts will be subject to the transfer-for-value rule (and thus result in the ultimate income taxation of the policy proceeds), or whether an exception to the transfer-for-value rule will apply.
Under the first fact pattern, a life insurance policy was sold for cash by one grantor trust to another grantor trust (the same individual was the grantor of each trust under the grantor trust rules). Because the grantor is deemed to own the assets of both trusts, when the policy is transferred by one trust to the other, there is no transfer occurring for federal income tax purposes. Therefore, the transfer-for-value rule has no application, and the policy proceeds will not be subject to income tax at the death of the insured.
Under the second fact pattern, the life insurance policy is owned by a nongrantor trust, and a grantor trust holds cash. The insured is the grantor of the grantor trust. The grantor trust purchases the policy from the nongrantor trust. Since both trusts are not grantor trusts, there is a transfer for purposes of the transfer-for-value rule. However, since the insured, as grantor of the grantor trust, is deemed to own all the assets of the purchasing trust, the grantor/insured is treated as the buyer of the insurance policy. Thus, the exception to the transfer-for-value rule for transfers to the insured applies, and again, the policy proceeds payable at the death of the insured will continue to be exempt from income tax.
A practical benefit of these rulings will be to allow for more certainty in dealing with insurance policies owned in trusts, so as to allow for transfers of policies that are no longer desired with policies that are better suited to trust purposes or to deal with changes in circumstances. While nothing in the ruling is of great surprise to tax practitioners, it is always helpful for the IRS to confirm by way of ruling or regulation what is generally otherwise believed to be the case.
Rev Rul 2007-13, 2007-11 IRB.