Among the more difficult topics on the Certified Financial Planner™ exam is the transfer for value rules. Why is this topic so frustrating and how can you think of it in a way that is easy to remember?
For starters, you need to recognize and remember for the CFP® exam (and in practice) that in most cases, the death benefit from a life insurance policy is received income tax-free by the beneficiary. Keep in mind, however, that this is the case most of the time. There are times, however, when life insurance proceeds are subject to federal income taxes, and violating any of the transfer for value rules will trigger taxation. To be clear, it’s important to remember that only the portion of the death benefit that is above and beyond what the purchaser of the policy paid, plus all premiums paid by the buyer, will be subject to tax. In other words, only the portion of the death proceeds that exceed the buyer’s basis in the policy will be taxed.
The reason why transfer for value rules exist is because at one point, investors (more like speculators) would purchase existing life insurance policies simply to get income tax-free proceeds. Congress felt that such an arrangement, while perfectly legal, was a bit egregious. Therefore, to dissuade investors from buying existing life insurance policies simply for the tax-free benefit, transfer for value rules were written into law.
However, as with many topics on the CFP® exam, there are exceptions to the transfer for value rules. In other words, even if an existing policy is purchased from a policy owner, the transfer for value rules and associated taxation of life insurance benefits will not apply.
Here are the 5 exceptions to the transfer for value rules:
1. Anyone whose basis is determined by reference to the original transferor’s basis
- Think 1035 exchange here. In other words, a policy owner can exchange (sell) an existing policy for a new policy without triggering the transfer for value rules because when doing a 1035 exchange, the owner’s basis in the new policy is determined by reference to their original basis.
2. The insured (or insured’s spouse or ex-spouse) if part of a divorce settlement
- After a divorce, it may not make too much sense for the ex-spouses to insure each other. Under a typical arrangement after marriage, a husband insures his own life and names his wife and the beneficiary, and vice versa. After a divorce, it should be understood that this may not be an appropriate arrangement any longer.
3. A business partner of the insured
- Think cross-purchase plan where each business partner buys a life insurance policy on the life or lives of the other partner or partners. If one of the partners leaves the company, he may want to buy the policy that the other partner or partners have on his life since the policy may have been purchased many years earlier and has acquired significant cash value.
4. A corporation in which the insured is a shareholder or officer
- Think entity-purchase plan where the corporation buys life insurance policies on the lives of some of its shareholder or officers. When the shareholder or officer leaves the company, they oftentimes will buy the life insurance policy from the corporation. Why would they do that? Because it’s likely the policy was purchased on the life of the shareholder or officer a decade or two earlier when the insured was much younger. Also, it’s likely the has been significant cash value accumulation so it may be in the insured’s interest to buy the policy from the corporation and use the policy for estate planning and other needs.
5. A partnership in which the insured is a partner
- Refer to the explanation in #4 above. It’s the same idea except we’re dealing with a partnership instead of a corporation.
Hopefully this clarifies some of the confusion that could exist on the Certified Financial Planner® exam regarding transfer for value rules. It should be noted that it’s important not to confuse a transfer for value (i.e. sale or similar arrangement) with the gifting of a life insurance policy. These are two different types of transactions and need to be kept separate when you encounter these topics on the CFP® exam.