Transferring business-owned life insurance to an individual may make sense for several reasons. A business owner may be selling or leaving the company and want to retain the coverage for personal planning. A retiring employee may want to continue coverage, including coverage originally maintained for a key-person insurance need, that was previously owned by the employer. In other situations, a business may simply determine that it no longer needs to own the policy.
Transferring a business-owned life insurance policy, however, is more than an administrative change of ownership with the insurance company. The transfer can have income-tax, compensation, distribution, valuation, and policy-basis consequences for both the business and the individual receiving the policy.
The tax treatment depends on several factors, including:
- The type of business entity that owns the policy,
- Who will receive the policy,
- Whether the policy is sold, distributed, or transferred as compensation,
- The fair market value and tax basis of the policy, and
- Whether other tax rules, including the transfer-for-value rules, apply to the transaction.
These distinctions matter because two businesses transferring otherwise similar life insurance policies can produce different tax results depending on how the transaction is structured.
Before Transferring a Business-Owned Life Insurance Policy
Before changing policy ownership, the business and its advisors should determine why the policy is being transferred and how the transaction will be characterized for tax purposes.
For example, a policy transferred to a shareholder-employee might be treated differently depending on whether it is transferred as compensation, distributed to the shareholder in their capacity as an owner, or sold to the individual. A policy transferred to a non-owner employee presents a different set of considerations. The transfer may also need to be coordinated with an existing buy-sell agreement or other ownership-transition plan. Partnerships operate under different property-distribution and basis rules than corporations.
The policy itself must also be reviewed. Its cash value, tax basis, outstanding loans, surrender charges, death benefit, and other contractual rights may affect the economics or tax consequences of the transfer.
For that reason, the ownership-change form should generally be one of the final steps in the process—not the first. The transaction should be evaluated by the company's tax and legal advisors before the carrier records the new owner.
Determining the Fair Market Value of a Life Insurance Policy
Determining the value of the policy is an important part of many business-owned life insurance transfers. Fair market value can affect the amount treated as compensation, a corporate distribution, or the consideration required in a sale.
The fair market value of a life insurance policy should not automatically be assumed to equal its cash surrender value. Life insurance contracts can include rights and benefits that are not fully reflected by the amount available upon immediate surrender, and the appropriate valuation method can depend on the type of policy and the circumstances of the transfer.
IRS guidance addressing life insurance contract valuation recognizes that the value of a policy can require consideration of the policy's contractual rights and, in certain circumstances, an approximation based on policy reserves and other amounts rather than simply its cash surrender value.
Because valuation can materially affect the tax consequences of a transfer, businesses should consider obtaining appropriate policy information from the insurance carrier and coordinating with their tax advisor. For transactions involving significant policy values or unusual circumstances, an independent valuation may also be appropriate.
Transferring a Life Insurance Policy From an S Corporation
When an S corporation transfers a life insurance policy to an individual, the tax consequences depend in part on whether the recipient is a shareholder, an employee, or both, and how the transfer is characterized.
Transfer to a Shareholder-Employee
A policy transferred to a shareholder-employee may potentially be treated as compensation for services or as a distribution with respect to the individual's ownership of the corporation. Those alternatives can produce different tax consequences and should be established before the policy ownership is changed.
Transfer as Employee Compensation
If the policy is transferred as compensation for services, the fair market value of the policy generally becomes relevant in determining the amount included in the employee's compensation. The corporation may be entitled to a corresponding compensation deduction if the applicable requirements for deductibility are satisfied.
The corporation must also determine whether transferring the policy causes it to recognize gain at the corporate level. The policy's fair market value, tax basis, and other policy-specific tax rules should therefore be reviewed as part of the transaction.
The amount included in the recipient's income generally affects the recipient's tax basis in the policy after the transfer. Accurate documentation of the transaction and the recipient's resulting policy basis is important for future withdrawals, surrender, sale, or other taxable events involving the policy.
Transfer as a Shareholder Distribution
If the policy is distributed to an individual in their capacity as a shareholder, the transaction is governed by the rules applicable to S corporation property distributions rather than compensation.
An S corporation generally recognizes gain when it distributes appreciated property if the property's fair market value exceeds the corporation's adjusted tax basis in the property. That gain generally passes through to the shareholders and can affect their stock basis.
At the shareholder level, the tax treatment of an S corporation distribution depends on factors that include the shareholder's stock basis and whether the corporation has accumulated earnings and profits from a period in which it was a C corporation. For many S corporations without accumulated earnings and profits, a non-dividend distribution is generally not taxable to the extent of the shareholder's available stock basis, while a distribution exceeding stock basis can create taxable gain.
The shareholder's basis in property received in a corporate distribution is generally its fair market value. This policy basis should be tracked separately from the shareholder's basis in the S corporation stock.
Because S corporation income and distributions can change shareholder stock basis during the same tax year, the basis calculation should be completed as part of the transfer analysis rather than relying solely on the shareholder's beginning-of-year stock basis.
Transfer to a Non-Shareholder Employee
If an S corporation transfers a policy to an employee who is not a shareholder, the transfer would generally be analyzed as compensation rather than as a shareholder distribution. The fair market value of the policy may be included in the employee's taxable compensation, and the corporation may be entitled to a compensation deduction if the applicable requirements are satisfied.
The corporation must also determine whether it recognizes taxable gain in connection with the transfer and should document the employee's resulting tax basis in the policy.
Whether the recipient is a shareholder-employee or a non-owner employee, the company should coordinate the policy valuation, compensation or distribution treatment, corporate gain, reporting requirements, and resulting policy basis with its tax advisor before completing the ownership change.
Transferring a Life Insurance Policy From a C Corporation
When a C corporation transfers a life insurance policy to an individual, the tax treatment depends on who receives the policy and whether the transfer is treated as compensation, a shareholder distribution, or another type of transaction.
Transfer to a Shareholder-Employee
A shareholder who is also an employee may receive the policy in connection with services performed for the corporation or in their capacity as a shareholder. Determining the character of the transfer is important because compensation and shareholder distributions are subject to different tax rules.
Transfer as Employee Compensation
If the policy is transferred as compensation for services, the fair market value of the policy generally becomes relevant in determining the amount included in the employee's taxable compensation. The corporation may be entitled to a corresponding compensation deduction if the applicable requirements for deductibility are satisfied.
The corporation must also determine whether the transfer causes it to recognize taxable gain. The policy's fair market value and adjusted tax basis should therefore be established before the transaction is completed.
The amount included in the recipient's income generally affects the recipient's tax basis in the policy following the transfer. That basis should be documented because it can affect the tax consequences of future withdrawals, surrender, sale, or other transactions involving the policy.
Transfer as a Shareholder Distribution
If the policy is transferred to an individual in their capacity as a shareholder, the transaction is generally analyzed under the rules governing corporate distributions of property.
A C corporation generally recognizes gain when it distributes appreciated property to a shareholder as though the property had been sold for its fair market value. If the policy's fair market value exceeds the corporation's adjusted tax basis, the corporation may therefore recognize taxable gain in connection with the distribution.
At the shareholder level, the tax treatment of the distribution generally depends on the corporation's earnings and profits and the shareholder's stock basis. A distribution may be treated as a dividend to the extent of applicable earnings and profits, followed by a reduction of stock basis and, if the distribution exceeds the remaining stock basis, potentially taxable gain.
The shareholder's tax basis in property received in a corporate distribution is generally its fair market value. The resulting policy basis should be documented separately from the shareholder's basis in the corporation's stock.
Unlike compensation paid for services, a distribution made to a shareholder in their capacity as an owner does not create a compensation deduction for the corporation.
Transfer to a Non-Shareholder Employee
If a C corporation transfers a policy to an employee who is not a shareholder, the transaction would generally be evaluated as compensation. The fair market value of the policy may be included in the employee's taxable compensation, and the corporation may be entitled to a corresponding compensation deduction if the applicable requirements are satisfied.
The corporation must also evaluate whether the transfer results in taxable gain and should document the employee's resulting tax basis in the policy.
Whether the recipient is a shareholder-employee or a non-owner employee, the corporation should coordinate the valuation, characterization of the transfer, corporate-level tax consequences, reporting requirements, and resulting policy basis with its tax advisor before completing the ownership change.
Transferring a Life Insurance Policy From a Partnership
Life insurance owned by a partnership presents different tax considerations from coverage owned by an S corporation or C corporation. The consequences depend in part on whether the policy is distributed to a partner, transferred to an employee, sold, or transferred as part of another transaction.
Distribution of a Policy to a Partner
A partnership generally does not recognize gain or loss simply because it distributes property to a partner. Likewise, a partner receiving property in a partnership distribution generally does not recognize gain merely because the fair market value of the distributed property exceeds its tax basis. However, exceptions and additional rules can apply depending on the assets distributed and the circumstances of the transaction.
The partner's tax basis in a distributed life insurance policy is particularly important. In a non-liquidating distribution, the basis of distributed property generally begins with the partnership's adjusted tax basis in the property immediately before the distribution, but it cannot exceed the partner's remaining adjusted basis in the partnership interest after taking into account money distributed in the same transaction.
If the policy is distributed in complete liquidation of the partner's interest, different basis rules apply. In that situation, the aggregate basis of property received generally reflects the partner's remaining adjusted basis in the partnership interest after taking into account money distributed as part of the transaction.
The distribution also reduces the partner's basis in the partnership interest. Because the policy's fair market value and its tax basis may be substantially different, the value of the policy should not be assumed to determine the partner's resulting tax basis in the contract.
Transfer of a Policy to an Employee
A policy transferred by a partnership to an employee who is not receiving it in their capacity as a partner is generally analyzed differently from a partnership property distribution. If the transfer represents compensation for services, the policy's fair market value may be relevant in determining the employee's taxable compensation and the partnership's potential compensation deduction.
The partnership must also evaluate the tax consequences associated with disposing of the policy itself, including any gain that may be recognized in connection with the transfer. The employee's resulting basis in the policy should be documented as part of the transaction.
Partnership Reporting and Basis Documentation
Partnership property distributions can also create reporting obligations for the partner receiving the policy. Beginning with tax years in which the current reporting requirements apply, a partner receiving certain distributed property may be required to report the distribution and the basis of the property on Form 7217, Partner's Report of Property Distributed by a Partnership.
The partnership and the recipient should therefore coordinate the policy's adjusted basis, fair market value, the partner's basis in the partnership interest, and the applicable reporting requirements before ownership is transferred.
Tracking the Tax Basis After a Policy Transfer
Once a business-owned life insurance policy has been transferred to an individual, documenting the new owner's tax basis in the policy is important. The resulting basis may depend on how the transfer occurred, so it should not automatically be assumed to equal the premiums historically paid by the business.
This distinction can become important years after the ownership change. The new owner may eventually take withdrawals, surrender the policy, sell it, exchange it, or allow a policy with outstanding loans to lapse. The policy's tax basis can affect the amount of gain recognized in several of those transactions.
Carrier Records May Not Reflect the Entire Tax History
An insurance carrier maintains information about premiums and other transactions involving the contract, but its records may not fully reflect tax-basis adjustments resulting from a prior transfer between a business and an individual.
For example, if an individual received a policy as taxable compensation and recognized income based on the policy's fair market value, the individual's resulting tax basis may differ from the historical premium information maintained in the carrier's records. Similar documentation issues can arise after other types of transfers.
Future Tax Reporting
If the policy is later surrendered or another reportable transaction occurs, the insurance carrier may issue Form 1099-R or other applicable tax reporting based on the information available in its records. That reporting may not necessarily establish the owner's correct tax basis for federal income-tax purposes.
For that reason, the business and the individual receiving the policy should retain documentation showing how the transfer was characterized, the policy's fair market value at the time of transfer, amounts included in income, the business's tax basis in the policy when relevant, and the recipient's resulting tax basis.
Maintaining those records at the time of the transfer can be considerably easier than reconstructing the transaction years later when the policy is surrendered, sold, lapses, or otherwise creates a potential taxable event.
Transfer-for-Value and Other Policy-Specific Tax Issues
Changing the ownership of a business-owned life insurance policy can raise tax issues beyond the immediate income, compensation, distribution, and basis consequences of the transfer. One of the most important is the transfer-for-value rule.
Understanding the Transfer-for-Value Rule
Life insurance death benefits are generally excluded from federal gross income, but that treatment can be limited when an interest in a life insurance policy is transferred for valuable consideration. If the transfer-for-value rule applies, the amount of death benefit that can be excluded from income may generally be limited to the consideration paid for the policy plus certain premiums and other amounts subsequently paid by the transferee.
Several exceptions can preserve the income-tax treatment of the death benefit in qualifying transactions. Depending on the circumstances, exceptions may apply to certain transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Certain transfers in which the recipient's tax basis is determined by reference to the transferor's basis may also qualify for an exception.
Those exceptions should not be assumed to apply automatically. Current law also contains special rules for reportable policy sales, and the history of prior policy transfers can affect the analysis.
Policy Loans Require Separate Analysis
Outstanding policy loans should also be identified before ownership is transferred. A policy loan can affect the economics of the transaction, the policy's future performance, and the tax consequences of a later surrender or lapse.
The existence of a policy loan does not by itself mean that the transfer-for-value rule applies. Rather, the transfer-for-value analysis depends on whether an interest in the policy has been transferred for valuable consideration and whether an applicable exception is available.
Review the Policy's Transfer History
The current ownership change should not always be analyzed in isolation. Prior transfers of the policy, changes in ownership, sales or other transactions involving an interest in the contract may affect the tax treatment of a subsequent transfer or the eventual death benefit.
Before completing a business-to-individual transfer, the advisory team should therefore review the policy's ownership history, tax basis, outstanding loans, proposed consideration, and the relationship between the insured and the new owner.
Before Completing a Business-Owned Life Insurance Policy Transfer
Transferring a business-owned life insurance policy to an individual can appear straightforward, but the ownership-change form is only one part of the transaction. The tax consequences can depend on the type of business entity, the relationship between the business and the recipient, how the transfer is characterized, the policy's fair market value and tax basis, and whether other policy-specific tax rules apply.
Before completing the transfer, the business and its advisors should determine:
- Why the policy is being transferred and who will become the new owner,
- Whether the transaction will be treated as compensation, a distribution, a sale, or another type of transfer,
- The policy's fair market value and adjusted tax basis,
- Whether the business or recipient may recognize taxable income or gain,
- The recipient's resulting tax basis in the policy,
- Whether outstanding loans or prior transfers require additional analysis, and
- Whether the transfer-for-value or other policy-specific tax rules could affect the transaction.
The appropriate structure should be determined before the insurance carrier records the ownership change. Coordinating the transaction with the company's CPA, legal counsel, and life insurance advisor can help ensure that the policy transfer, tax reporting, and basis documentation are handled consistently with the intended transaction.
Once the transfer is complete, the new owner should retain the transaction records and periodically conduct a life insurance policy review to determine whether the coverage, beneficiaries, funding, and policy performance continue to support the planning objective for which the policy is being retained.
Important Tax and Legal Information
This article is provided for general informational and educational purposes only and is not intended to provide tax, legal, accounting, or investment advice. The tax consequences of transferring a life insurance policy depend on the specific facts and circumstances of the transaction and applicable law. Business owners and policyholders should consult their own tax and legal advisors before transferring or changing ownership of a life insurance policy.
