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Life insurance proceeds are generally received income tax-free, but failure to avoid the transfer for value rule may result in a loss of the exclusion from income. This first part of a two-part article analyzes the rule and its exceptions.
The utility of life insurance to clients' estate planning cannot be overstated.1 Life insurance is essential for meeting the needs to provide capital and income for food, clothing, shelter, and education for a client's family, to pay death-generated expenses and taxes, to satisfy mortgages and other debts, to fund buy-sell agreements, to stabilize a business following the death of a key individual, to finance the satisfaction of a business obligation (such as an employer's obligation under a death-benefit-only plan or a non-qualified deferred compensation plan or to help meet retirees' health insurance costs), to equalize an estate, to provide a significant charitable gift, and to meet the often immense financial needs of physically, mentally, or emotionally challenged-or gifted-children. Through life insurance, death-the event that creates the need for cash-creates the cash to satisfy the need.
Unfortunately, the incredible usefulness of life insurance is diminished to the extent of any tax burden it must bear. Failure to avoid the transfer for value rule can trigger such a loss. Although the transfer for value rule and the various exceptions to its application pervade much of the life insurance planning that practitioners undertake on behalf of their clients, the rule and its limited exceptions are all too easy to overlook or misunderstand. An awareness of the transfer for value rule and its potentially draconian dangers is crucial in planning personal or business life insurance transactions. Every transfer of a life insurance policy or even of an interest in a life insurance policy during the insured's lifetime should be considered suspect, until it is scrupulously checked and each element of the transfer for value rule is examined.2
Income tax exclusion lor life insurance proceeds
One of the most important exceptions to the general rule that all income from whatever source derived is taxable3 is the one which provides that gross income does not include amounts received under a life insurance contract, if those amounts are paid by reason of the insured's death.4
The exclusion for life insurance...