Tax TreatmentQuestion 232 of 315
An investor purchases an existing $500,000 life insurance policy from the original owner for $40,000 and continues to pay $5,000 in annual premiums until the insured dies five years later. The investor is NOT one of the exempt transferees listed in §101(a)(2). How much of the $500,000 death benefit is taxable to the investor as ordinary income?
a.$0 — the full death benefit is income-tax-free under §101(a)
b.$40,000 — only the purchase price is taxable
c.$435,000 — the amount that exceeds the $40,000 consideration plus $25,000 of subsequent premiums
d.$500,000 — the entire death benefit is taxable because the policy was sold
Explanation
The transfer-for-value rule under IRC §101(a)(2) taints the §101(a) exclusion when a policy is transferred for valuable consideration to a non-exempt party. The new owner's basis is the consideration paid plus subsequent premiums ($40,000 + $25,000 = $65,000). The death benefit above that basis ($500,000 − $65,000 = $435,000) is ordinary income.
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