A corporation owns a $1,000,000 key-person life policy on its CEO. The corporation transfers the policy to an unrelated third party for $40,000 cash. The CEO subsequently dies and the third-party owner collects $1,000,000. How is the death benefit taxed to the third-party owner?

Question

Accepted Answer

Under the IRC §101(a)(2) 'transfer-for-value' rule, the income-tax exclusion of the death benefit is LOST; only the amount equal to the buyer's basis (purchase price plus any subsequent premiums) is tax-free, and the excess is taxable as ordinary income — UNLESS one of the statutory exceptions applies (transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation of which the insured is an officer/shareholder)

Answer

Only premiums paid after the transfer are recoverable; no death benefit is paid at all, because a sale of the contract to an unrelated buyer destroys the insurable interest that supported the policy, and an insurer may not pay a face amount to an owner who has no insurable interest in the insured; the corporation's key-person interest in its own CEO is personal to the corporation and cannot be assigned along with the contract, and the buyer may recover the $40,000 it paid only by suing the corporation that sold it the policy

Answer

It is entirely income-tax-free under IRC §101(a)(1), because the exclusion for amounts received under a life insurance contract by reason of the insured's death follows the policy into the hands of whoever owns it at the time of death; the consideration the buyer paid is irrelevant to the exclusion, and the transfer-for-value rule reaches only contracts transferred without consideration, such as an outright gift to a trust

Answer

It is fully taxable as long-term capital gain, because the buyer held the contract as an investment asset for more than one year before the insured died, so the full $1,000,000 is reported as a capital transaction; purchasers in the life-settlement market recognize the entire death benefit at long-term capital-gain rates, and no part of the proceeds is recovered tax-free as a return of the buyer's basis, even in the year of the insured's death

A corporation owns a $1,000,000 key-person life policy on its CEO. The corporation transfers the policy to an unrelated third party for $40,000 cash. The CEO subsequently dies and the third-party owner collects $1,000,000. How is the death benefit taxed to the third-party owner?

Explanation

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