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

Under IRC §101(a)(1), life insurance death benefits are generally received income-tax-free by the beneficiary. However, IRC §101(a)(2) — the TRANSFER-FOR-VALUE rule — carves out an exception: when a life policy is transferred FOR VALUABLE CONSIDERATION, the income-tax exclusion is largely lost. The transferee may exclude only an amount equal to the consideration paid plus any subsequent premiums; the excess death benefit is taxable as ordinary income. Five SAFE-HARBOR exceptions preserve the full exclusion: transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is an officer or shareholder, or a transfer with a carryover basis (e.g., gift). Here, the unrelated third-party buyer fits no exception, so the §101(a)(2) rule applies. Options A, B, and D misstate the rule.