FIT INCOME TAXATION, IRC 101(a) – proceeds of life insurance payable by reason of death not included in gross income, except –

a    transfer for value rule, 101(a)(2) – if life insurance contract is transferred for a consideration, proceeds over and above purchaser’s basis is ordinary income.

b    Example – F is insured and owner of $100,000 life insurance policy that names daughter D as primary beneficiary.  CSV = $9,500.  D buys policy from F for $9,500.  After transfer, D pays $6,500 in premiums to keep policy in force.  F dies and D is paid $100,000. The proceeds not included in F’s GE b/c he owned no incidents of ownership.  D has basis of $16,000 ($9,500 + $6,500) and under transfer for value rule, realizes $84,000 in gain taxed to D as ordinary income.

c    Example 2 – Same facts except F gives all incidents of ownership of policy to D.  Now, there are no gift tax consequences b/c falls within the $10,000 annual exclusion.  F dies more than 3 years later and the $100,000 paid to D is not included in F’s GE and there are no income tax consequences to D.

d    Example 3 – D applies for policy on F’s life.  F is insured but D is owner and pays all premiums.  F dies several years later and $100,000 paid to D.  The policy proceeds are not included in F’s GE for FET purposes and there are no income tax consequences to D.

e    Return to example 1 where F is insured with D as beneficiary.  F cashes the policy in for $9,500 during his lifetime.  He only pays income tax on the amount that $9,500 exceeds his basis in policy.