Under the transfer-for-value rule in IRC §101(a)(2), when a life insurance policy is sold or transferred for valuable consideration, the death benefit received by the new owner is:
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Answer & full 3-part explanation (select an option above, or peek)
Why B is correct
Normally death proceeds are tax-free, but the transfer-for-value rule under IRC §101(a)(2) is an exception: if a policy is transferred for valuable consideration, the new owner includes in gross income the death proceeds to the extent they exceed the consideration paid plus any premiums the new owner later paid. The buyer's basis is the purchase price plus later premiums, and the gain is taxed as ordinary income at death. Certain transfers are exempt, such as transfers to the insured or to a partner or partnership of the insured, and those exempt transfers preserve the tax-free death benefit.
Why the other options are wrong
- A) The general §101(a) exclusion is lost when a policy is transferred for value; the new owner includes the proceeds over their basis in the contract in income. The exception overrides the general rule.
- C) The proceeds are not fully taxable; the new owner first recovers the purchase price and later premiums before recognizing any gain on the death benefit. Only the profit over basis is taxed.
- D) Holding period does not restore the exclusion; the transfer-for-value rule applies regardless of how long the buyer owns the policy. Time in force never cures the problem. The rule is automatic.
Memory hook
Buy a policy, and the profit over your purchase price becomes taxable at death.