Selling A Term Life Insurance Policy creates thorny tax issues

A life insurance policy is like the proverbial pot of gold at the end of the rainbow.

But in the case of term life insurance policies, collecting the pot of gold can prove elusive. If the insured dies after the policy term ends, the beneficiaries get nothing. In fact, most term policies never pay any death benefits.

Purchasing an existing term policy from the insured as an investment is incredibly risky for the buyer- they will end up with nothing if the insured lives too long. For this reason, investors in the business of purchasing life insurance policies seldom purchase term policies unless they can be converted into permanent insurance, such as whole life.

The only exception is where the insured is terminally ill and highly unlikely to outlive the policy term.

The story of Uncle Bob

You might be able to sell your term life insurance policy to a relative or another individual not in the business of buying life insurance policies. Consider the following example.

Uncle Bob has had, for several years, a $1 million term life insurance policy that is not convertible to whole life or other permanent insurance. The policy term has 10 years left. Uncle Bob is a widower and has no children. His nephew, Joe, offers Uncle Bob $10,000 and promises to pay the rest of the premiums if Bob makes Joe the beneficiary.

As expected, such a transaction has tax consequences, as you will see in the answer to the three questions below:

Question 1
How does Uncle Bob treat his $10,000 payment from Joe?

Although the transaction appears informal, its economic substance is that Uncle Bob received $10,000 in exchange for valuable future rights to a $1 million death benefit. The IRS and courts would likely view this as a transfer for valuable consideration.

In the life insurance context, a “transfer for valuable consideration” means any transfer of an interest in a life insurance contract for cash or other consideration reducible to a money value. Thus, for example, the IRS ruled that there was a transfer for value when a couple’s children paid them a nominal amount and agreed to pay all future premiums on the couple’s life insurance policy in return for a share of the death benefits.

Whether Uncle Bob has a taxable gain on his $10,000 payment from Joe depends on his basis in his policy. Bob’s basis is equal to the premiums he paid before the transfer to Joe. This is true even though the premiums only provided insurance protection, not a basis in a cash value account.

Thus, if Bob paid $10,000 or more in premiums, he would have no taxable gain. If, for example, he paid $5,000 in premiums, he’ll have $5,000 in taxable income. Because this is a term policy with no cash surrender value and Bob has owned the policy for more than one year, the entire amount would be taxable as a long-term capital gain.

Question2:
If Uncle Bob dies within 10 years, how will Joe’s $1 million death benefit be taxed?

Generally, life insurance death benefits are tax-free. But this is not the case when a policy is purchased for valuable consideration. In this event, the death benefits paid on the policy are excluded from income only up to the amount paid for the policy plus any premiums paid after the transfer.

There are some exceptions to the transfer-for-value rule: transfer to a partner of the insured to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, but none of them apply here.

Joe paid $10,000 for the policy. If Joe also pays $10,000 in premiums, $20,000 of the death benefit will be excluded from income. His taxable income upon Bob’s death will be $980,000. This is taxed as ordinary income, not capital gain.

Question 3:
If Uncle Bob doesn’t die within 10 years?

A life insurance policy is a capital asset. Does this mean that Joe has a $10,000 capital loss? No, a term insurance policy us not like a whole life policy with cash value. It has no property-like investment attributes that accrue over time. Once it expires, it’s economically worthless.

When a term policy expires, there is no sale, exchange or other fixed identifiable event that the IRS recognizes for deduction. The “mortality loss” attributable to Uncle Bob’s longevity is not a recognized loss for tax purposes.

Can Joe deduct the premiums he paid? No, taxpayers cannot deduct the premiums they pay for a life insurance policy if they are a beneficiary of the policy.

FAQs

What are the tax consequences of selling a term life insurance policy?
Suppose a term policy is sold to an individual (and not to buying life policies). In that case, the IRS generally treats the payment received as a “transfer for valuable consideration.”

How are death benefits taxed if the buyer (new owner) receives them?
Typically, life insurance death benefits are tax-free. However, if the policy was purchased for valuable consideration, the tax-free portion is limited to the total paid for the policy plus future premiums paid.

What if the insured outlives the policy term?
Suppose the insured does not die within the policy’s active term and the policy expires. In that case, the buyer cannot claim a deductible capital loss—even if the policy is considered economically worthless.

BergerCPAFirst, with over 30+ years of experience, offers comprehensive tax preparation services for individuals and businesses nationwide. Our commitment is to provide personalized attention while ensuring compliance and maximizing tax benefits. If you have any questions or would like to schedule a consultation, please call (201) 587-9200 or send us an inquiry.