Category: Miscellaneous
Subject: Grants/Life Insurance Transfers
Title: Various Issues
IRC Sections: 101, 61
Filename: 1339.html
Date Produced: 09/94

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Facts/Issues
1) Taxpayer received state grants in exchange for hiring and retraining displaced workers. Are these amounts taxable for federal income tax purposes?

2) Facts are as set forth in your memorandum of 9/15/94. Assume the life insurance policies are transferred to a partnership consisting of the four insured shareholders. Assume further that the entire cash surrender value of each policy is borrowed by the corporation prior to the transfer. What are the ramifications under Section 101(a)(2)? Is the initial transfer to the partnership a taxable event?

Issue 1
The language of Internal Revenue Code (IRC) §61 reads in pertinent part "except as otherwise provided in this subtitle" [ i.e., IRC §§1 through 1564, commentary added] "gross income means all income from whatever source derived...". In essence, any realized economic gain is includible in gross income unless explicitly excluded by statute. IRC Subchapter B, Part III (§§101 through 131) provide the various available statutory exclusions from income, and there is no provision exempting grants from state or local governments in connection with hiring displaced workers. Absent a specific provision excluding such amounts, it seems that the government grants would be taxable.

Issue 2
Internal Revenue Code (IRC) §101(a) provides generally that gross include does not include life insurance proceeds paid by reason of death. §101(a)(2) provides an exception to the general rule applicable to cases in which the life insurance policy has been previously transferred for value, i.e., sold. Under §101(a)(2), the amount of life insurance proceeds excludable with respect to policies transferred for value is limited to the amount of value for which the policy was transferred plus the value of any subsequent premiums paid by the transferee.

§101(a)(2)(B) provides an exception to the exception. If the transfer is made to (among other things) a partnership in which the insured is a partner, the general rule of §101(a)(1)--providing for exclusion of life insurance proceeds paid by reason of death--applies notwithstanding the fact that the policy might have been transferred for value.

The exception under §101(a)(2)(B) applies directly to the instant facts and seems to provide an easy means of avoiding the general transfer for value problem. It seems to me that the initial plan of borrowing out the remainder of the existing cash surrender value would not be effective in avoiding the transfer for value problem. As a practical matter, I strongly suspect that the transferee partnership would be forced to assume the existing policy debt; the relief of that indebtedness would almost certainly be viewed as a transfer for value. Accordingly, without the protection of §101(a)(2)(B), a transfer to a partnership of the insured shareholders would be subject to the general transfer for value rules of §101(a)(2).

As to the secondary issue of the taxability of the initial transfer of the policies, it seems clear that this would be a taxable event to the corporation. Again as a practical matter it seems to me that the existing policy loans will necessarily "follow" the policies themselves. In other words, I assume that the insurance companies involved would not allow the owner of the policy to be changed without an assumption by the new owner of the existing indebtedness. If that is the case, it is clear under §1001 and the regulations thereunder that any amount of indebtedness assumed by the partnership would be treated as proceeds to the corporation from the sale or exchange of the policies.

In addition, it would seem to be necessary for the partnership to provide value to the corporation at least equal to the current cash surrender value of the policies in order to avoid constructive dividend problems. Either the partnership should pay the corporation the net fair market value of the policies (presumably the cash surrender values less the loans) or the corporation should borrow out the remainder of the cash surrender value in order to avoid the necessity of a cash transfer from the partnership to the corporation. In either case, it would seem that the corporation would have proceeds from sale of the policies equal to their aggregate cash surrender values.