Revenue Ruling 74-605 confirms that when partners transfer life insurance policies on each other’s lives as part of a buy-sell arrangement, those transfers fall within the partnership exception to the transfer for value rule under IRC Section 101(a)(2)(B), and the death benefit remains fully tax-free. The ruling is the reason partnerships and partnership-taxed LLCs can restructure their buy-sell agreements or exchange policies for consideration without converting a tax-free death benefit into mostly taxable ordinary income.
What the Ruling Addresses
The scenario at the heart of the ruling is a cross-purchase buy-sell agreement. Partner A holds a policy on Partner B’s life; Partner B holds a policy on Partner A’s life. The partners want to exchange or transfer those policies, and each transfer involves valuable consideration. Under the ordinary transfer for value rule, that consideration would strip the tax-free treatment from any future death benefit.
Revenue Ruling 74-605 confirms that the transfers fall within the statutory exception for transfers to a partner of the insured. The death benefit received by the surviving partner remains fully excludable from gross income.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits The same protection extends to transfers between the partnership entity and an individual partner, because both directions satisfy the statutory language.
The Transfer for Value Rule the Ruling Sidesteps
Federal tax law starts from a generous baseline: death benefits paid under a life insurance policy are not included in the recipient’s gross income.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits A $2 million policy pays out $2 million tax-free.
IRC Section 101(a)(2) is the major exception. When someone acquires a life insurance policy, or any interest in one, for valuable consideration, the tax-free exclusion shrinks dramatically. Only the amount the buyer actually paid for the policy plus any premiums paid afterward is excluded. Everything above that is taxable as ordinary income.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
An example shows how sharp the penalty is. You buy a policy on someone’s life for $50,000 and later pay $20,000 in premiums. The insured dies and a $1 million death benefit is paid. Only $70,000 is excluded from your income. The remaining $930,000 is taxable at ordinary rates. Practitioners call this the “transfer for value trap.”
The Partnership Exception
The statute carves out five situations where a policy can change hands for value without triggering the trap. One is the carryover basis exception under Section 101(a)(2)(A), which covers gratuitous transfers where the new owner takes the prior owner’s basis. The other four appear in Section 101(a)(2)(B) and are defined by relationship. A transfer for value does not trigger the rule if the policy goes to:
- the insured;
- a partner of the insured;
- a partnership in which the insured is a partner; or
- a corporation in which the insured is a shareholder or officer.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
Revenue Ruling 74-605 sits on the second and third of these. It is the IRS’s formal confirmation that the statute means what it says: a partner buying a policy from another partner, or a partnership shifting a policy to one of its partners, keeps the death benefit tax-free.
Why This Matters for Buy-Sell Restructuring
Partnerships fund buy-sell agreements in one of two ways, and the ruling is what lets them move between the two structures without a tax penalty.
In an entity purchase (or redemption) agreement, the partnership itself owns policies on each partner’s life. When a partner dies, the partnership collects the proceeds and uses them to buy out the deceased partner’s interest. The structure is administratively simple, especially with many partners, because the partnership needs only one policy per partner.
In a cross-purchase agreement, each partner personally owns a policy on every other partner’s life. When a partner dies, each survivor collects a death benefit and uses it to buy a share of the deceased partner’s interest directly. A four-person partnership needs twelve separate policies, so the paperwork is heavier. But the tax payoff is significant.
The Basis Advantage of a Cross-Purchase
When surviving partners buy a deceased partner’s interest through a cross-purchase, each surviving partner’s basis in the business increases by the amount they paid. Suppose Partner A and Partner B each invested $100,000 in a business now worth $1 million, and Partner A dies. Partner B buys A’s 50% interest for $500,000. B’s total basis becomes $600,000. A later sale of the entire business for $1 million produces a $400,000 gain.
Under a redemption structure, the partnership buys back A’s interest. Partner B’s original $100,000 basis does not change, because B did not personally purchase anything. If B later sells the entire business for $1 million, the gain is $900,000. More than double.
Moving Policies Between the Structures
That basis advantage frequently motivates partnerships to convert from an entity purchase to a cross-purchase. Doing so requires moving policies that the partnership owns into the hands of individual partners. The transfer involves consideration, typically the cash surrender value, which puts the transfer for value rule squarely in play.
This is where Revenue Ruling 74-605 does its work. Because the policies are moving from a partnership to a partner of the insured, the death benefit stays fully excludable.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits Partners can restructure to capture the basis advantage without creating a future income tax liability on the death benefit.
LLCs Taxed as Partnerships
The legal form of the business entity is not what matters. The tax classification is. A limited liability company that elects or defaults into partnership tax treatment files Form 1065, and its members are treated as partners for federal tax purposes.2Internal Revenue Service. LLC Filing as a Corporation or Partnership The full protection of Section 101(a)(2)(B), and by extension Revenue Ruling 74-605, applies to policy transfers between LLC members or between the LLC and a member exactly as it would for a traditional partnership.
What the Ruling Does Not Cover
Transfers Between Corporate Shareholders
The partnership exception does not help S corporation or C corporation shareholders. The statute exempts transfers to a corporation in which the insured is an officer or shareholder, but not transfers between individual shareholders.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits If a corporation transfers a policy on Shareholder A’s life to Shareholder B, the transfer for value rule applies. Shareholder B is not a partner of Shareholder A, and Revenue Ruling 74-605 offers nothing.
The standard workaround is a two-step process. The corporation transfers each policy to the insured shareholder, which qualifies under the “transfer to the insured” exception. That shareholder then gifts the policy without consideration to the intended owner. Because a gift is not a transfer for value, the second step does not trigger the rule.
Reportable Policy Sales Under the 2017 Tax Act
The Tax Cuts and Jobs Act of 2017 added IRC Section 101(a)(3), which narrows the exceptions in certain commercial transactions. When a life insurance policy is transferred in a “reportable policy sale,” the standard exceptions under Section 101(a)(2), including the partnership exception, do not apply.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
A reportable policy sale occurs when someone acquires an interest in a life insurance contract and has no substantial family, business, or financial relationship with the insured apart from the policy interest itself.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits The provision targets the life settlement industry, where investors buy policies from strangers as financial instruments. Most transfers between genuine business partners will not qualify, because the partners have a substantial business relationship with the insured.
The regulations flesh out what counts. A substantial business relationship exists when the insured is a key person who materially participates in an active trade or business owned by the acquirer. A substantial financial relationship exists when the acquirer buys the insurance to fund the purchase of the insured’s business interest at death. Active partners in a working business generally satisfy both tests. Passive investors and silent partners should look harder, because a transfer to a partner who has no real involvement in the business beyond holding a policy can be recharacterized as a reportable policy sale, and if it is, Revenue Ruling 74-605 provides no shelter.