Transfer-For-Value Rule

You have a life insurance policy. However, you've fallen on some hard times. Your earthworm farm didn't turn out like you expected, and now you're searching for cash. In order to raise money, you sell your life insurance policy to the guy who owns the live bait store. He gives you $20,000; now he's in line to receive your $50,000 death benefit when you die.

A couple weeks later, you get stuck in a mud hole trying to plant a new crop of worms (you never did understand the business very well). You drown. Now the bait store guy gets the $50,000 benefit.

Here's where the transfer-for-value rule comes into play. Normally, death benefits from insurance don't get taxed. Not even a politician wants to be seen taking cash from widows and orphans. However, that no-tax rule wasn't meant to benefit predatory bait store owners. As a result, the transfer-for-value rule exists. It states that if a life insurance policy gets sold (transferred for anything of value), it loses its no-tax status. The funds received by the bait store guy are now subject to ordinary income tax.