If a life insurance policy is transferred to another person in exchange for valuable consideration, then the death proceeds may:

When a life insurance policy is transferred to another person in exchange for valuable consideration, the death proceeds generally lose their income tax-exempt status under federal tax law. This means that instead of being completely free of income tax when the insured passes away, the proceeds may be partially taxable.

The reasoning behind this lies in the "transfer-for-value" rule, which states that if a policy is sold or transferred for something of value, the original owner (or beneficiary) may have to pay taxes on the gain received from the policy upon the policyholder's death. The tax implications arise because the transfer alters the original tax-exempt status of the policy.

In contrast, choices that mention a reduction of proceeds by the amount of consideration or taxation as capital gains do not accurately reflect how life insurance proceeds are treated. While probating generally involves settling a deceased person's estate, the specific taxation implications of transferring a life insurance policy are primarily focused on income tax consequences.