Under what circumstance might the tax-exempt status of death proceeds for a life insurance policy be lost?

The tax-exempt status of death proceeds for a life insurance policy can be lost if the policy is sold to a new owner. This scenario is commonly referred to as a change of ownership, which can trigger different tax implications. When a policy is sold, the IRS may view the transaction as a sale, which could result in taxable gain compared to when the death benefit is received by the original beneficiary upon the death of the insured.

In most cases, life insurance death benefits are paid to the designated beneficiaries income tax-free; however, if the policy has been transferred or sold, the new owner may not qualify for the same tax-exempt treatment that the original policyholder enjoyed. This situation is relevant for estate planning and tax consideration, where maintaining the tax-exempt status is a crucial factor.