50 / Does the substitution of one insured for another qualify as a tax-free exchange?

The substitution of one insured for another under an exchange-of-insureds option on a corporate-owned key person policy is treated by the IRS as a sale or other disposition under IRC Section 1001 and not as a tax-free exchange under IRC Section 1035(a).¹ The IRS determined that an insurance company’s exchange of old corporate-owned life insurance contracts (modified endowment contracts (MECs) issued after June 8, 1997) for new corporate-owned contracts qualified as a tax-free exchange under IRC Section 1035 when each new contract would insure the life of the same individual who was insured under the old contract.² The IRS also has ruled that if a taxpayer (employer) that owns MECs issued by the same insurance company in the same calendar year exchanges some of those MECs for new MECs issued by a second insurance company, the new contracts are not required to be aggregated with the remaining original contracts under IRC Section 72(e)(12).³