Disposition Policy Exchanges

<div class="Section1"><br /> <br /> When a whole life policy with an outstanding loan was exchanged for another whole life policy subject to the same indebtedness, the exchange was treated as an entirely tax-free exchange.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS reached the same conclusion when one policy was exchanged for another subject to the same indebtedness and the taxpayer contemplated making withdrawals or partial surrenders from the policy to reduce the indebtedness.<a href="#_ftn2" name="_ftnref2">²</a> The cost basis of the new contract will be the cost basis of the old, plus the amount of gain recognized, minus the amount of cash or other property received (with proper adjustments for premiums paid and dividends received after the exchange).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> Applying a step-transaction doctrine approach, life insurance companies typically treat loans repaid from policy values within six months (or a year) before or after the exchange as having been extinguished at the time of the exchange and will generally report such an extinguishment as taxable gain (to the extent of gain in the policy). It is important to know the reporting policy of the company issuing the new policy if a quick repayment of a carry-over loan is contemplated. But, even if not reported, extinguishment of the carry-over loan from policy values shortly before or after issue could be regarded by the IRS as extinguished at issue – possibly creating taxable income.<br /> <br /> <hr /><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Ruls. 8806058, 8604033.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Let. Rul. 8816015.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 1031(d); Treas. Reg. § 1.1031(d)-1.<br /> <br /> </div>

<div class="Section1"><br /> <br /> In a private ruling, the IRS concluded that exchanges of policies insuring a single life for a policy insuring two lives do not qualify for nonrecognition treatment under IRC Section 1035. The IRS reached this outcome in all of the following situations:<br /> <blockquote>(1)     Spouse A exchanges a policy insuring only Spouse A’s life for a policy that insures the lives of both Spouse A and Spouse B;<br /> <br /> (2)     Spouse A exchanges two life insurance policies, one of which insures Spouse A and the other of which insures Spouse B, for a single second-to-die policy insuring the lives of both Spouse A and Spouse B;<br /> <br /> (3)     Spouse A and Spouse B jointly exchange separate policies each of which insures the life of one spouse for a single jointly-owned second-to-die policy that insures the lives of both Spouse A and Spouse B;<br /> <br /> (4)     A trust owns and exchanges a policy insuring the life of Spouse A for a policy that insures the lives of both Spouse A and Spouse B; and<br /> <br /> (5)     A trust owns and exchanges two life insurance policies, one of which insures Spouse A and the other of which insures Spouse B, for a single second-to-die policy insuring the lives of both Spouse A and Spouse B.<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Rul. 9542037.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The IRS has concluded that the exchange of two nonparticipating flexible premium life insurance policies, each issued by a different life insurance company, for a single nonparticipating flexible premium variable annuity contract, issued by a third life insurance company, is a proper IRC Section 1035 exchange. The IRS agreed that the annuity could be initially issued in the amount of the proceeds received from the first policy and then increased in value when the proceeds of the remaining policy arrived.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> When a life insurance policy was exchanged for an annuity plus an additional cash payment, the IRS concluded that the exchange qualified for IRC Section 1035 treatment. The additional cash payment into the newly-issued annuity was needed to meet the annuity’s minimum premium requirement. Further, noting that administrative delays should not convert a tax-free exchange to a taxable one, the IRS concluded that if the two amounts were not received at the same time, the insurance company could issue the annuity in an amount equal to the cash payment and then later increase the value of the annuity when the funds from the life insurance policy were received.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Rul. 9708016.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Let. Rul. 9820018.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The IRC provides that the following are <em>nontaxable</em> exchanges: (1) the exchange of a life insurance policy for another life insurance policy, for an endowment or annuity contract, or for a qualified long-term care insurance contract, (2) the exchange of an endowment contract for an annuity contract, for an endowment contract under which payments will begin no later than payments would have begun under the contract exchanged, or for a qualified long-term care insurance contract, (3) the exchange of an annuity contract for another annuity contract or for a qualified long-term care insurance contract, and (4) the exchange of a qualified long-term care insurance contract for another qualified long-term care insurance contract.<a href="#_ftn1" name="_ftnref1">¹</a> These rules do not apply to any exchange having the effect of transferring property to any non-U.S. person.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If an exchange involves life insurance policies, the policies must be on the life of the same insured. Otherwise, the exchange does not qualify as a tax-free exchange under IRC Section 1035(a).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> If a policy loan is outstanding at the time of an IRC Section 1035 tax-free exchange, the amount of the <em>net</em> reduction, if any, in the taxpayer’s outstanding loan will be considered “boot” and taxable as ordinary income at that time to the extent there is income on the contract, without regard to basis.<br /> <br /> <hr /><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 1035(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 1035(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     Treas. Reg. § 1.1035-1.<br /> <br /> </div>

<div class="Section1">The IRS has ruled privately that the exchange of two individual life insurance policies for two participating interests in a group universal life insurance policy qualifies as a valid IRC Section 1035(a) transfer.<a href="#_ftn1" name="_ftnref1">¹</a> Thus, there is no tax liability.</div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Rul. 9017062.<br /> <br /> </div>

<div class="Section1">In a private ruling, the IRS has sanctioned IRC Section 1035 treatment for the exchange of a joint and last survivor life insurance policy, following the death of one of the insured persons, for a universal variable life insurance policy that insures the survivor. The IRS noted that at the time of the exchange, both policies were insuring the same single life and that the new policy would better suit the policy owner’s needs because it was less costly.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS reached the same conclusion in another private ruling in which a second-to-die policy was exchanged after the death of one insured for a policy insuring only the survivor.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Rul. 9248013.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Let. Rul. 9330040.<br /> <br /> </div>

<div class="Section1">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&nbsp;1001 and not as a tax-free exchange under IRC Section&nbsp;1035(a).<a href="#_ftn1" name="_ftnref1">¹</a> The IRS determined that an insurance company&rsquo;s exchange of old corporate-owned life insurance contracts (modified endowment contracts (MECs) issued after June&nbsp;8, 1997) for new corporate-owned contracts qualified as a tax-free exchange under IRC Section&nbsp;1035 when each new contract would insure the life of the same individual who was insured under the old contract.<a href="#_ftn2" name="_ftnref2">²</a> 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 <em>not</em> required to be aggregated with the remaining original contracts under IRC Section&nbsp;72(e)(12).<a href="#_ftn3" name="_ftnref3">³</a><div></div><div class="Section1">The IRS has ruled that if a taxpayer receives a check from a life insurance company under a nonqualified annuity contract, the endorsement of the check to a second company, as consideration for a second annuity contract, does <em>not</em> qualify as a tax-free exchange under IRC Section&nbsp;1035(a)(3).<br /> Instead, the amount received by the taxpayer is taxed on an income-first basis under IRC Section&nbsp;72(e).<a href="#_ftn4" name="_ftnref4">⁴</a></div><div></div><div class="Section1"><em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="19">19</a> for a discussion of the effect of an IRC Section&nbsp;1035 exchange on the grandfathered status of a policy issued prior to June&nbsp;21, 1988, and thus not subject to the seven pay test of IRC Section&nbsp;7702A.</div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 90-109, 1990-2 CB 191.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 200711014. <em>See also</em> Let. Rul. 200801001.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2007-38, 2007-25 IRB 1420.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 2007-24, 2007-21 IRB 1282.<br /> <br /> </div></div><br />