E—Non-Taxable 1035 Exchange Of Contracts
I.R.C. §1035 permits owners of life insurance and annuity contracts to exchange their contracts for similar or related types of contracts without the recognition of any unrealized gain which may have accrued in the contract given up in the exchange.
There are a variety of circumstances in which the holder of a life insurance or annuity contract may wish to exchange the original policy for a different type of insurance product or a similar product having different premium costs or other features.
While such exchanges would ordinarily be taxable transactions with gain or loss measured by the difference between the fair market value of the new policy and the owner`s basis in the old policy, exchanges which meet certain basic requirements are granted non-recognition treatment by I.R.C §1035. I.R.C §1035 does not provide a permanent income tax exclusion for gains on such exchanges, but merely a deferral--since the basis of the contract given up is carried over as the basis of the new contract received.
Non-recognition under §1035 applies only to an exchange of:
1. a contract of life insurance for another contract of life insurance or for an endowment or annuity contract; or
2. a contract of endowment insurance (a) for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or (b) for an annuity contract; or
3. an annuity contract for an annuity contract.
The contracts involved must meet the basic definitions of life insurance contract, endowment contract and/or annuity contract, as set forth in §1035(b). In all cases, the policy received must relate to the same insured as the policy given up in the exchange (although the contract issuer may be different). [Regs. §1.1035-1].
If an exchange would come within Code §1035 except that other property or money is also received "to boot", gain (in the policy given up) is recognized up to the value of the boot received. [I.R.C. §1031].
If a policy which is subject to an outstanding loan is exchanged in a transaction, otherwise qualifying for non-recognition under Code §1035, the balance of the loan at the time of the exchange is treated as boot to the extent that it exceeds the amount of any loan balance outstanding on the new policy received. This rule is necessary to prevent abuse of the non-recognition provision in a disposition transaction intended to yield cash (which would otherwise be taxable as boot) by structuring it as a non-taxable loan followed by a non-recognized exchange.
Example: W owns a life insurance policy with a basis of $50,000 and a current value of $80,000. He takes out a $60,000 loan against the policy. The receipt of the loan proceeds is not income. The following week, W exchanges his policy, subject to the loan balance, for a new life insurance policy with a value of $20,000. The $60,000 loan balance on the old policy is treated as boot (as well as part of the amount realized on the disposition of the old policy). Thus, there is a realized gain of $30,000, all of which must be recognized because the boot amount exceeds the gain. The basis in the new policy is $20,000 ($50,000 carryover, reduced by the $60,000 of boot and increased by the $30,000 of recognized gain). If the outstanding loan on the policy given up were not treated as boot, W would have received $10,000 cash in excess of his basis (at the time of the loan) and a policy worth $20,000, having a carryover basis of $50,000, with no recognition of any gain at any point.
Several recent prior private letter rulings have dealt with various factual situations in which exchanges involved not a straight exchange of one life policy for another life policy, or one annuity for another, but rather combinations of contracts, or contracts plus additional cash invested. For example:
· Ltr. Rul. 9708016 approved an exchange of two separate life insurance contracts for one annuity contract.
· Ltr. Rul. 9644016 approved an exchange of a single annuity contract for two new annuity contracts.
· Ltr. Rul. 9820018 approved a transaction in which a new annuity contract was acquired by in effect "trading in" an existing life insurance policy (issued by another company) and paying the balance of the cost of the new annuity in cash. The ruling held that the fact that a cash payment by the taxpayer was part of the exchange would not render §1035 inapplicable. It also concluded that the issuance of the new annuity in two steps, as the two elements of payment were separately received, would not disqualify the transaction.
What happens if only a portion of an existing contract is
exchanged for a new contract, while the balance of the original contract is
retained? This issue was dealt with in the Tax Court case of
Was this a qualified exchange transaction under §1035? The IRS deemed this to be stretching the exchange concept beyond reasonable limits. The Service basically argued that §1035 refers to an exchange of one contract for another contract involving the same insured, and the transaction here was not an exchange of the entire original contract, but rather, merely a withdrawal from the original contract which remained in effect. The fact that the amount withdrawn was sent directly to another insurance company for the purchase of a new annuity did not, the IRS argued, create a qualified exchange of contracts.
In prior private letter rulings dealing with multiple policy
exchanges (see above), the Service permitted relatively expansive
interpretations of the scope of §1035, the insurance contract(s) which had the
unrealized appreciation which was the subject of the desired non-recognition
treatment were given up in their entirety. In the
Tax Court Rejects IRS Position
IRS Acquiescence in
The IRS has announced acquiescence in the Tax Court’s
However, the Service will continue to challenge transactions
in cases where taxpayers enter into a series of partial exchanges and annuitizations as part of a design to avoid application of
the section 72(q) ten percent penalty, or any other limitation imposed by
section 72. In such cases, the Service will rely upon all available legal
remedies to treat the original and new annuity contracts as one contract. Since
A recent Revenue Ruling involved a factual situation in which the exchange involved not a straight exchange of one life policy for another life policy, or one annuity for another, but rather a consolidation of contracts [Rev. Rul. 2002-75; 2002-45 IRB 812]. The relevant facts in Revenue Ruling 2002-75 are relatively simple.
· X owns Contract 1, an annuity contract issued by Company 1, and Contract 2, an annuity contract issued by Company 2.
· X is the obligee for both contracts.
· X seeks to consolidate Contract 1 and Contract 2.
· X assigns Contract 1 to Company 2.
· Company 1 transfers the entire cash surrender value of Contract 1 directly to Company 2.
· Company 2 includes the transferred cash surrender value of Contract 1 in Contract 2.
· X will not receive any of the cash surrender value of Contract 1 that is transferred to Company 2 and deposited into Contract 2.
· No other consideration will be paid by X in this transaction.
· The terms of Contract 2 are unchanged, and Contract B terminates.
Based on the above facts the IRS held that:
1. Since X had no access to the cash surrender value transferred in the exchange her assignment of Contract 1 to Company 2 for consolidation with pre-existing Contract 2 meets the requirements of a tax-free exchange under § 1035.
2. After the assignment, pursuant to § 1035, X`s basis in Contract 2 immediately after the exchange equals the sum of X`s basis in Contract 1 and X`s basis in Contract 2 immediately prior to the exchange.
3. After the assignment, X`s investment in Contract 2 under § 72 equals the sum of X`s investment in Contract 1 and X`s investment in Contract 2 immediately prior to the exchange.
A situation occasionally arises in which an individual insured under a joint and last survivor policy dies and the owner wishes to continue coverage with another type of policy. The IRS has ruled privately that the contract can be exchanged under the tax favored provisions of Code § 1035. In one case, an irrevocable trust had been formed which purchased a joint and survivor contract on the lives of a husband and wife. The trust was the owner and beneficiary of the policy.
Upon the death of one spouse, the trust continued to pay premiums on the life of the survivor. However, the existing contract called for continued payments for a period of at least five more years. Another company offered the policy owner a more attractive contract which could be funded more efficiently, in exchange for the value of the original contract. The policy owner wished to make the exchange under the non-taxable provisions of Code § 1035 and applied to IRS for a ruling.
Code §1035 treatment was approved based on the fact that only one of the two original insureds was then living since, as the IRS viewed it, at the time of the exchange, each policy involved insuring the same single individual.
By reverse implication we can conclude that a second-to-die policy, insuring two individuals, could not be exchanged for a policy insuring only one individual at least while both insureds were living. [Ltr Rul 9248013].
In PLR 9542037, the IRS concluded that exchanges involving policies insuring a single life for a policy insuring two lives does not qualify for non-recognition treatment under Code §1035. In the letter ruling the Service sets forth five examples, none of which qualify for § 1035 treatment:
1. Spouse A exchanges a policy insuring only his life for a policy which insures the lives of both Spouse A and Spouse B.
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.
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 which insures the lives of both Spouse A and Spouse B.
4. A trust owns and exchanges a policy insuring the life of Spouse A for a policy which insures the lives of both Spouse A and Spouse B.
5. A trust owns and exchange 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 modified endowment contract is defined as any life insurance
contract entered into on or after June 21, 1988, that meets the life insurance
requirements of I.R.C. §7702, but which fails to meet a special 7-pay test or
is received in exchange for a modified endowment contract [I.R.C. §7702A(a). (see Modified
Endowment Contracts earlier in this Section for a discussion of the 7-pay
test). Contracts entered into before
If a life insurance contract which is grandfathered from the
seven-pay test because it was issued before
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