A 1035 Exchange may allow for a tax-free exchange of life insurance policies. Section 1035(a) provides that, under certain conditions, no gain or loss will be recognized on the exchange of a life insurance policy for another life insurance policy. The taxpayer’s basis in the policy acquired will be the same as that of the policy exchanged.1 These provisions allow the taxpayer to avoid the current recognition of gain that could result upon the surrender of an existing policy.2 Section 1035 prevents taxation to those “who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain.”3
A 1035 exchange allows the taxpayer to carry over gain or loss from one insurance policy to another. Absent 1035, an exchange must be effectuated through a surrender and replacement, usually resulting in unfavorable tax consequences.
No. Pursuant to IRC Sec. 7702A, a 1035(a) exchange of a life insurance policy is a "material change." Material change, however, does not mean that the new policy is automatically a modified endowment contract. It simply means that any further premiums must satisfy the "7-pay test." Although PL's illustration systems will test for this, a good rule of thumb is that after the 1035(a) exchange, if the new policy can accept at least 7 level premiums, then it will not be a modified endowment contract.
No. Life insurance policies issued prior to June 21, 1988, including those labeled single premium whole life, were grandfathered and not subject to the modified endowment rules of IRC Sec. 7702A. A 1035(a). However, they are still a material exchange. Any additional premium paid into the new policy will not make it a modified endowment policy so long as the new premium satisfies the applicable "7-pay test." Use the same rule of thumb outlined in the previous question.
No. Both the owner and the insured of the new policy must be the same as the owner and insured of the old policy.4
Yes. Section 1035 permits the exchange of a life insurance policy for: (1) another life insurance policy; (2) an endowment contract; or (3) an annuity.5 Section 1035, however, allows only those exchanges that do not delay the receipt of benefits by the taxpayer. So the exchange of an annuity to a life insurance contract is not permitted.
No. The exchange of two single life policies for one survivor life policy does not conform to the same insured requirements of Section 1035.6 Again, the resulting survivor life policy has a different insured than either of the exchanged policies. Further, instead of paying off at the first and second deaths under the single life policies, the policy would pay off only at the last death, delaying the receipt of benefits.
No. Application of IRS rulings suggests that, because the insured under each policy would be different, the requirements are not satisfied. Accordingly, policy splits made pursuant to a Policy Split Option Rider are taxable to the extent of gain in the policies.
No. There is no requirement that the values of the policy acquired be the same or similar to the values in the policy exchanged.7 As such, the death benefit on the acquired policy may be either more or less than the death benefit of the exchanged policy. Of course, the acquired policy’s death benefit must be sufficient relative to its cash values in order to qualify it as life insurance under Section 7702 in order to preserve certain tax benefits available, including an income tax-free death benefit.
Yes if there is gain in the policy. If a taxpayer receives property or money other than life insurance policy in a Section 1035 exchange, gain will be recognized to the extent of such property or money.8 This additional property or money is known as “boot” (from the colloquialism, “the exchange has netted the taxpayer a policy and something else to boot”) and is subject to income tax to the extent that there is gain in the policy.9
Typically, policy loans are not taxed at the time they are taken because no tax may ever be due on these amounts.10 Life insurance policy proceeds are received income tax-free to the beneficiary.11 Accordingly, loans from policy cash values are analogous to loans on amounts to be paid out as tax-free proceeds at the insured’s death. However, when a policy lapses, any loan outstanding is taxable to the extent that the loan exceeds the taxpayer’s basis in the policy. When a policy is surrendered, the transaction is taxable to the extent that the loan, plus any cash received, exceeds the taxpayer’s basis. It follows that, in a 1035 exchange, any loan not carried forward to the new policy will be treated as a surrender of a portion of the old policy -- boot -- taxable to the extent of gain in the policy.12 Where the old policy’s loan is carried forward to the new policy -- that is, the new policy is issued with the outstanding loan -- the transaction will be treated as entirely tax free.13
No if there is gain the policy. A partial surrender made prior to an exchange in order to extinguish a loan may be treated as part of the exchange if it can be shown that the policyholder did not intend the surrender to be an isolated transaction.14 Under the step transaction doctrine, all steps taken pursuant to a unitary plan to achieve an intended result are viewed as a single transaction.15 Accordingly, a partial surrender made pursuant to retiring a policy loan prior to a nontaxable exchange may be collapsed into that exchange, resulting in the receipt of taxable boot to the extent of gain in the policy.
1 I.R.C. § 1031(d)
2 I.R.C. § 72(e)
3 H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 81 (1954).
4 I.R.C. § 1035; Treas. Reg. § 1.1035-1(c); Treas. Reg. § 1.1035-(c); Rev. Rul. 90-109, 1990-2 C.B. 191
5 I.R.C. § 1035(a)(1)
6 Priv. Ltr. Rul. 95-42-037 (Jul. 21, 1995); see Priv. Ltr. Rul. 68-06-260330A (Jun. 26, 1968) (disallowing as tax-free the exchange of a single life annuity for joint life annuity).
7 Priv. Ltr. Rul. 98-20-018 (Feb. 11, 1998) (“[N]onrecognition treatment under section 1035 is not expressly conditioned upon the relative policy values of the policies exchanged, so long as no other property or cash is distributed as part of the exchange. Rev. Rul. 92-43, 1992-1 C.B. 288”).
8 I.R.C. §§ 1035(c)(1), 1031(b)
9 I.R.C. §§ 1035(c)(1), 1031(b); Treas. Reg. § 1.1031(d)-1(c)
10 I.R.C. § 72(e)(5)
11 I.R.C. § 101(a)(1)
12 Treas. Reg. § 1.1031(d)-2
13 Priv. Ltr. Rul. 86-04-033 (Oct. 25, 1985)
14 Priv. Ltr. Rul. 91-41-025 (Oct. 15, 1991)
15 Id., citing Kanawha Gas and Utilities Co. v. Comm’r, 214 F.2d 685 (5th Cir. 1954); and Biggs v. Comm’r, 632 F.2d 1171 (5th Cir. 1980)
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