E—Non-Taxable 1035 Exchange Of Contracts

In General

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.

Tax-Free Exchanges

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].

Effective August 5,1997, these nonrecognition rules will not apply to any exchange which transfers property to a foreign person [I.R.C.§1035(c)].

Debt Release As Boot

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.

Multiple Policy Exchanges

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.

Exchange Of Only A Portion Of An Existing Contract

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 Conway v. Commissioner [111 T.C. No. 20 (1998)]. The relevant facts in the Conway case are relatively simple. The taxpayer purchased an annuity contract in 1992 for $195,600. Annuity installments were not to begin until the year 2029. Two years later she decided to purchase a new second annuity contract from a different company, and requested the issuer of the first contract to withdraw $119,000 from that contract and send the net proceeds ($109,000, after the deduction of a $10,000 "surrender charge") directly to the issuer of the second contract, which thereupon issued the new $109,000 contract to the taxpayer.

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 Conway case, however, the original contract remained in effect, and it is easy to see how the Service would view this as a taxable withdrawal from a contract, the use of the withdrawal proceeds to purchase a new contract being irrelevant--not sufficient to permit characterization of the transaction as an exchange of contracts.

Tax Court Rejects IRS Position

In the Conway case, the Tax Court ruled in favor of the taxpayer, referring to the specific language of section 1035 and the related regulations, and concluding simply that the IRS had not provided any authority to support its position that section 1035 "is limited to exchanges involving replacement of entire annuity contracts." The Court saw no reason from the legislative history of §1035 to limit its application as the IRS contended, nor did it see any undesirable tax advantage to be gained by a taxpayer from such a transaction. In this connection the Court cites Greene v. Commissioner, 85 T.C. 1024 (1985), which sustained the application of §1035 in a case in which the taxpayer redeemed an annuity contract in full, received a check for the entire proceeds, and without obligation to do so, endorsed the check to apply the full amount for the purchase of a new annuity contract with a different company. Thus, to the extent that the transaction in the Conway case might be deemed a dangerous precedent, potentially permitting avoidance of tax upon a partial withdrawal of cash value from an insurance or annuity contract, the Tax Court does not perceive a problem as long as the facts indicate that all of the funds were reinvested in a contract which would have qualified the end result for §1035 treatment if the entire original contract had been given up.

IRS Acquiescence in Conway Decision

The IRS has announced acquiescence in the Tax Court’s decision in Conway, but with caveats [Action On Decision CC-1999-016, November 26, 1999]. The Service agreed with the court that as long as all of the funds in the original contract, less any surrender fee, remain invested in annuity contracts after the transaction, and, as long as the proceeds at all times during the transaction remained invested in annuity contracts, the transaction was within the parameters of section 1035.

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 the Conway case did not involve a design to avoid application of section 72, the Service acquiesced to the decision of the Court.

Consolidation of Contracts

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.

Exchange Of Joint Life Contract For Single Life Policy

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].

Examples Of Exchanges That Do Not Meet The Same Insured Requirement And Thus Do Not Qualify For §1035 Treatment

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.

Policy Exchanges Involving MECs

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 June 21, 1988 are considered "grandfathered" and, as such, are not subject to the 7-pay test. [TAMRA, Sec. 5012(e).]

If a life insurance contract which is grandfathered from the seven-pay test because it was issued before June 21, 1988 is exchanged on or after June 21, 1988, the grandfathering is lost and the new policy must qualify under the seven-pay test to avoid being a modified endowment contract. If a modified endowment contract is exchanged for another policy, the new policy (even if on its own it wouldn`t be a modified endowment contract) is also a modified endowment contract. Code §7702(a)(2).