Understanding the tax traps of Section 1035 exchanges will help consumers make a wiser, and more educated, decision in their policy purchases. The following is a checklist of the major tax traps incurred in section 1035 exchanges:
- Failure to meet same insured requirement – The tax deferred nature of a section 1035 exchange presumes that both the old and the new contract are on the life of the same insured. In the case of an exchange of annuity contracts the contracts exchanged must be payable to the same person or persons.
A taxable event will occur if the policies are on the lives of different insureds. For instance, a wife cannot exchange a policy on her life for a similar policy on the life of her husband. It is permissible, however, for the exchange to involve the policies of two different insurance companies. (There is no rule that requires the insurer of the new contract received in the exchange to be the same as the insurer of the old contract.)
A Change of Insureds Provision (also called Substitution of Insureds Option or Business Exchange Rider) allows a business to purchase a policy on one individual (typically a key employee or shareholder) but if that person leaves the firm, the firm has the option to substitute another key employee as the insured under the policy. The provision is advantageous because it does not require the policyowner business to incur new costs but the insurer does usually require medical evidence of the new person’s insurability.
But the exercise of a change of insured option is a taxable event because it does not meet the same insured requirement. Instead, when a new individual becomes insured under the old policy, a taxable event has occurred because the IRS treats the transaction as a surrender of the old contract. It’s as if the policy on the terminating executive had been canceled.
The employer is liable for the difference between the policy’s cash surrender value and the amount of premium the employer paid. Such riders will continue to be highly useful despite this unfavorable taxation since it takes the form of an option that can be used only when it is deemed appropriate by the client’s advisers and the tax costs are minimal.
It is the opinion of the authors that the same insured logic would prevent a tax deferral when a single life is exchanged in return for a joint life contract or vice versa. The essence of a life insurance contract is the life that is insured under it. Therefore, when a contract goes from one life to two or two lives to one, the same insured test could not be met.
It is permissible, however, to exchange two contracts for one – as long as they are all on the same life. For example, suppose an individual wants to exchange a nonparticipating flexible premium life insurance policy with an adjustable death benefit, issued by company A, and a similar contract issued by company B solely for a nonparticipating flexible premium variable deferred annuity contract issued by company C. The IRS has held that Code section 1035 allows for situations other than only a one for one exchange. The IRS pointed out in a private letter ruling that Code section 1031 (which deals with real estate exchanges) allows exchanges of more than one property for one property and also that, unless the specific words or context indicates to the contrary, words stated in the singular can be construed in the plural.
- Poor timing – Another fatal flaw is where there has been something other than an exchange of insurance contracts. The discussion above regarding the mechanics of the exchange implies that a major key to success is the timing and manner in which the transaction occurs; “neatness counts” in avoiding litigation. It is preferable (if not essential) that the existing contract be assigned to the insurer that will issue the new contract in exchange. This evidences that the transaction was in kind rather than in cash. Unfortunately, it is not always easy to discern between an exchange and a surrender and purchase.
If the IRS takes an extremely conservative (harsh) view, it would hold that Code section 1035(a) would not apply if a new life insurance policy has been issued prior to the surrender of the old policy. But as a practical matter, it would be foolish to surrender an in-force policy before obtaining new coverage. To blindly require the surrender of the old before the issuance of the new policy is a form over substance mentality that would seem to defeat the Congressional purpose of Code section 1035: to allow a taxpayer to defer the reporting of income if he has merely substituted one policy for another without truly reducing the built-in gain in the policy to his possession. Perhaps the key to success is to keep the interval between the issuance of the new policy and the surrender of the old policy as short as is mechanically feasible.
- Failure to give up the old policy in exchange for the new contract – For there to be an exchange, the old policy must be relinquished by the policyholder. Where the taxpayer borrows on the old policy and sends the loan check from the old policy to the new insurer as a premium payment for the new policy (either with the old insurer or a new insurer), since the old policy is still in force (even though subject to the loan) Code section 1035 should not be available.
Closely akin to this problem is the failure to physically obtain the new policy in exchange for the old. For instance, suppose the IRS can show that the new policy was put in force through the payment of new premiums rather than from cash received from the surrender of the old policy. The IRS could argue that the new contract of insurance was not received in exchange for the old policy but rather in exchange for the first premium which was paid from an outside source. This would seem to be a red flag against company assignment forms which indicate that the first premium is to be paid with funds other than those received from the old contract and with the amount received upon the surrender of the old contract being applied to future premiums.
A partial exchange of contracts will be allowed in the proper circumstances. For example, in one case, the Tax Court held that a woman’s exchange of only a portion of one annuity contract for an annuity contract issued by another company was a nontaxable exchange. When the court looked at the regulations promulgated under Code section 1035, it noted that in order for an exchange to qualify for nonrecognition treatment, it is required only that the contracts be of the same type, e.g., an annuity for an annuity and that the obligee under the two contracts be the same person. The regulations do not state any other requirements. The court noted that for deferral to be allowed, the only requirements are that: (a) the contracts be of the same type; and (b) that the obligee(s) be the same person(s). Here, the contract owner was in the same economic position after the exchange as she was in prior to the transaction. The same funds are invested in annuity contracts and none of the money was reduced to the taxpayer’s possession. So the exchange remained nontaxable even though partial.
- Exchanges of the unexchangeable – Government policies are technically owned by the government. Since they cannot be assigned, they cannot be exchanged and therefore cannot be protected under Code section 1035.
- Failure to carry over policy loans – as discussed earlier, the extinguished loan can result in taxable “boot” to the extent of gain in the policy.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM