As flight attendants always tell us, contents may shift during flight. Client circumstances, as well as the financial environment, have a tendency to change. Contracts that were suitable when purchased may no longer be effective today. Meanwhile, changes in the fundamentals that carriers use to build products have resulted in newer types of contracts which may provide increased benefits, better guarantees, or higher potential yields.
When replacing a life or annuity contract, the client has several options, including simply surrendering the old contract and purchasing a new one.
Under 1035 of the Internal Revenue Code, the owner of a life insurance, endowment, or annuity contract is allowed, under certain circumstances, to effect a like-kind exchange. If all the rules are followed, the gain in the original policy will not be taxed at the time of the exchange. A 1035 exchange can be a particularly useful approach when it enables the client to defer taxable gain on surrender of the old contract or to carry over basis from the original contract to the new contract.
What types of contracts can be exchanged?
1035 provides favorable non-recognition treatment for the following types of exchanges only:
- Life insurance contract for an annuity contract, endowment contract, or another life insurance contract.
- An endowment insurance contract for an annuity contract or another endowment contract.
- An annuity contract for another annuity contract.
Same lives required
When a life insurance contract is exchanged for another life insurance contract, the contracts must relate to the "same insured." Thus, for example, a single life policy may not be exchanged for a joint life policy, and vice versa. In the case of an exchange of annuity contracts, the regulations require that both contracts involve the same "obligees." For many years the prevailing view was that "obligee" was synonymous with "annuitant." However, in a 2003 private letter ruling, the IRS finally clarified that the term obligee refers to the owner of the contract.
When the client receives a new contract, plus "something else" 1035 provides non-recognition treatment to the extent that the exchange is truly "like-kind." When the client receives cash or other property in connection with the exchange, gain will be recognized to the extent of the cash or other property. Frequently this situation arises when a life insurance contract with outstanding policy loans is exchanged for a new contract, and the loans are extinguished in the transaction. Discharge of the owner?s loan obligation is treated as cash received, and gain is recognized to the extent of the loan. So, for example, if a life insurance contract with a cost basis of $30,000, a cash surrender value of $50,000, and a loan of $25,000 is exchanged for an annuity contract, the total gain of $20,000 will be recognized.
What about basis?
In a 1035 exchange, the owner?s cost basis in the original contract is carried over to the new contract. If "cash or other property" is involved, carryover basis must be adjusted. In the example above, the original cost basis of $30,000 is adjusted by subtracting the amount of the loan that is discharged ($25,000), then adding back the amount of gain recognized ($20,000). Thus, the basis of the new contract would be $25,000.
Frequently asked questions
Q. Can a client exchange multiple contracts for a single contract, and vice versa?
A. Yes. The IRS has permitted various combinations of multiple contract exchange. When the exchange results in multiple contracts, basis from the original contract(s) must be allocated to the new contracts in proportion to the allocation of cash values to the new contracts.
Q. Are partial exchanges permitted?
A. Yes. A 1998 Tax Court case in which the IRS acquiesced in 1999 permitted the exchange of a portion of the value in an existing annuity for a new annuity contract.
Q. Can one contract be exchanged for additional value in an already existing contract?
A. Yes. In a 2002 Revenue Ruling, the IRS permitted "consolidation" of two annuity contracts issued by different carriers under 1035. Under the same logic an exchange of an existing life insurance policy for additional value in an existing life insurance or annuity contract should also be permitted.
Q. Can an insurance contract owned by A on his own life be exchanged for an annuity contract owned by A with B as the annuitant?
A. Yes. Since the life insurance contract could clearly be exchanged for an annuity owned by A with A as the annuitant, and then that annuity could be exchanged for another owned by A with B as the annuitant, there appears no reason why the transaction could not be collapsed into a single step.
Q. How can a single life policy on A be exchanged for a survivorship policy on A and B?
A. The exchange cannot be done directly under1035 because of the "same insured" requirement. However, the original contract can be exchanged for an immediate annuity (with A, B, or both as annuitants), the payments from which can be used to purchase the new survivorship contract.
Q. Is there ever a reason to exchange a contract that has no gain?
A. Yes. A 1035 exchange can also be used to preserve a loss through the carryover basis rules. For example, A owns a life insurance contract with a cost basis of $50,000 and a cash value of $30,000. A no longer needs life insurance but would consider purchasing an annuity. If A surrenders the life policy and buys the annuity, he will have a basis of $30,000 in the annuity.
However, if he uses a 1035 exchange, his cost basis in the annuity will be $50,000. This means that the first $20,000 of growth in the annuity could be accessed income tax-free.
Contract replacement should be contemplated only when necessary to meet the client's needs more effectively. In such cases, the 1035 exchange strategy can be an extremely helpful tool.
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