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Exchanging One Policy for Another Could Ignite an IRS Tax Bomb
With the number and variety of life insurance and annuity products available to the general public today, there are many times when a client may believe their existing policy may not suit their changing needs.  But you need to be aware that exchanging one policy for another could trigger a tax event. 
Congress certainly recognized the changing needs of policyholders in 1954, when it enacted Internal Revenue Code Section 1035. 
This section of the tax code codified the belief that policyholders and annuitants should not be treated as having surrendered or sold their contracts when the difference between the old and the new contracts is not material.  
Section 1035 follows the like-kind exchange rules set in IRC Section 1031 for exchanges of investment, trade and/or business property. 
Assuming there is no 1035 qualification, the cash surrender of one policy and the purchase of another with the sale proceeds would result in income under the cost recovery rules equal to the cash surrender proceeds in excess of the owner’s basis in the old policy. Congress’ intent was to extend nonrecognition treatment to certain types of exchanges. 
IRC Section 1035(a) provides the following. No gain or loss shall be recognized on the exchange of:
  1. A life insurance contract for another life insurance, endowment or annuity contract. 
  2. An endowment insurance contract for an annuity contract or for another endowment insurance contract that provides for regular payments beginning at a date not later that the one in which payments would have begun under the contract that was exchanged. 
  3. An annuity contract for another annuity contract.  Section 1035 was amended by the Pension Protection Act of 2006 for future exchanges which allow for long-term care riders. 
Treasury Regulation 1035-1 provided even more clarification of the exchange rules provided by IRC Section 1035(a)(3) by stating that Section 1035 does not apply to such exchanges if the policies exchanged do not relate to the same insured person.  
The exchange, without recognition of gain or loss, of an annuity contract for another annuity contract covered under section 1035(a)(3) is limited to cases where the same person is the obligee under the contract received in exchange as under the original contract. These rules seem pretty straightforward as the Treasury and case law have refined the way in which contract exchanges will be measured. The basic requirements of Section 1035 are contained in the instructions for IRS form 1099-R.
While we all know that a life insurance contract may be exchanged tax-free for another life insurance contract, for a modified endowment contract (MEC) or for an annuity, the reverse is not true. A modified endowment contract can be exchanged into another MEC or for an annuity, but not for a life insurance policy.  Finally, an annuity contract may be exchanged for another annuity but not for an insurance policy or an endowment contract. 
The Pension Protection Act of 2006 created several changes to the long-term care market.  Specifically, the new rules of IRC Section 1035(a), as established by Section 844(b) of the Pension Protection Act, took effect in 2010. As of Dec. 31, 2009, the tax-free exchange rules were extended to cover long-term care contracts. For exchanges that occur after that date, Section 1035 states that:
  1. A life insurance contract can be exchanged for another life insurance contract or for an endowment or annuity contract or for a qualified long-term care insurance contract. 
  2. An endowment insurance contract can be exchanged for another endowment insurance contract which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged. An endowment insurance contract also can be changed for an annuity contract or for a qualified long-term care contract. 
So, since 2010, a life insurance contract, endowment contract, long-term care contract or annuity may be exchanged for a long-term care contract. However, a long-term care contract may not be exchanged for anything other than another long-term care contract. This is true even when a life insurance policy has a long-term care rider. 
Since there is no single-premium, long-term care policy in the marketplace, this brought about an interest in the partial 1035 exchange. This occurred through the guidance provided under Revenue Procedure 2008-24 and was later modified by Revenue Procedure 2011-38. I would suggest that when discussing this with a client, you also consult with your client’s tax attorney or accountant. 
Of course, a 1035 exchange to a hybrid life insurance policy with an LTC rider is acceptable. Also many insurance companies may or may not allow partial 1035 exchanges, and the long-term carrier may or may not accept the rules required under Section 1035. You will need to check with both the existing insurance company and the new insurance company to clarify their procedures for this. 
The IRS does not distinguish between the types of contract exchanges for Section 1035 use, such as variable universal life versus universal life versus whole life. 
Term conversions do not qualify for Section 1035 opportunities because the term conversion results in a permanent policy which comes from the exercise of a right under the old term policy, not from an exchange of it. Thus the owner’s basis in the new policy does not carry over from the old policy.  
As the IRS states, “there is no requirement that the issuer of the contract received in exchange be the same insurer as the original.” In addition, there is Private Letter Ruling 9319024. This provides the nonrecognition treatment even if one or the other of the insurers is a foreign company, as long as the product meets the statutory definition of life insurance annuity and endowment contracts.  Section 1035 also allows multiple life insurance and annuity contracts to be exchanged provided the other requirements of Section 2015 are all met.
Finally, the same insured requirement is provided in Treasury Regulation Section 1.1035-1, which states that Section 1035 does not apply if the policies exchanged do not relate to the same insured. This requirement also prevents most exchanges from a single life exchange to a survivorship contract.
However, the exchange of a second-to-die contract following the death of the first insured for a single life policy on the survivor qualifies for Section 1035 nonrecognition treatment. 
For exchanges with contracts containing outstanding loans, special attention must be paid to ensure that the loan is carried forward to the new policy. There are several private letter rulings that address the fact that when a contract with an outstanding loan is exchanged for a new contract and the loan is carried forward to the new policy of the same loan amount, there is no recognition of any gain.
However, any loan not carried forward or reduced by the exchange may create a tax recognition event for the owner. When in doubt, it is best to check with the owner’s tax advisor, the insurance carrier of the old policy and the insurance carrier of the new policy in order to obtain their thoughts and processes for handling the transaction. We certainly do not want to make any client unhappy by receiving an unwanted Form 1099 for one of these types of transactions.  
I have highlighted some of the most prevalent aspects of Section 1035 transactions, although there is much more that could be discussed regarding these. 
The best advice for a client’s situation is that if you are uncertain, ask before the transaction is submitted to a carrier for processing. Once a 1035 exchange is processed, in most cases it cannot be reversed. 

Dennis M. Axman, CLU, ChFC, AEP, CFP, is managing partner of Advanced Market Resources, LLC. He can be reached at [email protected].

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