Advanced Markets Because You Asked

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1 Advanced Markets Because You Asked Answers to Questions Frequently Asked of the Advanced Markets Group May 2011 Understanding the Tax Treatment of a Tax-Free Exchange of Life Insurance Policies The Advanced Markets Group is often asked questions about the federal income tax consequences of a Section 1035 exchange of a life insurance policy for a newly issued life insurance policy. The rules surrounding 1035 exchanges, including the basis and gain recognition rules, are quite complex and their application to any given transaction can be complicated. This piece is intended to provide a basic understanding of the application of the 1035 rules and should not be substituted for a thorough analysis by the client s professional tax and legal advisors. Advanced Markets Because You Asked 1. WHAT IS A 1035 EXCHANGE? Sections 1035 through 1045 of the Internal Revenue Code provide for the tax-deferred exchange of likekind properties. Section 1035 sets out provisions dealing with exchanges of life insurance and annuities. It was intended to defer taxation of individuals who merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain. The owner of the property acquired in a 1035 exchange takes that newly acquired property with the same basis as the property given up in the exchange. This basis carry-over postpones gain recognition until the taxpayer disposes of the newly acquired property (see IRC 1031(d)). 2. WHAT ARE THE REQUIREMENTS FOR A 1035 EXCHANGE? The requirements for an effective exchange of a life insurance contract appear simple: (i) as a practical matter, there has to be the same owner both before and after the exchange; and (ii), as and Rev. Rul state, both policies must relate to the same insured. 3. WHAT IF THE POLICY BEING EXCHANGED IS A MODIFIED ENDOWMENT CONTRACT? A modified endowment contract ( MEC ) is defined in 7702A(a)(1) as a life insurance contract that is both entered into after June 21, 1988 and fails to meet the 7-pay test of 7702A(b). Section 7702A(a)(1), which states that a MEC is a contract received in an exchange for an existing MEC, gives rise to the general rule for 1035-exchanged contracts: once a MEC, always a MEC. 4. IS THE NEW POLICY RECEIVED IN A 1035 EXCHANGE SUBJECT TO TESTING UNDER THE MODIFIED ENDOWMENT CONTRACT RULES? Yes. Section 7702A(c)(1) requires that all contracts be tested for compliance with the MEC rules at the time of their issue. This means that if a contract issued as part of a 1035 exchange fails the 7-pay test it will be considered a MEC. Page 1 of 6. Not valid without all pages.

2 5. IS IT POSSIBLE FOR A CONTRACT ISSUED UNDER 1035 TO CONSTITUTE A MEC WHEN THE ORIGINAL CONTRACT WAS NOT A MEC? Yes. If the original contract was a MEC, then the newly issued contract will be considered a MEC. However, there are other situations in which a new contract received in a 1035 exchange will be considered a MEC. For example, if there is a reduction in the face value of the newly issued contract in relation to the original contract, the new contract may fail the 7-pay test. A MEC can also be created if there is a dump-in of outside funds at the time of the 1035 in addition to the cash value being carried over from the original contract. This dump-in may be enough to cause the newly issued contract to fail the 7-pay test of 7702A. 6. IS IT POSSIBLE TO 1035 EXCHANGE SINGLE LIFE POLICIES FOR A SURVIVORSHIP POLICY? No. The IRS addressed this issue in Private Letter Ruling (PLR) , examining several different situations including: (i) the exchange of a policy on the life of Spouse A for a policy on the joint lives of Spouses A & B; (ii) Spouse A exchanges two single life policies, one on Spouse A and the other on Spouse B for a survivorship policy insuring Spouses A & B; (iii) Spouses A & B jointly exchange single life policies on each of their lives for a jointly owned survivorship contract insuring both Spouses; and (iv) situations similar to situations (ii) and (iii), except that the policies are owned by trusts. In all of the situations presented, the IRS held that the exchanges would not qualify for tax deferral under 1035 because the policies did not relate to the same insured, as is required in IRS Reg IS IT POSSIBLE TO EXCHANGE A SURVIVORSHIP POLICY FOR A SINGLE LIFE POLICY UNDER 1035? Possibly. PLRs and both involve a proposed exchange of a survivorship insurance contract, with only one of the insured still living, for a new single life insurance contract. In both PLRs, the IRS held that because there was only one remaining insured on the original contract, the exchange of that contract for a single life contract would qualify for tax-deferral, because both policies related to the same insured, making them like-kind policies. However, both PLR and PLR state that they make no determination as to the possibility of exchanging a survivorship insurance contract for single life contracts if both insureds under the original contract are still living. As discussed above, PLR makes it clear that an exchange of two single life contracts to one survivorship contract does not qualify for tax-deferral under There is no indication that unwinding a survivorship contract into two single life contracts should get any different tax treatment. Keep in mind that a PLR is binding authority only on the taxpayer to whom it is issued. 8. WHAT ARE THE TAX IMPLICATIONS OF WITHDRAWING CASH VALUE IMMEDIATELY BEFORE OR AFTER A 1035 EXCHANGE? Generally, 72 allows an owner of a life insurance contract to withdraw policy cash values up to the basis in the contract without recognizing gain. This allows the policy owner to recover her basis in the life insurance contract while leaving the gain inside the policy. However, 1035 exchanges are permissible under, and controlled by, 1031, not 72. In fact, in PLR , the IRS held that the withdrawal rules of 72 cannot be used to circumvent the boot recognition rules of 1031(b). Under 1031(b), if an exchange would have qualified for tax-deferral status under 1035 but for the receipt of other property or money in addition to the like-kind property, then generally, the exchange will still qualify, but the additional property is considered boot to the policy owner. This boot is included in the property owner s taxable income to the extent of gain in the original insurance contract. In addition to making the withdrawal of policy values taxable as boot to the policy owner, PLR applied the step-transaction doctrine to a withdrawal and subsequent 1035 exchange to treat both steps as Page 2 of 6. Not valid without all pages.

3 part of the same transaction, requiring the policy owner to recognize income to the extent of gain in the contract. While the IRS has applied the step-transaction doctrine to withdrawals on both sides of a 1035 exchange, there is no indication from the IRS as to how much time has to elapse between the withdrawal and the exchange in order to avoid the step-transaction doctrine. The following is an example of the application of 1031(b) to a withdrawal and a subsequent 1035 exchange where there is a gain in the contract. Assume that there was $1,000 of gross cash value, no loan on the contract, a basis of $500, and that the taxpayer plans to withdraw $400. Plus boot (cash withdrawn from policy prior to exchange) $400 Less basis of old policy $500 Gain realized (basis less total amount received) $500 Gain recognized (up to amount of gain in policy) $400 The following is an example of the application of 1031(b) to a withdrawal and a subsequent 1035 exchange where there is no gain in the contract. Assume that there was $1,000 of gross cash value, no loan on the contract, a basis of $1,100 and that the taxpayer plans to withdraw $400. Plus boot (cash withdrawn from policy prior to exchange) $400 Less basis of old policy $1,100 Gain realized (basis less total amount received) $0 Gain recognized (up to amount of gain in policy) $0 9. WHAT IF THE EXISTING LOAN ON THE POLICY IS CARRIED OVER TO THE NEW CONTRACT IN A 1035 EXCHANGE? If all of the cash value in the existing policy and the entire existing loan is carried over from the old policy to the new policy, then there is no receipt of other property or money for purposes of 1031(b) and no gain to recognize. The following is an example of the application of 1035 to an exchange of a contract where the loan on the original policy carries over to the new policy. Assume that there was $1,000 of gross cash value, a $400 loan on the contract, a basis of $600, and that the taxpayer plans to carry over the entire $400 loan Value of new policy received in the exchange (CSV in policy) $1,000 Plus boot (cash withdrawn from policy prior to exchange) $0 Plus old policy loan value $400 Total consideration received in the transfer $1,400 Less basis of old policy $600 Less new policy loan value $400 Gain realized (basis plus loan less total amount received) $400 Gain deferred under Section 1035 $400 Page 3 of 6. Not valid without all pages.

4 10. WHAT IF POLICY CASH VALUES ARE USED TO EXTINGUISH THE EXISTING LOAN AS A PART OF THE 1035 EXCHANGE? Using policy cash values to extinguish a loan as a part of the 1035 exchange will trigger income to the policy owner, to the extent of gain in the contract. This is because (b)-1(c) states that consideration received in the form of assumption of liabilities is treated as other property or money for purposes of 1031(b) and the boot-recognition rules. There are two reasons for the repayment of an outstanding policy loan triggering the boot rules as part of a 1035 exchange. First, as PLR outlines, the use of policy cash values to extinguish the loan is considered a partial surrender of the policy s cash values or a withdrawal of those values immediately prior to the 1035 exchange. The IRS then applies the step-transaction doctrine to the surrender/withdrawal and the exchange, treating the amounts used to repay the loan as boot to the policy owner, which triggers income to the extent of gain in the contract. The second theory frequently relied upon by the IRS in triggering income on the repayment of a loan with policy cash values prior to a 1035 exchange is articulated in Rev. Rul In Rev. Rul , the taxpayers are exchanging interests in partnerships under The IRS held that, under (b)-1(c) a taxpayer will recognize income to the extent that she has relinquished a liability in the exchanged property. Within the context of a 1035 exchange, the tax payer is giving up a policy that is subject to a loan in exchange for a new policy which is no longer encumbered by debt. This reduction in the taxpayer s debt is considered other property or money received under 1031(b) and triggers income recognition to the extent of gain in the contract. The following is an example of the application of 1035 to an exchange of a contract where the policy cash values are used to extinguish the loan on the original policy. Assume that there was $1,000 of gross cash value, a $400 loan on the contract, a basis of $600, and that the taxpayer plans to withdraw $400 to extinguish the loan. Plus boot (amount of extinguished loan) $400 Less basis of old policy $600 Less new policy loan value $0 Gain realized (basis less total amount received) $400 Gain recognized $ WHAT IF THE POLICY OWNER USES OUTSIDE (NON-POLICY) FUNDS TO EXTINGUISH THE LOAN AS PART OF A 1035 EXCHANGE? A use of outside (non-policy) funds will not trigger the boot recognition rules of 1031(d). This is because using outside funds is not considered the receipt of other property or money in conjunction with the 1035 exchange; the taxpayer has not accessed any of the policy s cash values to repay the policy loan. In addition, the repayment of the loan by the policy owner is not considered a relinquishment of a liability as part of a 1035 exchange. Rather than using policy values to extinguish the loan, the policy owner actually came out of pocket to repay the outstanding liability rather than relying on policy values. Page 4 of 6. Not valid without all pages.

5 12. HOW IS THE BASIS IN THE NEWLY ISSUED CONTRACT UNDER A 1035 EXCHANGE CALCULATED? Exchanges of policies under 1035 are designed to defer the tax in the original contract, which means that the basis in the original contract has to be preserved and carried over to the newly issued contract. Section 1031(d) provides that the basis in the newly exchanged property is the same as the basis in the original property; except that the basis is decreased by the amount of other property or money received in the transaction and increased by the amount of gain recognized in the exchange. The following is an example of the application of 1031(d) adjusting the basis in a newly issued contract following a withdrawal of cash value and a subsequent 1035 exchange. Assume that there was $1,000 of gross cash value, no loan on the contract, a basis of $700, and that the taxpayer plans to withdraw $400. Plus boot (cash withdrawn from policy prior to exchange) $400 Less basis of old policy $700 Gain realized (basis less total amount received) $300 Gain recognized (up to amount of gain in policy) $300 Basis Calculation: Basis of old policy $700 Plus amount of new loan $0 Less amount of withdrawal (loan or boot) $400 Plus amount of gain recognized $300 Basis of new policy $600 Page 5 of 6. Not valid without all pages.

6 This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any Taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. The potential policy cash value of a life insurance policy grows on a tax-deferred basis. As long as the policy is not designed as a Modified Endowment Contract (MEC), you can take tax-free withdrawals and loans from the cash value. Withdrawals from the policy are income tax free up to the policy s cost basis (premiums paid), after which point you would take distributions as policy loans, which are generally not taxable. Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including the generation-skipping transfer tax). Failure to do so could result in adverse tax treatment of trust proceeds. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, MA (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY MLINY Page 6 of 6. Not valid without all pages.