IRS provides favorable guidance for troubled insurers.

Rehabilitating or liquidating financially troubled life insurance companies raises difficult tax issues. In recent months, however, the IRS has issued guidance that generally is favorable to troubled companies and their policyholders.

Serial funding

Under a rehabilitation or conservatorship of a financially troubled life insurance company, state authorities may limit the amount that may be distributed on the surrender or exchange of the company's contracts. In some cases, an exchange of a contract issued by another life insurance company is funded by two or more payments. The Service provided in Rev. Rul. 92-43 that an insured in such an exchange would be protected from gain or loss under Sec. 1035 because there was no time limit on completing an exchange. The IRS held that this treatment applied to the serial funding of life insurance and annuity contract exchanges.

Rollover treatment

If the other requirements of Sec. 1035 are satisfied, a tax-free exchange of life insurance or annuity contracts issued by different insurance companies occurs if cash is transferred directly from the old insurer to the new insurer. In contrast, tax-free treatment generally cannot be obtained if cash is received by the insured on surrender and then reinvested. Recognizing that a direct transfer to a new insurer may be impossible when the old company is troubled, Rev. Proc. 92-44, as clarified by Rev. Proc. 92-44A, permits tax-free exchange treatment if cash received on surrender by a policyholder. is properly rolled over into a new insurance contract.

Grandfathered contracts

Tax legislation affecting insurance products frequently provides grandfathering rules for contracts issued before a new law's effective date. Generally, such grandfathering is lost if the contract is materially modified after the effective date. Under Rev. Proc. 92-57, a contract that is modified or restructured retains its grandlathered status under Secs. 79., 101(f), 264, 7702 and 7702A if two conditions are met. First, the modification or restructuring must occur as an integral part of a rehabilitation, conservatorship, insolvency, or similar state proceeding of a troubled insurer. Second, the modification must be approved by the state court, insurance commissioner, or other official with authority to act in such state proceeding. The modification or restructuring may include reductions in benefits, adjustments to mortality or other expense charges, reductions in the rate of interest credited to the contract, and restrictions on the policyholder's ability to receive benefits under the affected contract. This revenue procedure is effective as of Jan. 1, 1991.

Debt discharge

Under Sec. 108, gross income does not include any amount arising from the discharge of a company's indebtedness if the discharge occurs when the company is insolvent. In Letter Ruling 923909,6, the IRS ruled that an insolvent insurer will not recognize income as a result of the court's discharge of certain obligations to policyholders that arose from a restructuring of the insurance contracts under a rehabilitation plan. The Service also provided favorable rulings on tax-free Sec. 1035 exchange treatment and grandlathering on the restructuring of the insurance contracts.

Taxpayers in these situations should take prompt action, observing the 60-day deadline after receipt of cash distributions on the affected policy or contract for rollover to the insurer issuing the new policy or contract. From Beth A. Brooke, CPA, Washington, D.C.