Life insurance policy exchanges.

Recent publicity regarding bankruptcy filings by major life insurance companies has prompted reviews by policy owners of the financial stability of insurance carriers. In some cases the policy owners may wish to exchange existing policies for policies to be written by a different carrier. In order to be a nontaxable Sec. 1035 exchange, the policyholder should assign its rights to the new insurance carrier, which should then surrender the old policies and issue its own new policies. If the holder surrenders the policy itself, and then applies the proceeds to the purchase of the policy from the other carrier, a Sec. 1035 exchange will not have occurred. (See IRS Letter Ruling 9017062.) IRS Letter Ruling 9044022 explained the amount of taxable "boot" that would apply when the loan on the existing policy is larger than the loan (if any) on the policy issued by the new carrier. IRS Letter Ruling 9141025 considered the policyholder's cash withdrawal on an existing endowment policy with a concurrent exchange of the policy's residual interest for a new policy; such a withdrawal would be equivalent to a policy loan and taxable boot.

This planning should be distinguished from a substitution of a new insured life for an old insured life under a policy issued by the same carrier. In Rev. Rul. 90-109, a corporation purchased life insurance (frequently referred to as "COLI" or corporate-owned life insurance) on employee A's life in 1987. The corporation was the sole beneficiary under the policy. The policy provided that the corporation had the option to change the insured. In 1988, A left the corporation. Thereafter, the corporation hired employee B to replace A and exercised the option in the policy to change the insured from A to B. The insurance company substituted B for A as the person's life insured under the policy. The benefits and premiums under the policy were not changed. The issues were whether the exercise of the option to change the insured was a sale or disposition of the policy under Sec. 1001 and, if so, whether the nonrecognition provisions of Sec. 1035 applied.

Sec. 1001(c) generally requires gain or loss recognition on the sale or exchange of property. However, Sec. 1035(a)(1) provides a special rule that no gain or loss is recognized on the exchange of a life insurance contract for another life insurance contract. Regs. Sec. 1.1035-1 limits the scope of Sec. 1035(a)(1), in that it provides that nonrecognition treatment under Sec. 1035 does not apply to life insurance policies exchanged if the policies exchanged do not relate to the same insured person.

The IRS first addressed whether the exercise of the option to change the insured constituted a sale or disposition under Sec. 1001. A change in contractual terms effected through an option provided in the original contract is treated as an exchange under Sec. 1001 if the change is so significant or material that it changes the substance of the original contract. In such circumstances, the old contract is treated as if it were actually exchanged for a new one. In the ruling, the corporation exercised an option in its COLI that permitted it to change the person insured under the policy. Because the essence of a life insurance contract is the life of the person insured under the contract, this change was considered to be a change in the fundamental substance of the original contract. Thus, the corporation's exercise of its option to change the insured was an actual exchange of contracts and was a sale or other disposition generally requiring recognition of gain or loss under Sec. 1001.

The IRS next examined whether nonrecognition treatment for an exchange of life insurance contracts under Sec. 1035 would apply. Regs. Sec. 1.1035-1 expressly excludes exchanges of policies that do not relate to the same insured; thus, policy owners are prevented from indefinitely deferring recognition of gain on a policy value by changing the insured. In the ruling, had the corporation actually assigned the life insurance policy on A to the insurance company as consideration for a new life insurance policy on B, any gain realized would have been ineligible for nonrecognition treatment under Sec. 1035. Thus, the corporation was not able to avoid the "same-insured" limitations of Sec. 1035 simply by placing terms in its original documents so that, in form, there was not an actual exchange of policies (even though, in substance, an exchange had taken place). The revenue ruling further provided that the result would be the same if a corporation insured a person holding a particular position (e.g., vice president), thereby eliminating the need for a formal susbtitution when a new person occupied that position.