Life insurance policy exchanges.

• Author: Brusso, Corinne L.

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...