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Tax-Free Exchanges of Insurance Products

Part 1: As new products have come to market, financial professionals may wish to upgrade the annuities their clients own--and need the know-how to accomplish a successful tax-free exchange.

Judith A. Hasenauer and William E. Hasenauer, 05/02/2013

Co-authored by William E. Hasenauer, JD

Variable annuities first came to the market in the mid-1950s and were used exclusively for "Tax-Sheltered Annuities" for most of the first 20 years of their existence. Since "Tax-Sheltered Annuities" not only "sheltered" investment gains, but also provided tax deductions for premiums, there was never any need for concern about the tax consequences of exchanging one contract for another.

In the early 1970s variable annuities began to be sold to people who could not qualify for "Tax-Sheltered Annuities" so that the tax consequences of exchanging one contract for another was a concern to contract owners that desired to change their annuities. At the same time, a number of insurers began offering fixed annuities with considerably more competitive rates of return than had been the case with the types of annuities that had been offered by insurers for many years prior. The confluence of the increased sales of these products made the question of tax-free exchanges of greater import to financial professionals and their customers.

In addition, both variable and fixed annuities began a regular series of revisions, with new product features and more flexible and appealing terms. As new products came to market, financial professionals faced the need to constantly upgrade the annuities their clients owned. Thus arose the need for an intimate knowledge of the methodology for accomplishing a successful tax-free exchange. In the 1980s, variable life insurance reached the market and sparked the need for reconsideration of the rules for tax-free exchanges of life insurance products to keep life policies in tune with the latest developments in product features and underlying investment options.

We intend to devote the next few articles on the subject of tax-free exchanges of annuities and life insurance products in order to assist readers in understanding the intricacies of such exchanges.

The Internal Revenue Code, in Section 1035, provides, in effect, that there will be no recognizable gain or loss on the exchange of: (i) a life insurance contract for another life insurance contract or for an endowment or annuity contract; or (ii) for the exchange of an endowment contract for an endowment or annuity contract; or (iii) for the exchange of an annuity contract for another annuity contract. It is important to note that Section 1035 does not provide for the tax-free exchange of an annuity contract for a life insurance contract. The obvious reason for this difference in treatment is that annuities merely provide for deferral of taxes on investment gain whereas life insurance products can provide for tax-free investment gains on the death of the insured.

When annuities first started to become the major element of life insurance sales for the life insurance industry that they are today, the IRS took the position that, in order to qualify for a tax-free exchange, there had to be an actual exchange of one contract for another. A surrender and repurchase did not work. Moreover, in order to be successful as a tax-free exchange, all the parties to the transaction before the exchange had to be in exactly the same position after the exchange, except for the insurer.

It was never quite clear how much change could be made to the product features without causing disqualification, but so long as the only change to the parties to the transaction was the change to the new insurer, the IRS never raised the question of qualification. We have always advised that the exchange, in order to be effective, should look like two snapshots: the one before and the one after the exchange should display all of the same parties except that the later snapshot would include the new insurer and exclude the old insurer.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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