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Know the Rules Governing Tax-Free Exchanges of Insurance Products

Part 2: Not all products are created equal when it comes to a tax-free exchange.

Judith A. Hasenauer and William E. Hasenauer, 06/06/2013

Last month, we talked about the general framework of tax-free exchanges under Internal Revenue Code Section 1035 and the need to keep the essential parties to the insurance contact in the same position before and after the exchange. It is important in any analysis of the issues related to Section 1035 exchanges to keep in mind that the rules under Section 1035 generally apply only to non-qualified contracts. Exchanges and transfers involving contracts qualified for use with IRAs (Sec. 408(a) and 408(b)), tax-sheltered annuities (Sec. 403(b)), Section 457 plans, and Section 401 plans are governed by different rules applicable to the specific type of qualified plan.

In this installment of the series on Section 1035 exchanges, we will discuss the mechanics of the exchange process, the different types of products that are allowed to be exchanged under Code Section 1035, and the rulings issued by the Internal Revenue Service.

As a general proposition, an exchange under Section 1035 must be a transfer of one contract for another contract with the requirement that the exchange be implemented directly between the issuing insurance companies with the proceeds transferred directly between them. In order to accomplish this direct transfer, the contract owner, as part of the application process for the new contract, assigns the old contract to the new insurance company. The new insurance company will then surrender the contract to the old company and request that the surrender proceeds be sent directly to the new company. If the surrender proceeds are sent by the old company to the contract owner, the exchange generally will not qualify as a tax-free exchange but rather will be treated as a taxable surrender of the old contract and the purchase of the new contract. This unfavorable tax treatment will result even if the contract owner immediately endorses over the proceeds check to the new insurance company.

As part of the exchange process, the new company will request the old company to provide certain tax reporting information, such as cost basis and earnings, about the surrendered contract. This information will be necessary for future tax reporting by the new company. Even though a 1035 exchange is treated as tax-free, it is still a reportable transaction for federal income tax purposes. As a result of the surrender of the original contract as part of the exchange, the old insurance company is required to report the surrender on Form-1099 and should report it as a Section 1035 exchange rather than a taxable surrender. It is important for the contract owner to maintain records of the exchange in the event the old company does not properly report the transaction. In many cases, tax-free exchanges are done to allow a contract owner to move from one product to another product offered by the same insurer. These so-called "internal exchanges" should also be structured as a 1035 exchange; however, under the tax reporting rules, the insurance company is relieved of its obligation to report the transaction on Form-1099 since the insurer already has the information about cost basis and earnings necessary to perform future tax reporting.

In considering a Section 1035 exchange, one must be mindful of the different types of insurance products that may be exchanged on a tax-free basis. Not all products are created equal in this regard. Code Section 1035 allows for the exchange of a life insurance contract for another life insurance contract or an annuity contract, and allows for the exchange of an annuity contract for another annuity contract. Since 2010, a life insurance contract or an annuity contract may also be exchanged for a qualified long-term care contract; however, a qualified long-term care contract may be exchanged only for another qualified long-term care contract. Similarly, the presence of a long-term care rider as part of an annuity contract will not prevent the tax-free exchange of the annuity contract.

Furthermore, over the years a number of Internal Revenue Service rulings have provided guidance as to what types of different contracts may be used in tax-free exchanges. A fixed annuity contract can be exchanged for a variable annuity contract and vice versa. A deferred annuity contract can be exchanged for an immediate annuity contract, but keep in mind that the issue date of the deferred annuity will be used as the issue date of the immediate annuity, so if the immediate annuity contract doesn’t annuitize within one year of that original date, then it won't be treated as an immediate annuity for certain tax purposes, such as avoiding the 10% premature distribution penalty.

In relation to life insurance contracts, the tax-free exchange rules don't distinguish between the various types of permanent life insurance, so consequently a variable life insurance contract, a universal life insurance contract, and a whole life insurance contract can each be exchanged for the other. Furthermore, an individual life insurance contract can be exchanged for a participation certificate under a group life insurance policy. However, due to the requirement that the insured must be same under the life insurance contracts involved in the exchange, the Internal Revenue Service has ruled that an exchange involving policies that insure the life of one spouse for a policy insuring both spouses, or an exchange of single life policies insuring each spouse for a second-to-die policy insuring both spouses, will not qualify under Section 1035. Nonetheless, an exchange of a joint and last survivor policy, where the first insured died, for a single life policy covering the survivor will be allowed on the basis that the survivor, as the only remaining insured, will be the same under both policies.

In reviewing a proposed Section 1035 exchange, consideration should be given to the effect of the exchange on any "grandfathered" tax status of the contract to be surrendered. This is critically importance if the contract to be exchanged was issued prior to a change in the tax rules applicable to that contract. When the rules regarding the tax treatment of insurance contracts are changed, often contracts in existence prior to the rule change will be "grandfathered" if certain conditions are met. If granted "grandfather" status, those contracts or some of the value of those contracts will continue to be taxed under the old rules, which applied when the contract was issued. However, if the "grandfathered" contract is exchanged after the effective date of the tax rule change, a question arises as to whether the new contract, issued after the tax rule change, still retains the "grandfather" status. Unless the tax rule change specifically provides for "grandfathering" after a Section 1035 exchange, the new contract probably would not retain its "grandfathered" status and therefore would be taxed under the new tax rules. Depending on the circumstances, this may be an important factor in determining whether or not the exchange is suitable for the contract owner.

In the next article, we'll discuss exchanges involving multiple contracts, partial exchanges, and suitability issues related to tax-free exchanges.


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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