By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
Under §1035(a)(1), no gain or loss will be recognized on the exchange of a contract of life insurance for another contract of life insurance. In order for a contract to be considered a "life insurance contract" for purposes of the Code, a contract must satisfy the requirements of §7702(a), and, for purposes of §1035, also must satisfy the definition of that term in §1035(b)(3).
Section 1035(b)(3) defines for purposes of §1035 the term "contract of life insurance" to be a contract with an insurance company that depends in part on the life expectancy of the insured, but that is not ordinarily payable in full during the life of the insured. Applicable Treasury regulations1 also provide that §1035 does not apply to an exchange of policies if the policies exchanged do not relate to the same insured.
In the past, the IRS has, in some instances, interpreted the "same insured" requirement strictly. Thus, in PLR 9542037, the IRS ruled that a first-to-die policy held by one spouse could not be exchanged for a survivorship or "second-to-die" policy insuring both spouses, and that two first-die-policies (separately insuring two spouses) could not be exchanged for a second-to-die policy insuring both spouses. The IRS stated in that ruling that the same result would obtain if the policies in question were held in trust.
In PLR 9330040, in contrast, the IRS approved, as a tax-free exchange under §1035, the exchange of a second-to-die policy for a first-to-die policy after the death of the first spouse covered by the second-to-die policy. PLR 201304003, described below, reaffirms this conclusion on slightly different facts.
In PLR 201304003, Husband and Wife established a trust that purchased a survivorship or "second-to-die" life insurance policy insuring the lives of both of them. It provided for the payment of a death benefit to the trust upon the death of the survivor of Husband and Wife.
Sometime thereafter, Husband died, leaving Wife as the sole insured under the second-to-die policy. At a later date, the second-to-die policy was transferred to "New Trust," an irrevocable trust settled by Wife, with the consent of all the beneficiaries of the old trust, in accordance with the requirements of state law. (Note: There was no "New Trust" in PLR 9330040, above, and the creation of a new trust would not appear to be necessary to the rationale of the ruling. It is likely, therefore, that New Trust was created for nontax reasons.)
The trustee of New Trust subsequently exchanged the second-to-die policy for a new life insurance contract, covering only the life of Wife (the "New Policy"). The exchange was effectuated by New Trust assigning its interest in the second-to-die policy to the issuer of New Policy (the "New Issuer"). New Issuer issued New Policy to New Trust and then surrendered the second-to-die policy to its issuer.
New Trust was the owner and sole beneficiary of the old second-to-die policy, and is the owner and sole beneficiary of New Policy. New Trust represented that both the old second-to-die policy and New Policy qualify as life insurance contracts under §7702(a). New Trust further represented that neither policy was (or is) ordinarily payable in full during the lives or life of the insured(s).2
On these facts, the IRS ruled that New Trust does not have to recognize any gain or loss from the assignment of the second-to-die policy in exchange for the first-to-die policy (New Policy).
The IRS, as in PLR 9330040, supra, cited the legislative history of §1035, which "indicates that Congress viewed nonrecognition treatment as appropriate for "individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain."3
It reasoned that, after the death of Husband, the sole remaining insured on the old second-to-die policy was Wife. Similarly, the sole insured on New Policy is also Wife. Therefore, "[t]he exchange does not involve a change of insured, which would disqualify the transaction from nonrecognition treatment under section 1035."
The ruling expresses no opinion on whether section 1035 applies to the exchange of a survivorship or "second to die" life insurance contract for a single life insurance contract prior to the death of either of the insureds under the survivorship contract.
For more information, in the Tax Management Portfolios, see Budin, 826 T.M., Life Insurance, Brody, Richey, and Baier, 828 T.M., Insurance-Related Compensation, and in Tax Practice Series, see ¶1540, Exchanges and Sales of Insurance, Endowment and Annuity Contracts, and ¶6160, Gross Income Exclusion for Gifts, Bequests and Insurance Proceeds.
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