Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client owns a life insurance contract where he is the insured and his daughters are the beneficiaries. Can he make a Section 1035 exchange so that an ILIT becomes the owner of the policy? If so, does the three-year rule that would bring the full death benefit back into his estate still apply?

Answer: Section 1035 requires consistent ownership before and after the exchange for it to be tax-free. Since an ILIT is a legally distinct entity, the ownership change would generally disqualify it for Section 1035 treatment, and it would simply be a surrender of the old policy followed by the purchase of a new policy in the name of the ILIT.

It could be argued that if the ILIT is a grantor trust, the grantor/original policy owner is still the constructive owner of the life insurance policy; therefore Section 1035 would apply. However, if this analysis is true, Section 1035 would apply, but the individual would not avoid the rule bringing the death benefit back into his estate if he dies within three years from the transfer.

As you can see, the bottom line is that an individual cannot make a Section 1035 exchange into an ILIT and avoid the three-year rule. If he wants to get the life insurance policy inside an ILIT, he would either have to (1) take the risk of the full death benefit being brought back into his estate if he dies within three years, or (2) surrender the policy for its cash value, pay income taxes on any gain, transfer money to the ILIT, and have the ILIT purchase a policy on his own life.

If he chooses the latter, he faces gift taxes on the transfer of money to the ILIT if such transfers are more than the $14,000 exclusion amount in 2014. He also faces potential problems with the policy being considered a modified endowment contract (MEC). Both options have risks or costs, and so it’s up to the client to decide which option suits him best.

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