Advanced Underwriting Consultants

Ask the Experts – April 14

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.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – December 10

Ask the Experts!

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

Question: I have a client who inherited a nonqualified annuity from his father. Can he exchange this contract for another nonqualified annuity without recognizing gain under Section 1035, or is he stuck with the current annuity contract?

Answer: It appears so, but the beneficiary must still take required distributions.

The IRS recently issued Private Letter Ruling 201330016 addressing this issue. There, the owner of several fixed and variable nonqualified inherited annuities wanted to exchange these contracts for another variable annuity contract. The IRS allowed the tax-free exchange because:

  • The technical requirements for the 1035 exchange were honored; and
  • The beneficiary ensured that distributions from the new annuity would be at least as rapidly as required under the old, inherited contract.

The IRS essentially wants to make sure that the exchange is not simply used to avoid the Section 72(s) post-death required distribution rules. The exchange must only provide a means of changing the contract and investments.

As long as these requirements are met, a beneficiary should be able to make a tax-free exchange of his current inherited annuity contract for a new one.

If the IRS did not allow this tax-free transfer, the beneficiary would recognize gain on the distribution from her inherited annuity, and then reinvest whatever remains in a separate contract.

As always, keep in mind that Private Letter Rulings are not binding on the IRS, but they can serve as guidance on the IRS’s interpretation of the Code.

 

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – August 20

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 has a whole life contract with a separate deferred annuity rider.  She wants to exchange her whole life policy for universal life under Section 1035.  May the client use both the cash value from the base policy and the money in the deferred annuity rider for the Section 1035 exchange?

Answer:  It appears that the answer is no.

Section 1035 allows one life policy to be exchange for another life policy on a tax-free basis.  While a life policy can also be exchanged for a deferred annuity under Section 1035, the rules do not permit an exchange of an annuity for a life policy.

Certain kinds of life insurance policy riders are considered to be part of an underlying life insurance policy.  Any values associated with such riders would be eligible for a Section 1035 exchange from life policy to life policy.

Section 7702 of the Internal Revenue Code describes the kind of riders that would be considered to be an integral part of the underlying life policy.  Here’s a list:

(5) Qualified additional benefits

(A) In general

The term “qualified additional benefits” means any—

(i) guaranteed insurability,

(ii) accidental death or disability benefit,

(iii) family term coverage,

(iv) disability waiver benefit, or

(v) other benefit prescribed under regulations.

Annuity riders are not listed as qualified benefits—so the cash value associated with the rider would be most likely be treated, for tax purposes, as if it is in a stand-alone annuity contract, and not in a life contract.

Thus, the cash in the annuity rider is probably not be eligible for Section 1035 treatment if transferred to a new life policy.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.