Advanced Underwriting Consultants

Question of the Day – April 19

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 is interested in doing a tax-free Section 1035 exchange of a life insurance policy for a new one.  The existing policy has substantial cash value.  Will the transfer of that cash to the new life policy create a modified endowment contract (MEC)?

Answer: A transfer of cash value from a non-MEC existing contract to a new one, by itself, will NOT cause the new contract to become a modified endowment contract.

If a taxpayer buys a new permanent life policy, depositing premiums in excess of the seven-pay limit during the policy’s first seven years will cause the contract to become a MEC.  Distributions from MEC policies during the policy owner’s lifetime are taxed less favorably than those from “normal” life policies.

A Section 1035 exchange is treated as a material modification rather than a new policy purchase for the purpose of the seven-pay test.  That means that the money rolled over is not treated as new premium, but rather as existing cash value for MEC testing purposes.  The new contract will be subject to seven pay testing, but the cash value will simply act to adjust the seven pay limit for the policy’s first seven years.

It is still possible for the new exchanged contract to become a MEC if

  • The old policy was a modified endowment contract at the time of exchange,
  • Dividends, unearned premiums or other cash were transferred as part of the exchange process, or
  • New premiums are deposited into the new contract in excess of the modified seven pay limit.

While cash values transferred as part of the Section 1035 process are not considered new premiums for seven pay testing purposes, they ARE considered new premiums for federal guideline premium purposes.

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.

Question of the Day – October 10

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 permanent life policy with a loan against it.  He wants to exchange the policy for a new, loan-free policy.  Is that allowed?

Answer: Section 1035 of the Internal Revenue Code allows a taxpayer to exchange life policies for new ones without paying tax on the gain.

However, there are policy transfers which may not qualify as tax-free exchanges.  One such transfer is the exchange of a life policy with an outstanding loan.  Money or other property received as part of an exchange is known as “boot.”

If a policy, in which the owner has a gain, is exchanged for a new one and the loan on the old policy disappears as part of the transaction, the owner must recognize taxable boot.  The boot is the lesser of the loan repaid or the gain in the policy.

In several private letter rulings, the IRS has held a policy may be exchanged tax-free for another policy, if the new policy is subject to the same amount of indebtedness as the old one.

If the new insurance company will not issue a policy with a loan against it the taxpayer has two options:

(1) pay off the loan on the old policy with funds from another source and then borrow on the new policy, if necessary; or

(2) exchange the policy, “bite the bullet” and pay the tax generated when the loan on the old policy is extinguished.

The IRS may find taxable boot in a step transaction.  In Private Letter Ruling 9141025, a taxpayer owned a life insurance policy bought with a single premium of $1 million; there was a $448,000 outstanding loan on the policy.  The taxpayer proposed to pay off the loan through a partial surrender (withdrawal) from the policy.

The taxpayer expected to treat the withdrawal as a tax-free return of premium.  The plan was to then exchange the remaining cash value for a new policy and treat it as a 1035 exchange.

Smartly, the taxpayer asked the question before doing the act.  IRS held the proposed transaction would cause taxable boot equal to the extinguished $448,000 loan; the policy withdrawal would not be an independent transaction but part of a step transaction.

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.