Advanced Underwriting Consultants

Unusual Section 1035 Exchange Question

A producer recently passed along this fact situation.  A few years ago, the producer’s client had a life policy with Company A, which was exchanged under Section 1035 to Company B.  At the time of the exchange, the client had a basis of $54,000 in the life policy, and cash surrender value of $37,000.  The exchange was done properly, and the client still owns the coverage with Company B.

In the intervening years, a class action lawsuit was filed against Company A on behalf of certain current and past policyowners.  The client, pursuant to that class action, received a cash settlement of $21,000 from Company A in satisfaction of claims resulting from policy ownership.

Company A intends to report part of that $21,000 as a taxable event for the client.  The producer wanted to know why.

I can’t speak with 100% certainty regarding Company A’s position, but apparently it feels the settlement is taxable boot, and therefore is a taxable distribution to the extent there was gain in the contact at the time of the 1035 exchange.  It measures gain by comparing cash value ($37,000) plus settlement ($21,000) to basis ($54,000).  That means that there was $4,000 of unrealized gain when the contract was exchanged.

Company A apparently feels the settlement amount should be treated as an amount retained by the policyowner at the time of the 1035 exchange.  As such, $4,000 of the $21,000 settlement should be taxable.

I am not sure that I agree with the analysis, and I encouraged the agent to have the client’s tax preparer evaluate the situation for possible argument with either Company A or the IRS.

Linas Sudzius