January 2008
by Jana Dimitrova, Zurich
When a US holder of a life insurance or annuity policy decides to change carriers, he can avoid paying US tax on the inside build-up of the policy provided certain conditions are met. The process is commonly known as a “Section 1035 exchange”, referring to the applicable section of the US Tax Code permitting the nonrecognition of income and gain.
Choose Your Carrier Carefully
Among the conditions for tax-free treatment of an exchange is that the assets move directly from one carrier to another without passing through the policyholder. The US Internal Revenue Service (IRS) recently underscored the importance of taking the right steps in the right order to complete a tax-free Section 1035 exchange. Curiously, the taxpayer was penalized for the uncooperativeness of his former insurance carrier.
In Revenue Ruling 2007-24, the IRS considered a holder of an annuity contract issued by a life insurance company who requested that a check be issued directly to the new insurance company as consideration for a new annuity contract. The individual intended the transaction to be treated as a tax-free Section 1035 exchange. However, the old carrier refused to do so and, instead, issued a check directly to the individual. Even though the individual did not cash the check and instead endorsed it to the new carrier, the IRS considered his mere possession of the check impermissible and ruled that the exchange did not qualify as tax-free under Section 1035. As a result, the individual was considered to have received a taxable distribution from the first policy and was liable for tax on all income and realized capital gains attributable to the underlying assets.
The ruling applies with equal force to life insurance policies other than pure team policies.
Interplay with the MEC Rules
By way of background, a life insurance contract is a modified endowment contract (MEC) if premiums paid at any time during its first seven years exceed the premiums that would have been paid if the contract had called for full payment in seven level annual premiums. Some of the potentially adverse US tax consequences associated with MECs are that distributions and loans from a MEC are treated as withdrawals of income earned on the investment in the contract and are taxable to the owner to the extent of such income.
All contracts issued by a single insurer to the same insured in any one calendar year are treated as a single contract for this purpose. This rule was enacted by the US Congress in order to stop the marketing of serial contracts that are designed to avoid the MEC rules.
The IRS recently ruled that there is no aggregation of MECs issued in a Section 1035 exchange. In Revenue Ruling 2007-38, it considered a taxpayer who exchanged several MECs issued three years prior and treated as a single MEC under the rule described above for new MECs issued by an unrelated insurance company and also treated as a single MEC. The IRS concluded that the exchange qualified under Section 1035 and the new MECs were not required to be aggregated with the remaining original MEC contracts for purposes of determining amount includible in gross income because they were not issued to the taxpayer by the same company in the same calendar year.
Depending on the particular policyholder’s circumstances, this ruling may open up planning possibilities.