IRS rules free life insurance exchanges from tax traps

The Internal Revenue Service and the Treasury Department issued final regulations this week on Section 1035 exchanges for life insurance contracts, eliminating a number of tax gotchas from regulations issued in 2019 that also affected corporate reorganizations and death benefits for survivors.

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A 1035 exchange allows taxpayers to swap out an existing life insurance policy, annuity or endowment for a new, similar contract without triggering immediate taxes on their investment gains. The final regulations offer guidance on the application of the transfer for valuable consideration rules and the associated information reporting requirements for reportable policy sales of interests in life insurance contracts to exchanges of life insurance contracts qualifying for nonrecognition of gain or loss and certain acquisitions of interests in life insurance contracts in transactions that qualify as corporate reorganizations.  

The final regulations also affect parties involved in these types of life insurance contract transactions, including with respect to payments of reportable death benefits. The IRS and the Treasury issued proposed regulations in 2023 to fix the problems that commenters had brought to their attention in the 2019 regulations, and the final regulations they issued Wednesday address them with some changes in response to later comments. 

“For CPAs and tax professionals managing life insurance transactions, corporate mergers and client wealth transfers, this Treasury Decision represents a major victory,” wrote Ed Zollars of Thomas, Zollars & Lynch on his Current Federal Tax Developments blog. “It successfully dismantles an ‘inadvertent’ tax trap created by the 2019 final regulations that threatened to tax death benefits on ordinary Section 1035 exchanges, while also establishing a de minimis exception for corporate reorganizations.”

The Treasury and the IRS said the proposed changes relating to Section 1035 exchanges aimed to correct an unintended change in the 2019 final regulations to the treatment under Section 101 of a life insurance contract issued to a policyholder in a Section 1035 exchange, while continuing to address the concerns that prompted the inclusion of rules for section 1035 exchanges in the 2019 final regulations. These concerns included that the reporting of death benefits paid under Section 6050Y(c) could be avoided by exchanging a contract transferred in a reportable policy sale contract for a new contract in a Section 1035 exchange and that a policyholder could attempt to avoid the limitation on the excludability of death benefits resulting from the application of the “transfer for value” rule through a Section 1035 exchange.  

The 2023 proposed regulations would accomplish these objectives in four ways: (1) by removing the reference to Section 1035 exchanges in the definition of a “transfer of an interest in a life insurance contract” (2) by adding a new rule on how to determine the amount of the proceeds attributable to an interest in a life insurance contract issued in a Section 1035 exchange that is excludable from gross income; (3) by modifying the definition of “reportable policy sale” to address Section 1035 exchanges; and (4) by making conforming modifications to the 2019 final regulations.  

The final regulations also help with reporting of death benefits. The additional collection of information in the final regulations was suggested by commenters on the proposed regulations as a simpler and less burdensome alternative to the collection of information rules in the proposed regulations, especially because most old issuers routinely provide new issuers with relevant information about the contract being exchanged, including relevant information on reportable policies for sale. Because the additional collection of information would achieve the goal of providing the information necessary for the proper reporting of reportable death benefits, the final regulations eliminate the reporting obligations that would have been imposed by the 2023 proposed regulations on new issuers. 

The guidance indicates that the tax attributes of a policy, including its status as a reportable sale, generally carry over to the new contract received in an exchange. The regulations also include a de minimis exception for life insurance interests acquired during certain corporate reorganizations, as long as the insurance assets represent only a small fraction of the total business value. To reduce administrative burdens, the IRS has adopted a streamlined information sharing process between insurance companies instead of requiring entirely new tax forms for these exchanges. The final rules aim to prevent tax avoidance while preserving the intended benefits of tax-free policy replacements for legitimate consumers.