1. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 1  Why an exchange?  Higher rate of return can be realized in a new policy  Present insurer may become insolvent  Current policy has substantial loan  Interest costs increasing and nondeductible  Change from individual to group product  Death benefit under new policy exceeds that from old policy  Change from ordinary life to a single premium policy  New policy is more flexible (premiums, death benefits, etc.)  Premiums are lower on the new policy

2. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 2  Income tax Implications  Section 1035 of the internal revenue code  No gain or loss recognized on exchange of  A life insurance contract for another life insurance contract  A life insurance contract for an endowment policy  A life insurance contract for an annuity  An annuity for another annuity  An endowment contract for another endowment contract  An endowment contract for an annuity contract

3. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 3  Income tax Implications (cont'd)  New contract receives basis of old contract  Partially tax deferred exchanges  If cash or any “in kind” payment of value, such as a life insurance contract in exchange for an annuity  Gain must be recognized to the extent of such “Boot” (i.e., cash or in kind property  Cash includes repayment of any outstanding loans at surrender  If a taxpayer sells or exchanges property subject to a debt, relief from that debt is treated in the same manner as if cash were received by the seller

4. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 4  Taxable exchanges  IRC section 1035 does not allow a tax free exchange, but rather to defer the tax on any gain  Section 1035 will not apply if the exchange  Increases the possibility of eliminating the tax by extending the period of life insurance protection or  Providing life insurance protection were none existed before  Any gain inherent in the contract must be reported by the client in any transaction that does not fully meet the IRC Section 1035 rules

5. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 5  Issues under IRC Sections 7702 and 7702A  Lifetime distribution from a “modified endowment contract (MEC) is includible in the income of the recipient to the extent of gain  Distribution is defined broadly to include all loans, partial surrender and even dividends  A 10% penalty tax is imposed on the amount includible in gross income unless the distribution is due to  Death of the insured  Disability of the insured  Made after the policyowner turns age 59½  Is paid over the life expectancy of the taxpayer or joint life expectancy of the taxpayer and beneficiary  Planners should not taint a non-MEC policy through an exchange

6. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 6  Mechanics of the exchange  Absolute assignment and exchange agreement form  Unsigned copy of old company’s surrender form  Original policy attached to above forms  New policy issued before old policy is surrendered  If new policy is heavily rated or declined, insured should be notified so that exchange may not be executed if new policy will be worse than the old one  If the new policy is issued, the old policy is surrendered  Cash value goes from one carrier to the other carrier

7. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 7  Exchanges involving loans  Extinction of indebtedness is boot  If there is a policy loan on the old policy  Exchange agreement should provide that the loan is outstanding and  New carrier will assume the liability  New policy will serve as security for that loan  Exchanges involving qualified pensions or profit sharing plans  Do not have to qualify under the 1035 safe harbors (as a tax exempt entity)  Potential serious problem – Executing an exchange that inadvertently violates the plans’ rule regarding incidental life insurance  Maximum percentage allocation for ordinary life = 49.9%. For all others = 25%  Exchange of ordinary life to universal life created an excess over those maximums  Plan could be disqualified!

8. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Section 1035 Exchanges Chapter 20 Tools & Techniques of Life Insurance Planning 20 - 8  Fatal flaw checklist  Failure to meet same insured requirement  Poor timing  Failure to give up the old policy in exchange for the new contract  Exchanges of unexchangeable  Government policies