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Comdex Review Of The In-force Carrier

This comprehensive review covers topics like Comdex ratings, policy risk assessment, company structure changes, tax implications of restructuring policies, and exchanges involving loans or surrenders. Clarification on taxable events, MEC status, grandfathered contracts, and policy loan limits are discussed.

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Comdex Review Of The In-force Carrier

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  1. Comdex Review Of The In-force Carrier • The Comdex gives the average percentile ranking of this company in relation to all other companies that have been rated by the rating services. The Comdex is the percentage of companies that are rated lower than this company.

  2. A Review Of Policy Risk • A change in dividends or non-guaranteed pricing could signal a transfer in risk from the insurance company to the insured.

  3. Change In Company Structure • Has the insurance company changed its operating structure through a conversion from a mutual company to a publicly traded company? Has the in-force dividend scale declined suggesting a move away from policy holder focus to stockholder interest?

  4. Exchange Of A Policy With An Outstanding Loan • In order for an exchange to be tax-free, it must be of a like kind, meaning that no money or other property (I.e., no “boot”) can be received in addition to the contract. The receipt of the boot will cause the gain in the contract to be recognized to the extent of the sum of money and the fair market value of the property received. Sec. 1031(b). If the boot received exceeds the gain in the contract, the entire gain will be recognized; if the boot is less than the gain in the contract, gain recognition will be limited to the amount of the boot.This also includes the amount of any liability of which the transferor is relieved as a result of the exchange. Sec. 1031(d). A policy loan is treated as a liability for this purpose. Thus, the exchange of a life insurance contract with an outstanding loan can result in the receipt of boot and make an otherwise tax-free exchange taxable. The Internal Revenue Service has, however, taken the position that if the new contract is encumbered by an equivalent liability, no gain or loss will result. See, e.g., PLR 880658. Although a taxable event may be avoided if the new contract is issued with an equivalent loan, few insurers will do so; meaning many 1035 exchanges of contracts with the outstanding loans will result in the recognition of gain.

  5. Exchange Of The Policy Following A Partial Surrender • Since the exchange of a contract with an outstanding loan will result in the recognition of gain (assuming there is gain in the contract) a seemingly logical tactic might be to first eliminate the loan by effecting a partial surrender of the contract, and the then effect the exchange of the now unencumbered policy. A partial surrender is not a taxable event unless the loan paid off with the surrender proceeds the contract holder’s basis in the contract. Sec. 72(e)(5). The Internal Revenue Service has taken the position, however, that this is the equivalent of the exchange of the contract with an outstanding loan. In PLR 9141035 the Service invoked the “step transaction” doctrine to collapse the repayment of the loan and the subsequent 1035 exchange into a single transaction and ruled that the contract holder was taxable on the amount of the gain to the extent of the loan.

  6. Exchange Of A Modified Endowment Contract • Internal Revenue Service Code provides that if a modified endowment contract (MEC) is exchanged for a new contract, the new contract will be a MEC.SEC 7702 (a)(2). Thus, it is not possible to purge a MEC of its MEC Status by exchanging it for a new contract.

  7. Exchange Of A pre-June 21, 1988 Single Premium Life Insurance Contract • A single premium life insurance contract issued prior to June 21, 1988 is not treated as a modified endowment contract. If such a contract is exchanged later for a new single premium life insurance contract, will it lose it’s grandfathered status and be treated as a MEC? • Although the law is not entirely clear, most insurers do not treat the new contract as modified contract to 7-pay premium testing. In calculating the seven pay limit on the new contract, the formula takes into account the cash value of the existing contract, but do not treat it as a premium payment. The new contract will therefore have a very low or perhaps zero seven-pay limit, but will not be a MEC. This often means, however, that if any additional premiums are paid into the new contract, it will become a MEC.

  8. Policy Loan Limits - Exchange OfA pre-June 21, 1986 Business-owned Contract • Prior to the enactment of the Tax Reform Act of 1986 there was no limitation on the amount of policy loan interest a business could claim as an income tax deduction. The Act added section 264 (a)(4) to the Code, which limited the deduction of policy loan interest, with respect to one or more policies on the life of any officer, employee or individual financially interested in the business, to the interest paid or accrued on an aggregate $50,000 of indebtedness. The Small Business Job Protection Act of 1996 amended section264(a)(4) and added section 264(d), which placed further restrictions on the deductibility of policy loan interest paid or accrued after October 15, 1995. Contracts purchased prior to June 21, 1986 were grandfathered under the 1986 Act, and were in large measure spared by the 1996 changes. Thus, in the case of these pre-June 21, 1986 policies, interest paid or accrued on an unlimited amount of policy borrowing continues to be deductible, albeit subject to an interest rate cap imposed by the 1996 Act. If however, a pre-June 21, 1986 contract is exchanged for a new contract, will its grandfathered status be lost?

  9. Grandfathered Loan Limits • The legislative history of section 264 (a)(4) indicates that a contract’s grandfathered status will be lost if it is exchanged for a contract of a different insurer. Although this implies that grandfathered status will be retained by a contract that is exchanged for a contract of the same insurer, the legislative history is actually ambiguous on this point. It suggests that changes to a pre-June 21, 1986 contract, other than “minor administrative changes” may cause the contract to be treated as if purchased after June 20, 1986. In light of the uncertainty, if the deductibility of interest is a significant consideration, a business intending to exchange a grandfathered contract should consult with their tax advisors prior to the exchange. It should also be kept in mind that any loan outstanding at the time of the exchange will, as described above, be treated as boot, if it is repaid or eliminated in the process of the exchange.

  10. Exchange Of A Contract Under A Business Exchange Rider • Business-owned insurance contracts often carry a rider that allows the insured to be replaced with another employee of the business. The fact that these are called “business exchange riders” has led some to believe that this “exchange” of insureds would constitute a section 1035 exchange. Section 1035 requires that the contracts exchanged relate to the same insured, i.e.. That the insured under both contracts be the same. Since an exchange under a business exchange rider, by its very nature, involves a change of insured’s, such an “exchange” does not qualify as tax-free under section 1035. The IRS made this explicitly clear in Revenue Ruling 90-109, 1990-2 C.B 191, which held that such “exchanges” are treated as surrenders for income tax purposes. Thus, the exercise of a business exchange rider will result in the recognition of gain by the business that owns the contract, as though it had been surrendered.

  11. Exchange Of A Contract In Conjunction With A Change Of Ownership • Very often, in a business or estate planning context, the exchange of a contract will be accompanied by a simultaneous change of ownership to another person, or to entity, such as a trust. Although an insurer may process the exchange as a single transaction, for tax purposes this constitutes two separate transactions; a transfer of ownership and a 1035 exchange. Although the exchange itself will be non-taxable (assuming no boot is received) the transfer of ownership will have income and/or gift tax implications. If the contract is owned by a business and is transferred to the insured employee, the employee will be subject to income tax on the value of the contract. If the business transfers the contract to a member of the insured's family, or to an irrevocable trust created by the employee, the change of ownership will likely be treated as a constructive transfer to the insured, followed by a constructive transfer to him or her, and the constructive transfer by the insured will be treated as a gift to the transferee.

  12. Exchange Of A Contract In Conjunction With A Change Of Ownership (Continued) • The direct transfer of the policy by the business, to a family member of the insured or to a trust, may also raise a potential “transfer for value,” issue. The transfer for value rule comes into play whenever there is a transfer, for a valuable consideration, of a right to receive proceeds of a life insurance policy. A transfer made in connection with employment, i.e., in exchange for services rendered, would be for a valuable consideration. If a transfer for value occurs, and if no exception to the rule is applicable, the death proceeds in excess of the transferee’s basis in the contract will be subject to income tax. The exceptions to the rule are: (1) A transfer to the corporation in which the insured is an officer or a shareholder; and (2) A transfer in which the basis of the transferee is determined in whole or in part by reference to the basis of the transferor. Sec. 101 (a)(2).

  13. Exchange Of A Contract In Conjunction With A Change Of Ownership (Continued) • For estate tax purposes, section 2035(a) of the IRS code requires an insured to outlive the transfer of an insurance contract on his or her life by three years in order for the proceeds to be removed from his or her estate. If the exchange of a contract is effected in conjunction with a change of ownership, e.g., to the children or to an irrevocable trust, should the three year rule apply to the new contract? What if the policy is exchanged by the transferee after the initial transfer? In each case, arguably, the proceeds are paid from a new contract and not from the contract transferred by the insured within three years of death. But there is an undeniable link, in each case, between the old and new contracts. • It is unlikely that the law will be interpreted to permit the carryover of basis and other attributes (such as MEC grandfathering) to the new contract without treating the new contract as transferred by the insured for the purpose of the three year rule. This is also true when an exchange is followed by an immediate transfer of the new contract. In both situations, the likely result is estate taxation of the proceeds if the insured dies within three years of the transaction.

  14. Exchange Of A Single Life Contract For A Second-to-die Contract • The prevalence of second-to-die insurance brought with it the question whether a contract insuring one life or, alternatively, two contracts insuring two lives, might be exchanged under section 1035 for a second-to-die contract. The IRS set forth its position in PLR 952037, wherein it ruled that such exchanges would not qualify under section 1035 since the contracts exchanged did not each relate to the same insured: in one of the situations presented in the ruling was the insured, under the contract exchanges were deemed taxable. In all likelihood, the Service would adopt the same position if it were to rule on the exchange of two or more individual contacts for a first-to-die contract. • It is worth noting that the Service has ruled favorably on the exchange of a second-to-die contract where one of the insureds died and the survivor sought to exchange the contract for a new single life contract. • PLR 9248013. There the Service reasoned that since the survivor remained the only insured under the contact, the exchange would not result in a change of insureds and would therefore qualify under section 1035.

  15. Exchange Of A Single Life Contract For A Second-to-die Contract (Continued) • Section 1035 provides for the non-recognition of gain when a contact is exchanged for another contract. It is not clear, however, whether the literal terms of section 1035 would be met if a contract is exchanged into another existing contract. The Service has never ruled directly on this question. An argument can be made that if the exchanged is structured in a manner that is the equivalent of the issuance of a new contract, section 1035 should apply. For these transactions to be equivalent, it would seem necessary that there be an underwritten increase in the death benefit of the contract into which the exchange is to be affected. If the transaction results in this additional insurance, this should arguably, satisfy the requirements of section 1035.

  16. Exchange Of A Contract Into An Existing Contract • The closest the Service has come to ruling on an exchange into an existing contract was a ruling involving the deposit of surrender proceeds from one annuity contract into another annuity contract. PLR88010010. The ruling did not involve the assignment of a contract holder which he then sought to deposit into the new contract. Under these circumstances, it was not difficult for the Service to conclude that this was not an exchange under section 1035. It did however, opine that “an exchange of insurance contracts requires that the taxpayer relinquish ownership in one insurance contract and, as a result thereof, acquire, ownership in a second insurance contract.” This language is clear evidence of the Service’s likely intent to apply a strict interpretation of section 1035’s requirements. • Although it may be possible to effect a 1035 exchange in the manner described, given that the procedure for doing so would be no different that an original application procedure, there appears to be little benefit to be gained by taking this route rather than simply applying for a new contract (apart from the benefit of ending up with a single policy).

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