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Ask the expert: Settlements and 1035 exchanges

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The question was: Can a life insurance settlement qualify for Section 1035 exchange treatment? The answer is: Marketing organizations have suggested that the purchase of a new policy with life settlement proceeds can qualify for Section 1035 exchange treatment. A sale-purchase departs significantly form the standard industry practice used to effectuate Section 1035 exchanges. Under the classic “direct exchange” approach, the policyowner assigns the policy to the new carrier, the new carrier surrenders the policy with the replaced carrier, and the new carrier than applies the surrender values from the old contract to the new policy. Under the direct exchange method, the policy owner is never in receipt of the surrender proceeds, a fact that has figured prominently in the Internal Revenue Services’ favorable private rulings involving Section 1035. In Greene v. Comm. [(85 TC 1024 (1985), acq., 1986-2 CB 1)], a decision involving annuity contracts, the Tax Court held that a transaction qualified for Section 1035 treatment where a policyowner took receipt of an annuity’s surrender proceeds and used them to purchase a comparable annuity with a new carrier. Although a policyowner could argue that an escrow agent was in receipt of the settlement proceeds that were then applied to the new policy, it remains to be seen whether the Service would rule that this transaction qualifies for Section 1035 treatment. In a Section 1035 exchange, the replaced carrier typically issues a Form 1099R and enters Code 6 in Box 7 to identify the transaction as a tax free exchange of life insurance. It is not clear how an escrow agent that uses settlement proceeds to purchase a new contract would report the transaction for 1099R purposes. Source: This is an excerpt from Life Settlement Planning, a 2008 book in the Tools & Techniques series published by The National Underwriter Company, Cincinnati, Ohio, which also publishes Settlement Watch. The book is co-authored by: Stephan R. Leimberg, Caleb J. Callahan, Bryan T. Casey, James Magner, Barry Reed, Lawrence J. Rybka, Paul A. Siegert.