Advanced Marketing Forum Question

1035 Exchange While Changing Ownership to a Trust

Question:
I have husband and wife clients whom each have a whole life policy with themselves as the insured and their spouse as the owner and beneficiary (cross-ownership). Both policies have little if any gain, the surrender value is almost identical to total premiums paid. I am in the process of 1035 exchanging these policies into new FPVUL policies. I assume that the existing ownership must be maintained in completing the 1035 exchange. Ultimately I would like to name existing irrevocable life insurance trusts as the owner & beneficiary of the new policies. Is my only option applying for the new policies under the current ownership and then requesting an ownership change and subjecting the transfer to taxation (if any), gifting consequences and the three-year "in contemplation of death" provisions? Please provide comments, options and a recommendation.

Note: The husband's is insured for $1,000,000 and the policy has a surrender value of about $93,000. The wife is insured for $350,000 and that policy has a surrender value of about $33,000. I am not sure of the number of beneficiaries in each of the existing ILIT's.

Reply #1:
1035 won't get you around the gift tax issue and three year rule. The newer policy is considered to be a continuation of the old for ownership purposes. The only benefit I can see is to do the 1035 first so that the loading charges and start up expenses on the new policy may reduce the gift tax value of the policy somewhat. There would be a delay, however, before the transfer as the 1035 gets completed by the insurance carrier. This would push back the tolling of the three year period, something the insured would have to be comfortable with.

Eric Burke Mills, JD, LLM
Director - Advanced Designs
Pacific Life Insurance Company
Phone: (800) 800.7681 x3713
Fax: (949) 219.5049
E-mail: emills@pacificlife.com

Reply #2:
Doing the 1035 before transferring the policy to the trust will not lower the value of the gift. The value of the gift within 12 months of issue is the premium paid, in this case the amount exchanged (1035'd into the new contract)

Andrew I. Shapiro, CLU, ChFC Senior Advanced Sales Consultant Nationwide Life Insurance

Reply #3:
You might try gifting the policy to the trust first. If the CSV is as low as you say, there may be lifetime gift credit to use here. Then have the trust do the 1035 exchange. The gift to the trust, if it is a grantor trust is a transfer to the insured for transfer for value purposes but the three year rule would apply. Of course both husband and wife would have to have their own grantor trusts or wife would first have to gift her policy on husband - to husband- and then he would gift it to the trust.

Jane Warner, Esq.
Director, Advanced Planning
Sun Life Financial
Phone: (800) 432-1102

Reply #4:
You can either first 1035 the policies and then transfer them to the trust, or transfer them to the trust and then 1035 exchange them. The first option may result in lower gift tax results as the policies "may" have a lower gift tax value after the 1035 exchange (check with the new insurer to find out what the gift tax value would be and compare that to the value that the old insurer would report).

Since these were cross owned policies, the husband did not have incidents of ownership in the policy owned by his wife and visa versa. It should be noted that these policies would not be subject to the three year rule. Code section 2035 pulls life insurance death proceeds back into the estate (if the donor dies within 3 years of the transfer) only to the extent that they would have been includible in the donor's estate had Code section 2042 applied at the time of the transfer. Code section 2042 is inapplicable in this case as neither insured possesses incidents of ownership in the policy insuring his or her own life.

Also, you mention that the transfers will be made to existing ILITs. I would imagine that each spouse has set up an ILIT for the benefit of the other spouse and children. If that is the case, transferring the policies into these trusts could be a problem. Assume Husband transfers the policy he owns on his Wife's life into the ILIT he has established for the benefit of the Wife and children. Now we have a situation where the ILIT owns a policy on a beneficiary. If that beneficiary is a trustee or possesses a limited power of appointment, that policy will be includible in the spousal beneficiary's estate. I'd make sure that transferring the policies into the existing trust will not cause any adverse estate tax consequences.

Keith Buck, J.D., LLM, CLU, FLMI
Estate & Business Planning Hartford Life

Reply #5:
Why do a 1035 exchange in the first place if the cash value of the existing policies are about equal to the premiums paid? Why not cash them in, gift the cash to the trust and allow the trustee to purchase the new policies as desired?

Sue Torbin, M.S., CFP

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