1035 Exchanges – Keep Your Hand Out Of The Cookie Jar!
In his work, A Collection of Polite Conversation, Jonathan Swift used an idiom that spoke to the difficulty of transforming a man of coarse origins and crude behavior into a proper gentleman, having one character simply state, “You can’t make a silk purse out of a sow’s ear!”
But to sully or spoil something good is another and an easier matter. No better example illustrates than misconduct during the non-taxable exchange of a life policy.
A universal life policy is a beautiful thing. Among the usual tax advantages is the feature (for non-MECs) that allows for the tax-free withdrawal of premiums; i.e., first-in/first-out (FIFO) distributions.
A silk purse indeed, but more a sow’s ear when FIFOs are attempted incidental to a 1035 exchange. Consider:
- A life-for-life 1035 exchange must be a strict policy-for-policy transaction.
- Anything received other than the new policy is considered “boot.”
- Boot is taxable to the extent there is any gain in the old policy.
- A withdrawal from the old policy taken incidental to the exchange is considered boot!
- The IRS has never been clear how long prior to an exchange a withdrawal must be made to avoid treatment as boot.
- Even recycled withdrawals used to pay off policy loans before the exchange are considered boot!
There are many reasons that a client may want to access a policy’s value at the time of an exchange. Alert them that there may be issues. Then come to us with your case to see if there are strategies that could avoid taxation or, at least, avoid the consequences of withdrawals. Contact Tom Virkler, JD – Director of Advanced Markets, at tom@cpsadvancedmarkets.com or (706) 614-3796
For What It’s Worth: Jonathan Swift might advise that creating boot is killing the goose that lays the golden eggs, or snatching defeat from the jaws of victory, or creating a fly in the ointment, or throwing the baby out with…