Bill is a friend of yours from the gym. He owns a successful manufacturing company and has inquired about whether you can help him with retirement planning and a possible buy-sell agreement. You just ran into him at the juice bar and he looks very agitated. Apparently Bill purchased a universal life policy from his brother-in-law 14 years ago. The policy has a current cash value of $800,000 and an income tax basis of $500,000. Bill is the insured and policy owner. On the advice of his brother-in-law, Bill withdrew an amount equal to his basis from the policy and the next day executed a section 1035 exchange of the policy for a new life insurance policy with a value of $300,000. Bill's tennis partner (a retired IRS attorney) tells him that he may have a tax problem. Bill wants to know what you think. What are the issues?
The concept of boot in non-recognition transactions
In a typical non-recognition transaction (like a 1035 exchange) an asset is disposed of and another is acquired in an exchange in which the transferor receives no money or money equivalents. However, what if the transferor of property receives in exchange primarily another property, qualifying for non-recognition treatment but also receives some cash or other property to boot? Such cash or other property received in an exchange otherwise qualifying for non-recognition treatment is referred to as "boot." In general, any gain realized in an exchange transaction must be recognized to the extent of the value of the boot received. [I.R.C. §1031(d)].
Debt release as boot -- 1035 exchanges of policies subject to outstanding loans
If a policy which is subject to an outstanding loan is exchanged in a transaction, otherwise qualifying for non-recognition under Code §1035, the balance of the loan at the time of the exchange is treated as boot to the extent that it exceeds the amount of any loan balance outstanding on the new policy received. This rule is necessary to prevent abuse of the non-recognition provision in a disposition transaction intended to yield cash (which would otherwise be taxable as boot) by structuring it as a non-taxable loan followed by a non-recognized exchange.
Sean owns a life insurance policy with a basis of $50,000 and a current value of $80,000. He takes out a $60,000 loan against the policy. The receipt of the loan proceeds is not income. The following week, Sean exchanges his policy, subject to the loan balance, for a new life insurance policy with a value of $20,000. The $60,000 loan balance on the old policy is treated as boot (as well as part of the amount realized on the disposition of the old policy). Thus, there is a realized gain of $30,000, all of which must be recognized because the boot amount exceeds the gain. The basis in the new policy is $20,000 ($50,000 carryover, reduced by the $60,000 of boot and increased by the $30,000 of recognized gain). If the outstanding loan on the policy given up were not treated as boot, Sean would have received $10,000 cash in excess of his basis (at the time of the loan) and a policy worth $20,000, having a carryover basis of $50,000, with no recognition of any gain at any point.
What about withdrawals?
In Private Letter Ruling 8905004, the policy owner withdrew an amount equal to his basis from a pre-TEFRA* annuity contract and put that money into a single premium life insurance contract. The cash-stripped annuity was then exchanged for another annuity. Although the taxpayer claimed that the transaction should be a tax-free exchange under Section 1035, the IRS said that the total transaction was a single exchange and that the distribution of the life insurance policy was a taxable distribution of boot. The IRS rejected the taxpayer's argument that he was entitled to a Section 72(e) tax-free distribution from the annuity, notwithstanding the subsequent 1035 exchange.
In reaching this conclusion, the Service made two points (1) Section 72(e) cannot be used to circumvent the limitations on tax-free exchanges under §1035; and (2) the step-transaction doctrine is applicable because the cash withdrawal and the exchange were part of a unitary plan to achieve an intended net result, and should therefore be treated as a single transactions (i.e., an exchange involving boot).
If an amount is withdrawn from a policy in the form of a loan, there is no question that the loan balance at the time of the exchange would be boot -- whether or not a step transaction was involved. This is because the regulations specifically provide that the assumption of a liability or the taking of the surrendered policy subject to a liability is to be treated as "other property or money," i.e., the loan amount is boot [Reg. §1.1031(b)-1(c)]. What is not so clear is whether a cash withdrawal that is not in the form of a loan must be treated as boot.
Under a strict reading of the statute and the regulations, it arguably would not be. Thus, it appears that, the use of the step-transaction doctrine was critical to the Service's holding in Ltr. Rul 8905004. Since the boot rule of Code §1031 (which is also applicable to §1035 exchanges) applies only to "property received in exchange," the Service is technically obliged to link the withdrawal to the exchange, as an integrated transaction. (As stated above, this would not be necessary in the case of a loan.)
Based on its reasoning in Ltr. Rul. 8905004 the IRS would likely find that the $500,000 Bill withdrew from his original universal life policy is boot. Thus, under this treatment, there would be a realized gain of $300,000, all of which must be recognized because the boot amount exceeds the gain. A private letter ruling does not have the same legal effect as a regulation, or even a Revenue Ruling -- but it does indicate the IRS's view of the appropriate tax treatment in a situation very much the same as Bill's.
Of course, if Bill had sought your advice prior to engaging in the transactions, you could have advised him to either (1) allow sufficient time to pass between the withdrawal and the exchange (and avoid a paper trail showing that this was an integrated transaction in two steps); or (2) attempt to structure the transactions by first completing the 1035 exchange, based on an $800,000 replacement policy, followed by the $500,000 withdrawal from the new policy. This latter approach would remove the transaction from the fact pattern in Ltr. Rul. 8905004. Although the Service could still conceivably try to apply the integrated transaction theory, there would seem to be a less compelling need to do so since the taxpayer will not have received the cash in hand as of the date that the exchange was effected -- and the policy received in the exchange will have been in the same amount as the policy given up, without any prior stripping of cash value -- a cleaner exchange of like kind property.
* Prior to the effective date of TEFRA -- August 14, 1982, "amounts not received as annuities
" were taxed under the "cost-recovery-first"
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