Final regs adopt fix for Section 1035 life insurance exchange

Tax Hot Topics

The IRS recently finalized regulations under Sections 101 and 6050Y (TD 10052 (PDF - 301.01KB)) addressing the application of the transfer-for-value and reportable policy sale rules to certain life insurance contract transactions, including Section 1035 exchanges and certain corporate reorganizations.

The final regulations generally adopt the 2023 proposed regulations with targeted modifications, including changes to the information reporting rules, and are generally effective as of July 9, 2026.

Death benefit proceeds under employer-owned life insurance contracts (including corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) contracts) generally are excluded from federal income tax under Section 101(a)(1). However, if a life insurance contract is sold or otherwise transferred for valuable consideration, the “transfer-for-value rule” set forth in Section 101(a)(2) generally limits the excludable portion to the sum of (1) the amount of consideration paid by the transferee to acquire the life insurance contact, and (2) any premiums and other amounts subsequently paid by the transferee under the contract.

Section 101(a)(2) provides two exceptions to this transfer for value rule. Specifically, the transfer for value rule does not apply if (i) the transferee’s basis in the contract is determined in whole or in part by reference to the transferor’s basis in the contract (for example, in a tax-free merger or acquisition of the original owner of the policy), or (ii) the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

The Tax Cuts and Jobs Act of 2017 (TCJA) added reportable policy sale rules under Section 101(a)(3) and related reporting under Section 6050Y. Under these changes, the exceptions under Section 101(a) to the transfer-for-value rule remain, but they no longer apply if the acquisition of the life insurance contract constitutes a “reportable policy sale.”

Section 101(a)(3) defines a reported policy sale as “the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured apart from the acquirer’s interest in such life insurance contract.” New Section 101(a)(3) further provides that “the term ‘indirectly’ applies to the acquisition of an interest in a partnership, trust, or other entity that holds an interest in the life insurance contract.”

The issue addressed by the 2023 proposed regulations and the 2026 final regulations arose from the 2019 final regulations. Those regulations treated the issuance of a new policy in a Section 1035 exchange as a transfer of an interest in a life insurance contract, which could cause the new policy to be treated as transferred for valuable consideration and therefore subject to the Section 101(a)(2) transfer-for-value limitation, even where the old policy had not previously been involved in a reportable policy sale.

The final regulations confirm the proposed solution. A standard Section 1035 exchange generally should not, by itself, cause an otherwise compliant life insurance contract to become subject to the transfer-for-value limitation. If the full death benefit under the old policy would have been excludable under Section 101(a), the death benefit under the new policy generally remains fully excludable. If the old policy was already subject to a limitation, that limitation carries over to the new policy.

The final regulations also address a separate anti-avoidance concern: a taxpayer should not be able to use a Section 1035 exchange to avoid reportable death benefit reporting under Section 6050Y(c) or to eliminate an existing transfer-for-value limitation. Accordingly, if the old policy was previously transferred in a reportable policy sale, the new policy generally inherits that status.

The final regulations also clarify the Section 1035 exchange treatment of “boot,” meaning money or other property received in the exchange, and streamline issuer reporting by requiring the old issuer to provide relevant information to the new issuer using any reasonable method in certain cases.

Before the 2019 final regulations were issued, it was not clear the extent to which ordinary course business transactions (for example, mergers and acquisitions) could fall within the definition of a reportable policy sale with respect to policies owned by the target before the transaction. The preamble to the 2019 final regulations acknowledged the confusion, and the 2019 final regulations included provisions that effectively exclude from the definition of reportable policy sales certain acquisitions of life insurance contracts, or interests therein, in ordinary-course business transactions in which one trade or business acquires another trade or business that owns life insurance.

The 2023 proposed regulations included a proposed new de minimis exception to the definition of a reportable policy sale for certain acquisitions under Section 368(a) involving C corporations if certain conditions are satisfied, including a requirement that no more than 5% of the gross value of the assets of the target C corporation consists of life insurance contracts. The preamble to the final regulations explained that the IRS had received comments requesting that the proposed new de minimis exception be expanded to cover certain other types of ordinary course business transactions.

The IRS declined to expand the de minimis exception, and the final regulations include the proposed de minimis exception without modifications. However, the IRS indicated that it will continue to consider the possibility of proposing a broader de minimis exception and invited additional comments on the issue.