Tax-Free Exchange by the Surviving Spouse of Second-to-Die Life Insurance Approved by the IRS
After the death of the first spouse insured by a second-to-die, or survivorship, life insurance policy, can the surviving spouse exchange the second-to-die policy for a first-to-die, or single-life, policy without any tax consequences? The IRS has ruled in a 2013 private letter ruling that Section 1035 of the Internal Revenue Code, which in effect exempts exchanges of certain life insurance policies from income tax, applies to this type of exchange.1
Section 1035 provides that no gain or loss will be recognized on an exchange of a contract of life insurance for another contract of life insurance. However, Treasury Regulations provide an exception to this rule where policies being exchanged do not relate to the same insured. For example, in the past, the IRS has denied tax-free treatment where a first-to-die policy insuring one spouse was sought to be exchanged for a second-to-die policy insuring both spouses, or where two separate first-to-die policies (one on each spouse) were sought to be exchanged for a single second-to-die policy insuring both spouses.
Nevertheless, the IRS has now approved the “down-sizing” of a second-to-die policy, after the death of the first spouse, to a first-to-die policy on the life of the surviving spouse. In the facts addressed by the 2013 private letter ruling, a new trust was set up after the first death to take ownership of the second-to-die policy previously owned by a predecessor trust. The new trust exchanged the second-to-die policy for a new first-to-die policy insuring only the surviving spouse. The IRS ruled that this transaction was not taxable under Section 1035. (Note that the IRS has not ruled favorably on the tax treatment of the same exchange – a second-to-die policy for a single life policy – if made before the death of the first spouse.)
Furthermore, the IRS has found that the exchange after the first death complies with the requirement that the insured remain the same. The IRS has reasoned that on the death of the first spouse the second-to-die policy effectively insures only the surviving spouse just as the replacement first-to-die policy does. As a result, Section 1035 is not violated when the former policy is exchanged for the latter.
1Note that private letter rulings are only binding on the IRS with respect to the party that has requested the ruling, although they are generally considered to give good practical guidance on the perspective of the IRS.