EMPLOYER'S EXERCISE OF INSURANCE POLICY OPTION TO SUBSTITUTE A NEW INSURED PERSON EFFECTS A TAXABLE EXCHANGE.

Rev. Rul. 90-109

ISSUE

If a life insurance policy provides the policyholder with an option to change the insured, is the exercise of the option a sale or other disposition of the policy under section 1001 of the Internal Revenue Code? If so, do the nonrecognition provisions of section 1035 apply to the transaction?

FACTS

In 1987, X, a corporation, purchased a key person insurance policy on the life of A, an employee of the corporation. X was the sole beneficiary under the policy. The policy provided that X had the option to change the insured.

In 1988, A ceased to be employed by X. Thereafter, X hired B to replace A and exercised the option in the policy to change the insured from A to B. The insurance company thereupon substituted B for A as the person insured under the policy. The benefits and premiums under the policy were not changed.

LAW AND ANALYSIS

Section 1001(c) of the Code provides that, except as otherwise provided in subtitle A, the entire amount of the gain or loss on the sale or exchange of property shall be recognized.

Section 1001(a) of the Code provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

Section 1035 of the Code provides that no gain or loss shall be recognized on the exchange of a contract of life insurance for another contract of life insurance.

In order for a contract to be considered a life insurance contract for purposes of the Code, the contract must satisfy the requirements of section 7702 of the Code. To be considered a life insurance contract for purposes of section 1035, the contract must also satisfy the definition of "life insurance contract" in section 1035(b)(3). That section defines the term "life insurance contract" for purposes of section 1035 to mean a contract with an insurance company which depends in part on the life expectancy of the insured but which is not ordinarily payable in full during the life of the insured.

Section 1.1035-1 of the Income Tax Regulations provides that an exchange of a contract of life insurance for another contract of life insurance does not qualify for nonrecognition treatment under section 1035 if the policies exchanged do not relate to the same insured.

A change in contractual terms effected through an option provided in the original contract is treated as an exchange under section 1001 if there is a sufficiently fundamental or material change that the substance of the original contract is altered through the exercise of the option. Under such circumstances, the old contract is treated as if it were actually exchanged for a new one. Cf. Rev. Rul. 69-135, 1969-1 C.B. 198 (recognition of realized gain or loss under former section 1002 where bonds of one corporation are converted into stock of another corporation pursuant to an option contained in the bonds). See also Rev. Rul. 79-155, 1979-1 C.B. 153 (addition of new parent as obligor is a change which, together with other changes, constitutes a material change for purposes of section 1001).

In the present situation, X exercised an option in its key person insurance policy that permitted it to change the insured from A, the original insured under the policy, to B, the new insured. This resulted in a change in the fundamental substance of the original contract because the essence of a life insurance contract is the life that is insured under the contract. Thus, X's exercise of the change- of-insureds option is substantively the same as an actual exchange of contracts and is a sale or other disposition for purposes of section 1001.

Section 1.1035-1 of the regulations expressly excludes from the application of section 1035 exchanges of policies that do not relate to the same insured and thus prevents policy owners from deferring indefinitely recognition of gain with respect to the policy value. Had X actually assigned a life insurance policy on A to the insurance company as consideration for a new life insurance policy on B, any gain realized on the exchange would have been ineligible for nonrecognition treatment under section 1035 of the Code. X cannot avoid the same-insured limitations of section 1035 simply by placing terms in its original documents that obviate the need for an actual exchange but nevertheless effect a de facto exchange of the original contract for a new contract on a different insured. For example, the result would be the same if X insured a person holding a particular position and, thus, no formal substitution is made when a new person occupies that position.

HOLDING

The exercise of an option in an insurance policy to change the insured constitutes a sale or other disposition under section 1001 of the Code, and this disposition does not qualify as a tax-free exchange of insurance policies under section 1035.

DRAFTING INFORMATION

The principal author of this revenue ruling is Frederick S. Campbell-Mohn of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Campbell-Mohn on (202) 566-3294 (not a toll-free call).