A: Probably yes, although since some uncertainty exists, the annuity companies involved in the transaction will likely not cooperate in the exchange.
Code Section 1035 allows for a tax-free exchange of a life policy for a nonqualified deferred annuity (NQDA) or for an exchange of one NQDA for another. Section 1035 itself does not provide much detail regarding valid exchanges. The lack of detail has caused taxpayers and carriers to rely on various regulations, rulings, and company practices to fill in the blanks regarding what is a valid exchange.
One thing we know for sure is that an exchange must be done directly between the surrendering and issuing companies—and the client must not personally take control of the money during the process. As a practical matter, that means both carriers must agree that the proposed transaction is a Section 1035 exchange. If one of the carriers does not believe the transaction qualifies, it will stop cooperating in the Section 1035 process, and the exchange will fail.
The other things we believe we know about Section 1035 exchanges are: • The policyowner must be the same both before and after the exchange.
• The insured must be the same both before and after an exchange of life policies.
• The insured must be the same as the annuitant on a life for annuity exchange.
• The annuitant must be the same both before and after an exchange of an annuity.
Based on what we think we know, an exchange described in the question does not appear to be a valid exchange—and thus it would be rejected. Why did we say such an exchange might be possible?
The answer is that another section of the Tax Code—Section 1041—says that transfers of assets between spouses are tax-free. If you mash together Code Sections 1035 and 1041, they make a pretty good case that the transaction described would be income tax-free.
However, since the IRS has never explicitly said such a transaction is tax-free, most carriers will reject combining the logic of both Code sections to achieve the desired tax result.