IRS Fixes the ‘1035 Exchange Trap’: What Life Settlement Funds and PPLI Users Need to Know Now

The US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have just finalized regulations fixing a problem that has quietly complicated life insurance exchanges since 2019. On July 8, the IRS issued final regulations under T.D. 10052, effective July 9, adopting (with modifications) the proposed regulations (REG-108054-21) that Treasury floated back in May 2023.[1][2]

The problem the IRS just solved

Under Section 101(a)(2), if a life insurance contract is transferred for valuable consideration, the death benefit exclusion is capped at the consideration paid plus subsequent premiums, unless an exception applies. The Tax Cuts and Jobs Act layered a new concept on top of this in 2017: the "reportable policy sale," which comes with its own Form 1099 reporting regime under Section 6050Y.

When Treasury finalized the original reportable policy sale regulations in 2019 (T.D. 9879), it treated the issuance of a new contract in a Section 1035 exchange as a transfer of an interest in a life insurance contract. That meant a straightforward, tax-free exchange could be recharacterized as a reportable policy sale and could trigger the transfer for value limitation, unless the policyholder could show a substantial family, business or financial relationship with the insured. Treasury itself acknowledged this was an unintended consequence of the 2019 rules, not a deliberate policy choice.

For anyone who exchanges policies as part of normal portfolio management, this was a real trap. It threatened to convert an otherwise tax-free 1035 exchange into a taxable event, or at least create reporting uncertainty, purely because of how the new contract was issued.

What changes under the final regulations

Key features carried over from the 2023 proposal and are now adopted as final include:

• A Section 1035 exchange is no longer, by itself, treated as a reportable policy sale or a transfer for valuable consideration under Section 101(a)(2).
• If the death benefit on the old contract was fully excludable, the new contract's death benefit remains fully excludable. If the old contract's exclusion was already limited because of a prior reportable policy sale, that limitation carries over to the new contract. The exchange does not launder a prior taint, but it also does not add a new one.
• The exchange itself no longer must be reported to the IRS as a reportable policy sale by the acquirer on Form 1099-LS.  Notably, the final regulations dropped the 2023 proposal’s Form 1099-SB approach: where a contract with a reportable policy sale history is exchanged and the new issuer is different from the old issuer, the old issuer simply passes the needed information to the new issuer (by any reasonable method), and reporting is expected to run through the old issuer’s existing Form 1099-R, with a new Box 7 code to come.
• A separate, narrower exception applies to the direct acquisition of a life insurance interest by one C corporation from another (target) C corporation in a Section 368(a) reorganization, where the target runs an active trade or business (not investing in life insurance) and life insurance contracts make up no more than 5 percent of gross asset value for the target before, and the acquirer after, the deal.

One important caveat: the relief only addresses the consequences of Sections 101 and 6050Y. The new contract must still qualify as life insurance under Section 7702(a) and applicable state insurable interest laws, which generally require a real relationship with the insured, so the substantial relationship question does not disappear entirely.

Why this matters to our clients

For life settlement fund managers, this removes a persistent source of uncertainty when restructuring portfolios, consolidating carriers or otherwise exchanging previously acquired policies. A subsequent 1035 exchange will not, on its own, create a fresh reportable policy sale or expand the transfer for value limitation beyond what is already attached to the original policy.

One more taxpayer-friendly point: while the new rules apply going forward, taxpayers may also elect to apply them retroactively to exchanges and acquisitions occurring after December 31, 2017, which can help clean up the treatment of exchanges completed under the 2019 regime. We are preparing a detailed client advisory on T.D. 10052. In the meantime, clients currently structuring or considering a 1035 exchange, whether inside a life settlement fund or through a PPLI restructuring, should reach out to discuss how the final regulations affect their specific facts.