A 1035 Exchange Designed to Fail: Overfunding, a Policy Loan, and the 7-Pay Test

The exchange is not taxable; the loan is the exposure.

• IRC 1035 permits a tax-free exchange of a life policy for another life policy on the same insured. The $210,000 of value moves with no recognition of the $90,000 built-in gain ($210,000 value less $120,000 basis).
• The $60,000 loan does not disappear. Three possible outcomes:

1. Assumption: the new carrier accepts the policy subject to the loan. No tax now, but the new policy begins with $60,000 of debt and interest keeps accruing against cash value.
2. Repayment at exchange: he pays it from outside funds. Cleanest, and it preserves the new policy's cash value.
3. Extinguishment or forgiveness: a loan cancelled without repayment is treated as a distribution, taxable to the extent of gain. His entire $60,000 sits inside the $90,000 gain, so all $60,000 would be ordinary income.

• Mechanics matter: use a direct trustee-to-trustee transfer. A check to Devon creates constructive receipt, a taxable surrender, and loss of the exchange.
• His $120,000 basis carries over, which governs every later withdrawal and loan.

Yes - the design is a MEC, and MEC status defeats the stated goal.

• The 7-pay test asks whether premiums paid in the first seven contract years exceed the net level premium that would fund the contract's paid-up benefits in seven years. For a $500,000 policy on a 58-year-old, that ceiling is far below $100,000 a year; paying $100,000 in year one already breaches it.
• The exchange makes it worse: the $210,000 of transferred cash value counts as premiums paid for the 7-pay test, so the allowance is largely consumed by the exchange itself before any new money arrives.
• Consequences:
• Every distribution - withdrawals and policy loans, which are taxed as distributions - comes out income-first (LIFO), not basis-first. Each loan at 65 would generate taxable income.
• The 10% additional tax for amounts received before 59 1/2 is irrelevant to a 65-year-old, but the LIFO ordering never goes away at any age.
• The death benefit stays income-tax-free under IRC 101(a); a MEC is a problem during life, not at death.
• MEC status is permanent for that contract.

So the arrangement produces exactly the taxable income he is trying to avoid, on top of the acquisition costs of an over-funded policy.

Redesign to stay under the 7-pay limit.

1. Get the carrier's actual 7-pay premium for the proposed face, subtract the $210,000 transferred value treated as a year-one premium, and cap new contributions at the remainder. Anything above that is a MEC.
2. Raise the death benefit if he wants to put in more money. The 7-pay ceiling scales with the face amount, so a larger face on the same insured supports a materially larger non-MEC premium. Have the carrier run the guideline premium and 7-pay calculations on the larger face.
3. Or reduce the premium. $100,000 a year for seven years is a MEC design; funding at the non-MEC maximum for seven years still builds a large cash value.
4. Resolve the loan deliberately. Repaying the $60,000 at exchange increases net cash value and removes the interest drag; carrying it forward reduces both the death benefit and the value available for loans at 65.
5. Stress-test at guaranteed charges and a low credited rate, not just the illustration. A policy that lapses with a loan balance produces taxable phantom income and no death benefit - the worst of both worlds.
6. Compare alternatives in writing: keep the existing policy and repay the loan, versus exchanging into a properly sized non-MEC design.

Verify before executing: same insured and same policyowner, direct trustee-to-trustee transfer, the carrier accepts the loan assumption if that is the chosen route, and the illustration supports the projected loans to age 90 at conservative assumptions.