Tax Treatment of COLI Surrender?

[taxref]

I have a question as to when a cashing out of Corporate Owned Life Insurance (COLI) becomes taxable.  

The scenario is:  Husband and wife are S corp shareholders.  They are retiring, and younger family members are taking over the business.  The company has COLI on the retiring shareholders.  

The cash value of T's policy is less than basis, while the cash value of S's policy is more than basis. Combined, there is a negative basis.

The insurance company is going to do a 1035 exchange on the COLI policies, which will be a tax-free transfer of the cash values to an annuity in the corporation's name.  After the 1035 is complete, the ownership of the annuity will be changed to their individual names.

The retiring shareholders then plan to withdraw income yearly from the annuity for retirement purposes.

My questions are:  1. Will this be fully taxable to the retirees in 2013, or will tax only be due upon the annuity installments paid each year?

2. Does the basis situation affect the amount taxable to the retirees, or is it absorbed during the 1035 exchange?

While I have my own opinions, I haven't been able to find a definitive answer.  Any input would be greatly appreciated.  

[mwcpa]

this is a complex issue that needs to be researched.... and that research can take time....and be expensive.....

but, generally, if you transfer an asset that is "owned" by a corporation to a shareholder that is a deemed sale of the asset and distribution to the shareholder.  As the policies probably do not have the same value that could lead to disproportionate distributions.

I see problems.....

here is an article I found www.naepc.org/journal/issue03l.pdf

"Case 5—“Parting Gift”
Life Insurance Policy
A corporation has owned a key man policy funded with permanent insurance. The key employee is nearing retirement. The corporation paid $95,000 for the policy over the years. The current cash value of the policy is $200,000. The majority owner of the corporation wants to give the policy to the key employee as a “parting gift.” What, if any, consequences are there
to the corporation and the employee?

Issues Case 5. The corporation can transfer the policy to the key person. The transfer is a taxable event to the employee, where the employee will havetaxable income of $200,000. The corporation will have taxable income of $105,000 and an income tax
deduction (provided it is reasonable compensation) of $200,000 for the distribution to the employee.5 If the
employer and employee are willing to work together, the corporation can sell the policy to the employee
on an installment basis. Annually, the business can forgive that year’s debt. By doing this, you can spread
out both the taxable income to the executive, and the taxable income and income tax deduction to the
corporation. In this case, we valued the policy simplistically at its cash value. Recently, the IRS has provided safe harbor
guidelines on how to determine the fair market value of a life insurance policy. The fair market of a business-
owned life insurance policy may be the greater of the following: the interpolated terminal reserve and
any unearned premiums, plus a pro rata portion of expected dividends for that year; or the PERC amount.
“PERC” stands for a valuation formula that takes into account the Premiums paid, Earnings from the cash
in the contract and Reasonable Charges for mortality and policy expenses."

[taxref]

Thank you for your reply, MWCPA.  Your answer pretty much confirmed my thoughts on this.  I must confess, though, I was hoping that I was simply missing some simple solution among everything I was reading. 

Your example really helped my clarify the issues I was dealing with.  I was unable to find any examples relating to my scenario, as everything I was reading dealt with the company keeping the COLI after the employee retired.  

I'm afraid this is going to be the first non-estate/trust issue I'm going to refer to someone else.