A policyholder uses a Section 1035 exchange to replace an existing life insurance policy.

Comprehensive and Detailed Step by Step Explanation:

Under a1035 exchange, policyholders can replace an insurance policy or annuity without immediate tax consequences. However, gains realized later upon surrender of the new policy are taxed as:

Ordinary income (A):The difference between the cash surrender value and the cost basis (premiums paid) is taxed as income.

Capital gains (B):Not applicable because gains on life insurance are classified as ordinary income.

Ordinary income plus a 10% surcharge (C):The 10% penalty applies only to premature withdrawals from retirement accounts, not life insurance.

Deferred capital gain (D):Does not apply, as life insurance gains are not taxed under capital gain rules.