Annuity tax problems and issues

IRS eases rules for partial annuity exchanges

Mike Habib, EA

In 2003, IRS issued a revenue ruling formally sanctioning partial annuity exchanges as qualifying for tax-free treatment under Code Sec. 1035. At the same time, it issued a notice warning that it would go after taxpayers who use partial exchanges to avoid tax under Code Sec. 72(e)(2). It has adopted the interim guidance as final rules in a new revenue procedures. The final guidance reflects modifications that are mostly pro-taxpayer.

Background. Code Sec. 72(e) governs the federal tax treatment of distributions from an annuity contract that are not received as an annuity. Under Code Sec. 72(e)(2), such amounts generally are taxed on an income-first basis. For this purpose, all annuity contracts issued by the same company to the same policyholder during any calendar year are treated as a single annuity contract. (Code Sec. 72(e)(12)) Code Sec. 72(q)(1) imposes a 10% penalty on withdrawals or surrenders of annuity contracts, unless one of the exceptions in Code Sec. 72(q)(2) applies. No gain or loss is recognized on the exchange of an annuity contract for another annuity contract. (Code Sec. 1035(a))

Partial exchanges. In late ’99, IRS acquiesced to a Tax Court decision holding that the direct transfer of a portion of funds from one annuity contract to another qualifies as a nontaxable exchange under Code Sec. 1035. (Conway v. Comm., 111 TC 350 (1998), acq., 1999-2 CB xvi) See Federal Taxes Weekly Alert 12/2/1999)

Rev Rul 2003-76, 2003-2 CB 355 provided additional details on the tax consequences of partial annuity exchanges. Under the facts of that ruling, A owns, and is the obligee under, annuity contract B issued by Company B. A contracts with Company C to issue new annuity contract C. He assigns 60% of the cash surrender value of Contract B to Company C to be used to purchase Contract C. At no time during the transaction does A have access to the cash surrender value of Contract B that is used to purchase Contract C. No other consideration will be paid in this transaction. The terms of Contract B are unchanged by this transaction, and Contract B is not treated as newly issued. The ruling concluded that:

    • The direct transfer by A of a portion of the cash surrender value of Contract B to Company C for Contract C is a tax-free exchange under Code Sec. 1035(a)(3).
    • After the transaction, under Code Sec. 1035(d)(2), A’s basis in Contract C equals 60% of his basis in Contract B immediately before the exchange, and his basis in Contract B equals 40% of his basis in it immediately before the exchange. That’s because, basis is allocated ratably based on the percentage of the cash surrender value retained and the percentage transferred to the new contract.
    • After the transaction, under Code Sec. 72, A’s investment in Contract C equals 60% of his investment in Contract B immediately before the exchange and his investment in Contract B equals 40% percent of his investment in it immediately before the exchange, using the same ratable allocation approach.

    IRS’s concern about possible abuses. When it issued Rev Rul 2003-76, IRS, in Notice 2003-51, 2003-2 CB 362, expressed concern that some taxpayers may enter into a partial exchange to reduce or avoid the tax that would otherwise be imposed by Code Sec. 72(e)(2).

      Illustration: Smith withdraws $100 from an annuity contract with a cash surrender value of $200 and investment in the contract of $80. The entire $100 withdrawal is included in income under Code Sec. 72(e)(2). If, instead, he assigns 50% of the contract’s cash surrender value in a partial exchange, and then surrenders either the existing or new contract, only $60 is included in income and $40 is excluded as a return of investment in the contract. (Notice 2003-51, Sec. 3)

    At that time, IRS said it was considering whether to issue regs to provide rules for determining when a partial exchange of an annuity contract followed by the surrender of, or distributions from, either the surviving annuity contract or the new annuity contract should be presumed to have been entered into for tax avoidance purposes. Pending the publication of final regs, IRS said it would consider all the facts and circumstances to determine whether a partial exchange and a subsequent withdrawal from, or surrender of, either the surviving annuity contract or the new annuity contract within 24 months of the date on which the partial exchange was completed should be treated as an integrated transaction, and thus whether the two contracts should be viewed as a single contract to determine the tax treatment of a surrender or withdrawal under Code Sec. 72(e). IRS said, if, however, a taxpayer could demonstrate that one of the conditions of Code Sec. 72(q)(2), or any other similar life event, such as a divorce or the loss of employment, occurred between the partial exchange and the surrender or distribution, and that the surrender or distribution was not contemplated at the time of the partial exchange, the taxpayer would not be treated as having entered into the surrender or distribution for tax avoidance purposes.

    Final guidance. IRS has determined that it is in the interest of sound tax administration to adopt the provisions of Notice 2003-51 with changes, in the form of a revenue procedure. In doing so, IRS has determined that the 24-month period referred to above should be shortened to 12 months, and the subjective requirement that certain surrenders or distributions not have been “contemplated” at the time of the exchange should be removed.

      Observation: The change from 24 to 12 months is favorable for taxpayers who may be contemplating partial exchanges. They will be able to make withdrawals one year after entering into the exchange without concern that IRS may want to try to treat the new and original contracts as one to extract a higher tax cost on the withdrawal.

    In addition, IRS has determined it is appropriate to make these clarifications to the rules of Notice 2003-51:

      • First, if the direct transfer of a portion of an annuity contract for a second annuity contract does not qualify as a tax-free exchange under Code Sec. 1035 and Rev Proc 2008-24 , it will be treated as a taxable distribution followed by a payment for the second contract.
      • Second, the rule treating a transfer as a tax-free exchange if one of the Code Sec. 72(q)(2) conditions is met cannot be satisfied based on a payment described in Code Sec. 72(q)(2)(D) (distribution that is part of a series of substantially equal periodic payments) or Code Sec. 72(q)(2)(I) (distribution under an immediate annuity).
      • Third, IRS won’t require aggregation under Code Sec. 72(e)(12) or otherwise of two contracts that are the subject of a tax-free exchange under Code Sec. 1035 and Rev Proc 2008-24, Sec. 4.01, even if both contracts were issued by the same insurance company.

      Rev Proc 2008-24 applies to the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract, regardless of whether the two annuity contracts are issued by the same or different companies. It doesn’t apply to transactions (sometimes referred to as “partial annuitizations”) in which the holder of an annuity contract irrevocably elects to apply only a portion of the contract to purchase a stream of annuity payments under the contract, leaving the remainder of the contract to accumulate income on a tax-deferred basis. (Rev Proc 2008-24, Sec. 3)

      Effective date. Rev Proc 2008-24 is effective for transfers that are completed on or after June 30, 2008. (Rev Proc 2008-24, Sec. 5)

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