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)