Why is This Topic Important to Wealth Managers? This blogticle discusses the proper treatment of a partial exchange of an annuity contract for tax purposes. The information presented herein is useful for those wealth managers considering a tax-free exchange of annuities under Section 1035 for their clients.

The Internal Revenue Service recently released a revenue procedure addressing the tax treatment of certain tax-free exchanges of annuity contracts under Sections 72 and 1035 of the Internal Revenue Code. [1]

Generally, the Code provides that no gain or loss shall be recognized on the exchange of an annuity contract for another annuity contract. [2] The legislative history of IRC Section 1035 states that exchange treatment is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs.” [3]

The Income Tax Regulations provide that the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under IRC Section1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees (beneficiary or beneficiaries) under the contract received in the exchange as under the original contract. [4]

If, in addition to an annuity contract, a taxpayer receives other property or money in exchange for a second annuity contract, then gain (if any) is recognized to the extent of the sum of money and the fair market value of other property received, but loss (if any) is not recognized to any extent. [5]

The Tax Court has held that the direct exchange by an insurance company of a portion of an existing annuity contract to an unrelated insurance company for a new annuity contract was a tax-free exchange under IRC Section 1035.  [6] Such a transaction is sometimes referred to as a “partial exchange.”

Notwithstanding, the IRS has determined that the receipt of a check under a nonqualified annuity contract and endorsement of the check to a second company as consideration for a second annuity contract treated as a taxable distribution rather than as a tax-free exchange under IRC Section 1035. [7]

Generally, Rev. Proc. 2008-24 set forth circumstances under which a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract would be treated as a tax-free exchange under IRC Section 1035. Under the revenue procedure, a transfer was treated as a tax-free exchange if no amount was withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date of the transfer, or if the taxpayer demonstrated that one of the conditions described by IRC Sections 72(q)(2)(A)-(J) or any similar life event “occurred between” the date of the transfer and the date of the withdrawal or surrender.

Revenue Procedure 2011-38, in sum amends Revenue Procedure 2008-24, and recognizes that generally a partial exchange (usually of cash value) of an annuity contract for another annuity contract is treated as a tax-free exchange under section 1035 if no amount is withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 180 days beginning on the date of the transfer.

Tomorrow’s blogticle will discuss additional tax issues relating to life insurance and annuities.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] See Revenue Procedure 2011-38.

[2] IRC Section 1035(a)(3).

[3] H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954).

[4] Treas. Regs. Section 1.1035-1 of the Income Tax Regulations

[5] Section 1035(d)(1) (cross referencing § 1031(b) and (c)); § 1.1031(b)-1(a); § 1031(c)-1.

[6] Conway v. Commissioner, 111 T.C. 350 (1998), acq., 1999-2 C.B. xvi.

[7] See Rev. Rul. 2007-24, 2007-21 I.R.B. 1282.

Tags: Free trade, income tax, insurance, Internal Revenue Code, Internal Revenue Service, Internet Relay Chat, Life annuity, Tax

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