Why is this Topic Important to Wealth Managers? This blogticle provides discussion and analysis on the tax treatment of certain annuities. The blogticle provides detailed information for those wealth managers who sell annuities and for those who have clients with or are considering annuities.

In general, earnings and gains on a deferred annuity contract are not subject to tax during the deferral period in the hands of the holder of the contract.[1] When payout commences under a deferred annuity contract, the tax treatment of amounts distributed depends on whether the amount is received as an annuity (generally, as periodic payments under contract terms) or not.

For amounts received as an annuity by an individual, an exclusion ratio is provided for determining the taxable portion of each payment.[2] The portion of each payment that is attributable to recovery of the taxpayer’s investment in the contract is not taxed. The exclusion ratio is determined as of the taxpayer’s annuity starting date. Once the taxpayer has recovered his or her investment in the contract, all further payments are included as ordinary income. If the taxpayer dies before the full investment in the contract is recovered, a deduction is allowed on the final return for the remaining investment in the contract. Generally speaking, section 72 uses the term ‘‘investment in the contract’’ in lieu of the more commonly applicable term ‘‘basis.’’ Amounts not received as an annuity generally are included as ordinary income if received on or after the annuity starting date, and are included in income to the extent allocable to income on the contract if received before the annuity starting date (i.e., as income first).[3]

Moreover, present law provides for the exchange of certain insurance contracts without recognition of gain or loss.[4] No gain or loss is recognized on the exchange of: (1) a life insurance contract for another life insurance contract or for an endowment or annuity contract or for a qualified long-term care insurance contract; or (2) an endowment contract for another endowment contract (that provides for regular payments beginning no later than under the exchanged contract) or for an annuity contract or for a qualified long-term care insurance contract; (3) an annuity contract for an annuity contract or for a qualified long-term care insurance contract; or (4) a qualified long-term care insurance contract for a qualified long-term care insurance contract. The basis of the contract received in the exchange generally is the same as the basis of the contract exchanged.[5]

In interpreting section 1035, case law holds that an exchange of a portion of an annuity contract for another annuity contract qualifies as a tax-free exchange.[6] Treasury guidance provides rules for determining whether a direct transfer of a portion of the cash surrender value of an annuity contract for a second annuity contract qualifies as a section 1035 tax-free exchange. Under the Treasury guidance, either the annuity contract received, or the contract partially exchanged, in the tax-free exchange may be annuitized without jeopardizing the tax-free exchange (or amounts withdrawn from it or received in surrender of it) after the period ending 12 months from the receipt of the premium in the exchange.[7]

Section 2113 of the Small Business Jobs Act of 2010 [8] permits a portion of an annuity, endowment, or life insurance contract to be annuitized while the balance is not annuitized, provided that the annuitization period is for 10 years or more, or is for the lives of one or more individuals.

The provision provides that if any amount is received as an annuity for a period of 10 years or more, or for the lives of one or more individuals, under any portion of an annuity, endowment, or life insurance contract, then that portion of the contract is treated as a separate contract for purposes of section 72.

The investment in the contract is allocated on a pro rata basis between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity. This allocation is made for purposes of applying the rules relating to the exclusion ratio, the determination of the investment in the contract, the expected return, the annuity starting date, and amounts not received as an annuity.[9] Generally, a separate annuity starting date is determined with respect to each portion of the contract from which amounts are received as an annuity.

Tomorrow’s blogticle will continue our series on tax law changes related to wealth managers in 2011.

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

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[1] IRC Sec. 72.

[2] RC Sec. 72(b).

[3] IRC Sec. 72(e).

[4] IRC Sec. 1035.

[5] RC Sec. 1031(d).

[6] Conway v. Comm’r, 111 T.C. 350 (1998), acq., 1999–2 C.B. xvi.

[7] See generally, Rev. Proc. 2008–24, 2008–13 I.R.B. 684.

[8] Public Law 111–240.

[9] Secs. 72(b), (c), and (e).

NB: All or parts of this work may have originally appeared under government publication intended for the general public.

The recession may be over, but the current road to recovery is shaping up as painstakingly slow. Recent economic news has some commentators looking up for 2011’s prospects, but it’s not positive enough to warrant a strong conclusion about the country’s chances of recovery in the next couple years.

For starters, personal income and expenditures increased in November, according to the U.S. Department of Commerce. Both personal income and disposable personal income increased by .3 percent.  Wages and salaries increased by $6.6 billion in November, compared to a $31.2 billion increase in October. Also rising, although not as much as in October, were supplements to wages and salary, which increased by $2.7 billion in November.

Just in time for the holidays, consumer confidence bumped up a bit in December, taking it to its second highest level since the beginning of 2008—according to … Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

Why is this Topic Important to Wealth Managers?  Presents discussion on the Alternative Minimum Tax Exemptions that wealthy clients may consider in the calculation of his or her tax liability, generally, as high income earners.

“For more than three decades, the individual income tax has consisted of two parallel tax systems: the regular tax and an alternative tax that was originally intended to impose taxes on high-income individuals who have no liability under the regular income tax.” [1]

Current law imposes an alternative minimum tax (AMT) only on individuals.  “The stated purpose of the alternative minimum tax (AMT) is to keep taxpayers with high incomes from paying little or no income tax by taking advantage of various preferences in the tax code.” [2]

The parallel tax structure to the regular income tax law requires individuals “to recalculate their taxes under alternative rules that include certain forms of income exempt from regular tax and that do not allow specific exemptions, deductions, and other preferences.” [3]

Generally, the AMT is an amount that is the excess of the “tentative minimum tax” over the regular income tax.

Tentative minimum tax is equal to the sum of (1) 26 percent of so much of the taxable excess as does not exceed $175,000 ($87,500 in the case of a married individual filing a separate return) and (2) 28 percent of the remaining taxable excess, which is essentially an individual’s taxable income adjusted to take into account certain specified preferences and adjustments (also known as alternative minimum taxable income (“AMTI”)) minus the exemption amount.

In addition, the maximum tax rates on net capital gain and dividends used in computing the regular tax are used in computing the tentative minimum tax.

The Obama Tax Cuts extend the exemption amount beginning in 2010.  The exemption amounts for this year are (1) $72,450, in the case of married individuals filing a joint return and surviving spouses; (2) $47,450 in the case of other unmarried individuals; and (3) $36,225 in the case of married individuals filing separate returns.

Starting in 2011, the individual AMT exemption amounts are (1) $74,450, in the case of married individuals filing a joint return and surviving spouses; (2) $48,450 in the case of other unmarried individuals; and (3) $37,225 in the case of married individuals filing separate returns.

In addition, certain nonrefundable personal credits may be used to reduce the taxpayer’s traditional tax liability as well as his or her AMT tax liability.[4] These personal credits include, dependent care credit, the credit for the elderly and disabled, the child credit, the credit for interest on certain home mortgages, the Hope Scholarship and Lifetime Learning credits, the credit for savers, the credit for certain nonbusiness energy property, the credit for residential energy efficient property, the credit for certain plug-in electric vehicles, the credit for alternative motor vehicles, the credit for new qualified plug-in electric drive motor vehicles, and the D.C. first-time homebuyer credit.

Since its initiation, “the AMT has affected few taxpayers, less than 1 percent in any year before 2000, but its impact is expected to grow rapidly in coming years and affect about one-fifth of all taxpayers in 2010.” [5] Furthermore, the Internal Revenue Service’s National Taxpayer Advocate, Nina Olson, labeled the AMT “the most serious problem faced by taxpayers.” [6]

For further discussion on the calculation of the AMT see generally, AdvisorFX: How is the alternative minimum tax calculated.

Tomorrow’s blog will continue to discuss pertinent provisions of the new Tax Cuts and how they relate to wealth managers.

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

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[1] Congressional Budget Office.  Revenue and Tax Policy Brief.  A series of issue summaries from the Congressional Budget Office No. 4, April 15, 2004.  “The Alternative Minimum Tax”.  http://www.cbo.gov/doc.cfm?index=5386&type=0.  Last Accessed 12/27/2010.

[2] Congressional Budget Office. Revenue and Tax Policy Brief (April 15, 2004).

[3] Id.

[4] 26 U.S.C. 26(a).

[5] Congressional Budget Office. Revenue and Tax Policy Brief (April 15, 2004).

[6] Internal Revenue Service.   National Taxpayer Advocate 2003 Annual Report to Congress at 5.  December 31, 2003.

Why is this Topic Important to Wealth Managers? Discusses additional events and situations that may or may not trigger specific tax consequences related to common transactions.  Also provides distinctions common to these theories as well as methods to recognize particular fact patterns in relation to such.

The economic benefit doctrine is at issue when the taxpayer receives some benefit in connection with a business or contractual relationship with a current, real and measurable value. [1] One instance when an individual receives an economic or financial benefit or property is for compensation for services, whereby the value of the benefit or property is currently includible in the individual’s gross income. [2] This instance will be examined in further detail below.

Another common example is a promise to pay, which also provides a good illustration of how the doctrine applies.  A mere promise to pay, unsupported by notes or other evidences of indebtedness which by and large is unsecured, is not income to a cash method taxpayer. [3]

On the other hand, there is the cash equivalency doctrine, which states, where a promise to pay that is supported by notes or otherwise secured by a solvent obligor, which is unconditional and assignable, not subject to sett-offs, and issued at a reasonable discount, is therefore considered a cash equivalent.  Since, such notes are considered cash equivalents the notes are taxable in a like manner as cash, i.e., if cash instead of the note was received by the taxpayer the taxpayer would be taxed on the cash received.  “More simply, the cash equivalency doctrine provides that, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income.” [4]

Two additional examples of the economic benefit doctrine to further illustrate:

A football player entered into a two-year standard player’s contract with the Giants in 2009. In addition to salary, he received a signing bonus that was to be paid to an escrow agent designated by him. Under the agreement, the bonus plus interest were payable to the player over five years. The football player is taxed in full in 2009 when the payment was made to the escrow agent, because in that year, “the employer’s part in the transaction ended, and the amount of the compensation was fixed and irrevocably set aside for the player’s sole benefit” [5]

At the other end of the spectrum, consider ABC, a cash-basis taxpayer, who shares the top floor of an office building with the landlord. On December 31, 2009, a tenant from another floor mistakenly leaves cash rent in ABC’s office lobby, and ABC inadvertently deposits it. ABC discovers the error on January 5, 2010, and promptly issues a check to the landlord. The fact that ABC had dominion and control over the cash rent is irrelevant since it did not represent economic income to ABC. Therefore, ABC is not required to pay tax on the rent. [6]

Additionally, as briefly mentioned above, if an individual receives “any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual’s gross income.” [7] Furthermore, an employee is required to include in his gross income, the value of assets that have been vested unconditionally and irrevocably, and transferred into a fund for the employee’s sole benefit, so long as the employee’s interest is not subject to financial forfeiture or transferable.  [8] A common example of this situation occurs when employee retirement programs are funded with employer stock options.

Tomorrow’s blogticle will discuss the ever popular economic substance doctrine.

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

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[1] See generally, Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

[2] Internal Revenue Service—Department of the Treasury.  “Nonqualified Deferred Compensation Audit Techniques Guide”.  02-2005.  http://www.irs.gov/businesses/corporations/article/0,,id=134878,00.html. Page Last Reviewed or Updated: March 31, 2010.  Last Accessed 10/23/10.

[3] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  No. 385 s V, (BNA), 20XX WL 4742238 (FEDERAL).  Compensation Planning Series– 385-4th: Deferred Compensation Arrangements.  Westlaw.  Citing Rev. Rul. 60-31

[4] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[5] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  Citing Ex. 4 of Rev. Rul. 60-31, Rev. Rul. 55-727, [other citations omitted]; Rev. Rul. Rul. 60-31.

[6] CCH Federal Taxation Comprehensive Topics. Chapter 13, Exhibit 17b.  35 of 70.  blue.utb.edu/…/2006%20CCH%20Comp%20Topics%20Ch%2013.ppt.  Last accessed 10/23/10.

[7] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[8] 26 U.S.C § 83; Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit. ([09-36] 09/01/2009); Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.