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. 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. 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).
Moreover, present law provides for the exchange of certain insurance contracts without recognition of gain or loss. 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.
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. 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.
Section 2113 of the Small Business Jobs Act of 2010  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. 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.
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IRC Sec. 72.
 RC Sec. 72(b).
 IRC Sec. 72(e).
 IRC Sec. 1035.
 RC Sec. 1031(d).
 Conway v. Comm’r, 111 T.C. 350 (1998), acq., 1999–2 C.B. xvi.
 See generally, Rev. Proc. 2008–24, 2008–13 I.R.B. 684.
 Public Law 111–240.
 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.