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The IRS has released guidance [Rev. Proc. 2011-38] that substantially liberalizes the rules for partial exchanges of annuity contracts.
Section 1035 allows a tax-free exchange of an annuity contract for another annuity contract. Congress introduced the tax-free exchange because it recognized that the needs of life insurance and annuity owners change over time and that it would be unfair to tax them when they switched policies to better meet their needs.
Partial Exchanges of Annuity Contracts
Partial exchanges were initially approved of by the Tax Court case, Conway v. Commissioner [111 T.C. 350 (1998)]. There, the Tax Court ruled on a direct exchange—carrier to carrier—of part of an annuity contract for another annuity contract with a different carrier. These types of exchanges are referred to as partial exchanges.
In a partial exchange, the basis and investment in the contract associated with the first contract immediately prior to the exchange is allocated ratably between the old contract and the new contract. Basis and investment in the contract are divided between the contracts based on the percentage of the first contract’s cash value that is transferred to the new contract.
If, for example, John owns an annuity in which he has investment in the contract of $1,000 and has a basis of $500 in the contract, an exchange of half the cash value of the contract for a new annuity contract will transfer half of John’s investment in the contract, $500, and half his basis in the contract, $250, to the new contract. The portion of the old contract that is not exchanged will retain $500 in investment in the contract and $250 in basis.
Initial Guidance on Partial Exchanges
The IRS provided a procedure for partial exchange of an annuity contract in Rev. Proc. 2008-24. Under this guidance, a transfer is tax free only if the contract owner doesn’t withdraw any money from, or receive any money in surrender of, either of the contracts involved in the exchange during the twelve month period beginning with the date of transfer.
The rule doesn’t apply to amounts withdrawn from the annuity under the exceptions to the premature distribution rules of Section 72. For example, these are distributions made: (1) after the taxpayer turns 59½; (2) on or after the taxpayer’s death; and (3) as part of a series of substantially equal periodic payments.
The Small Business Jobs Act of 2010 included a provision permitting partial annuitization of an annuity contract. Interaction between the partial annuitization provision and Rev. Proc. 2008-24 necessitated the release of new guidance. On July 25, 2011, the IRS released such guidance, Rev. Proc. 2011-38 superseding the previous Revenue Procedure.
Under the new rules, for a direct transfer of part of the surrender value of an annuity contract for another annuity contract that doesn’t satisfy the 180-day test, general tax principles will be applied to determine the tax treatment of the transfer.
So, if within 180 days of an exchange the taxpayer takes a distribution from either of the annuities, the distribution won’t automatically break the tax-free exchange.
Instead, the circumstances surrounding the transfer and the distribution will be examined under general tax principles to determine how the distribution will be taxed and whether the exchange is tax-free under Section 1035. The distribution may be taxed as boot under a 1035 exchange or as an amount not received as an annuity.
The new rules provide a much higher degree of flexibility than the previous rules, giving annuity owners more flexibility to take distributions when they execute a partial exchange without killing the tax-free exchange.
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See also The Law Professor's blog at AdvisorFYI.