1035 Exchange Of One Annuity For Two Is Not Taxable, According To PLR

Showing some of the flexibility that is possible under Section 1035, the Internal Revenue Service recently ruled that a taxpayer could exchange one annuity contract for two different annuity contracts without recognizing gain on the transaction.

An exchange under Section 1035 is very useful in a situation where a client has purchased a life insurance policy or a deferred annuity contract that over time has become less useful because it no longer meets the clients current needs.

Under Section 1035, a taxpayer who owns a life insurance policy may exchange it for another life insurance policy, an annuity contract, or an endowment contract, and will not recognize any gain on the transaction. An annuity contract can be exchanged for another annuity contract also without recognizing gain.

However, an annuity contract cannot be exchanged for a life insurance policy on a tax-free basis because gain under an annuity will eventually be taxed, while all the gain in a life policy could become tax-exempt if the policy later pays a death benefit.

Under Section 1035, exchanges are not actually tax-free, but tax-deferred. The investment in the original contract is carried over to the new contract, so the gain is deferred until payments begin or a withdrawal from the policy is made.

An owner of a deferred annuity requested a ruling on whether the exchange of one annuity contract for two annuity contracts would qualify as a Section 1035 exchange. The two replacement contracts were to be issued by the same company that issued the original annuity contract. The exchange would not have resulted in a change of owner or annuitant.

The reason this was an issue is because the language of Section 1035 says that an exchange can be made of “an annuity contract for an annuity contract,” which might lead some to believe it means that one contract may be exchanged for only one new contract.

In the case at hand, one of the new annuities was to be a variable annuity. The other was to have a “guaranteed minimum income” feature so that regardless of the performance of the underlying investments of the annuity, a minimum amount will be paid out each month.

In its ruling, the IRS pointed out that if two or more annuities were purchased with the same consideration, the annuities would be treated as one annuity contract for income tax purposes.

The revenue service also said that Section 1035 is similar to Section 1031, which governs exchanges of other types of property such as exchanges of real estate. Under Section 1031, one piece of property may be exchanged for multiple pieces of property of a tax-deferred basis, such as one piece of real estate for two or more.

Therefore, the IRS concluded that the proposed exchange would qualify for Section 1035 treatment, and that the two new annuity contracts would be treated as one contract for income tax purposes.

Finally, the IRS ruled that any transfer of funds between the two new annuities would not be treated as a taxable distribution from the annuity.

The ruling is Private Letter Ruling 200243047.

Joseph F. Stenken, J.D., CLU, ChFC, is an assistant editor of Tax Facts, a National Underwriter Company publication.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 18, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.