IRS Issues Guidance On Partial 1035 Exchanges Of Annuities
The IRS has issued guidance on partial 1035 exchanges of annuities and also has said it is considering issuing regulations to curb what it believes are abusive transactions involving partial 1035 exchanges.
A partial exchange of a deferred annuity occurs when an owner withdraws some of the funds from an annuity and then invests these funds into a new annuity that is issued by a second unrelated insurance company. Until 1998, the IRS did not even allow partial exchange of an annuity contract to qualify as a 1035 exchange. However, the Tax Court, in Conway v. Comm., held that a partial exchange could qualify as a 1035 exchange.
Revenue Ruling 2003-76 discusses the tax implications of a partial 1035 exchange. Specifically it discusses how the basis in the original contract will be allocated between the original contract and the new contract after the exchange.
Not surprisingly, the IRS ruled that the basis in the two contracts must be divided on a pro rata basis. For example, assume an annuity contract with a basis of $10,000 and a cash value of $20,000 is to undergo a partial exchange. If $12,000 is transferred to a new annuity with another insurance company in a partial 1035 exchange, the original annuity contract will now have a basis of $4,000 and the new annuity contract will have a basis of $6,000.
At the same time Revenue Ruling 2003-76 was issued, the IRS released Notice 2003-51, which also discusses partial 1035 exchanges of annuities.
Notice 2003-51 says the IRS is concerned that taxpayers may use partial 1035 exchanges in abusive ways to “split” an annuity into two different contracts. An example has a taxpayer withdrawing $100 from an annuity contract that has a cash surrender value of $200 and a basis of $80. The entire $100 will be included in income. However, the taxpayer could initiate a partial 1035 exchange and transfer $100 to a new annuity contract, with each contract then having a basis of $40 and a cash surrender value of $100. Then if one of the annuity contracts is surrendered for $100, the gain will be only $60.