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.

The IRS and the Treasury department are considering regulations that would preclude the usefulness of the second transaction.

Specifically, the regulations will presume that certain distributions and surrenders that occur after a partial 1035 exchange will have been made for tax avoidance purposes. This presumption might be able to be overcome in different ways. One way the presumption could be overcome is if the subsequent distribution is not subject to the 10% penalty tax on certain annuity distributions. Examples of distributions not subject to the 10% penalty are distributions after the taxpayer reaches age 59, distributions made upon the death of the owner, distributions to a disabled taxpayer and distributions that are part of equal periodic payments.

The IRS also is considering whether events that are described in the regulations describing “unforeseen circumstances” with regard to whether the sale of a primary residence is tax-free will also allow a taxpayer to overcome the tax avoidance presumption. These unforeseen circumstances include divorce and a change in employment status.

Until these regulations are finalized, the IRS issued interim guidance on distributions from annuities following a partial 1035 exchange. The IRS will consider all the facts and circumstances to determine whether a partial exchange and a subsequent withdrawal or surrender within 24 months of the partial exchange should be considered one transaction.

However, the taxpayer can show that one of the circumstances that would preclude the 10% penalty tax, or some other similar life event occurred between the partial exchange and the subsequent surrender or distribution that was not thought of at the time of the partial exchange. If the taxpayer can show that one of these events occurred, he will not be considered to have entered into the partial exchange for tax avoidance purposes.

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 14, 2003. Copyright 2003 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.