Tax-Free Treatment Of Partial Annuity Exchanges Liberalized Even Further

Rev Proc 2011-38, 2011-30 IRB

In a Notice that further liberalizes previous guidance, IRS has provided that the direct transfer of part of the cash surrender value of an existing annuity contract for a second annuity contract will be treated as a tax-free Code Sec. 1035 exchange if no amount (other than an amount received as an annuity for a period of 10 years or more or during one or more lives) is received during the 180 days beginning on the date of the transfer. A later direct transfer won't be taken into account.

Background. No gain or loss is recognized on the exchange of an annuity contract for another annuity contract. (Code Sec. 1035(a)(3))

Under Code Sec. 72(e)(2), distributions from an annuity contract that are not received as an annuity generally are taxed on an income-first basis. For this purpose, Code Sec. 72(e)(12) provides that all annuity contracts issued by the same company to the same policyholder during any calendar year are treated as a single annuity contract. Code Sec. 72(q)(1) imposes a 10% penalty on withdrawals or surrenders of annuity contracts, unless one of the exceptions in Code Sec. 72(q)(2) applies.

In early 2008, IRS issued Rev Proc 2008-24, 2008-1 CB 684, which described when a direct transfer of part of the cash surrender value of an existing annuity contract for a second annuity contract would be treated as a tax-free Code Sec. 1035 exchange. A transfer was treated as a tax-free exchange if no amount was withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date of the transfer, or if the taxpayer demonstrated that one of the Code Sec. 72(q)(2) exceptions or any similar life event “occurred between” the date of the transfer and the date of the withdrawal or surrender. A transfer that wasn't treated as a tax-free Code Sec. 1035 exchange under this guidance was instead treated as a taxable distribution under Code Sec. 72(e), followed by a payment for the second contract.

For amounts received in tax years beginning after Dec. 31, 2010, the Small Business Jobs Act (P.L. 111-240, 9/27/2010) provides rules for the partial annuitization of a single annuity contract. Under Code Sec. 72(a)(2), if any amount is received as an annuity for 10 years or more or during one or more lives under any portion of an annuity, endowment or life insurance contract, (a) that portion is treated as a separate contract for purposes of Code Sec. 72; (b) the investment in the contract generally is allocated pro rata between each part of the contract from which amounts are received as an annuity and the portion from which amounts aren't so received; and (c) a separate annuity starting date is determined for each portion of the contract from which amounts are received as an annuity.

IRS has now modified and superseded the guidance in Rev Proc 2008-24 and has liberalized the rules even further.

New guidance. IRS says that a transfer described in Rev Proc 2011-38, Sec. 3, i.e., a direct transfer of a part of the cash surrender value of an existing annuity contract for a second annuity contract, that isn't a transaction described in Code Sec. 72(a)(2) —regardless of whether the two annuity contracts are issued by the same or different companies—will be treated as a tax-free Code Sec. 1035 exchange. This treatment applies if no amount, other than an amount received as an annuity for a period of 10 years or more or during one or more lives, is received during the 180 days beginning on the date of the transfer (in the case of a new contract, the date the contract is placed in-force). (Rev Proc 2011-38, Sec. 4.01)

A later direct transfer of all or a part of either contract involved in such an exchange isn't taken into account for purposes of applying this guidance if it qualifies (or is intended to qualify) as a tax-free Code Sec. 1035 exchange. (Rev Proc 2011-38, Sec. 4.01)

IRS won't require aggregation under Code Sec. 72(e)(12) or otherwise of an original, pre-existing contract with a second contract that is the subject of a tax-free Code Sec. 1035 exchange and Rev Proc 2011-38, Sec. 4.01, even if both contracts are issued by the same insurance company, but will instead treat the contracts as separate annuity contracts. (Rev Proc 2011-38, Sec. 4.03)

A transfer that is within the scope of the new revenue procedure (i.e., described in Rev Proc 2011-38, Sec. 3), but not subject to the above treatment under Rev Proc 2011-38, Sec. 4.01, will be characterized in a manner consistent with its substance, based on general tax principles and all the facts and circumstances. (Rev Proc 2011-38, Sec. 4.02) Thus, if a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract doesn't meet the 180-day test, IRS will apply general tax principles to determine the substance and tax treatment of the transfer. For example, an amount described by Code Sec. 72(e)(1)(A) that is received under either the original contract or the new contract within 180 days of the exchange may be characterized as either boot in a tax-free exchange under Code Sec. 1035(d)(1) and Code Sec. 1031(c) or a distribution under Code Sec. 72(e).

In sum, Rev Proc 2011-38 amends Rev Proc 2008-24 to provide that: (1) the 12-month period referred to in Rev Proc 2008-24, Sec. 4.01(a), is reduced to 180 days; (2) the rule requiring that one of the enumerated Code Sec. 72(q) conditions be met (or that a similar life event occur) is eliminated; (3) the limitations on amounts withdrawn from or received under an annuity contract involved in a partial exchange do not apply to amounts received as an annuity for a period of 10 years or more or during one or more lives; and (4) the automatic characterization of a transfer (as either a tax-free Code Sec. 1035 exchange or a distribution taxable under Code Sec. 72(e) followed by a payment for a second contract) is eliminated.

Effective date. Rev Proc 2011-38 is effective for transfers that are completed on or after Oct. 24, 2011. Rev Proc 2008-24 will continue to apply to transfers that are completed before that date. (Rev Proc 2011-38, Sec. 5)

Rev Proc 2011-38, Sec. 5, also clarifies that the requirement in Rev Proc 2008-24, Sec. 4.01(b), that one of the prescribed conditions of Code Sec. 72(q)(2) must have “occurred between” the date of the transfer and the date of the withdrawal or surrender, will be treated as satisfied if the condition was satisfied as of the date of the withdrawal or surrender. Thus, for example, an individual who attained the age of 59 1/2 before both the date of the transfer and the date of the withdrawal or surrender has satisfied this condition. (Rev Proc 2011-38, Sec. 5)

References: For tax-free annuity swaps under Code Sec. 1035, see FTC 2d/FIN ¶J-5301; United States Tax Reporter ¶10,354; TaxDesk ¶146,616; TG ¶12801.