Tax Court Permits Partial Annuity Exchanges

Written by Hersh Stern Updated Tuesday, April 2, 2024

A direct switch of a portion of funds invested in an existing annuity contract to a different annuity contract qualifies as a nontaxable exchange under Code Section 1035, the Tax Court determined in its December 30, 1998, decision in Conway v. Commissioner. After the transfer, the taxpayer owned two separate annuity contracts, each with a different company.

Under the facts set forth, the taxpayer owned an annuity contract with Company A with a "total purchase price of $195,643." This contract was purchased in 1992. Two years later the taxpayer requested company A withdraw $119,000. from the contract and transfer the funds directly to Company B for the purchase of a new annuity contract from Company B. Upon receipt of the funds from Company A as well as the taxpayer's application, Company B opened an annuity contract for the taxpayer with an investment of $109,000 (the original $119,000 less the $10,000 surrender charge). The taxpayer indicated on the Company B application that the withdrawal of the funds from the Company A annuity contract and transfer of the funds to Company B were to be treated as a section 1035 exchange.

The taxpayer did not report any taxable income relating to the transfer of the funds from the Company A annuity to the Company B annuity. On audit, the Service determined that the taxpayer's transfer of the funds from the Company A annuity to Company B did not qualify as a section 1035 exchange and that the taxpayer had received taxable income from the transaction. In the decision, the Court summarized the arguments made by the Service and by the taxpayer. In brief, the Service had argued "that because the entire {Company A} annuity contract was not replaced by the {Company B} annuity contract, petitioner's withdrawal of $119,000 from the {Company A} annuity contract, does not qualify as a nontaxable exchange under section 1035.

The taxpayer's argument provided "that because {Company A} did not distribute any funds to her personally but rather transferred the funds directly to {Company B} and because she gave up a portion of her {Company A} annuity contract solely in exchange for the new {Company B} annuity contract, the transaction should qualify as a nontaxable exchange of annuity contracts under section 1035."The Court agreed with the taxpayer, basing its ruling on the wording of Section 1035, its regulations and legislative history. It found that:

• Neither section 1035 nor the regulations condition non-recognition treatment upon the exchange of an entire annuity contract.
• Respondent {Service} cites no authority to support respondent position that non-recognition treatment under section 1035 is limited to exchanges involving replacement of entire annuity contracts.
• Neither the statute nor the regulations contain any such requirement, either expressly or by any necessary implication.

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The Court determined that a broad definition of exchange, within the meaning of section 1035, was appropriate and that as a result of the transaction the taxpayer was "in essentially the same position after the exchange as she was in before the exchange, and the same funds are still invested in annuity contracts (less the surrender fee), except that now the petitioner owns two annuity contracts." Thus, the court concluded that the taxpayer's "direct exchange of a portion of her {Company A} annuity contract for a new {Company B} annuity contract qualifies under section 1035 and that no gain to the petitioner is to be recognized by reason of the exchange.

This case is significant as it explicitly permits a partial exchange to fall within the non-recognition provisions of section 1035. This is an area of prior uncertainty. Historically, the Service has indicated that partial exchanges are essentially surrenders for tax purposes and that the provisions of section 1035 (for exchanges) do not apply. We do not have any information as to how the IRS will respond to this decision.