IRS Provides Guidance About Partial 1035 Exchanges

As you probably know, annuity owners may exchange a portion of an annuity contract directly for another annuity contract and the exchange can qualify for tax-free exchange treatment. The IRS has recently issued Revenue Procedure 2008-24, which radically alters the subsequent tax treatment of the two annuity contracts involved in the partial exchange.

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New Ruling from the IRS

Revenue Procedure 2008-24 provides that if amounts are withdrawn or surrendered from either contract for a 12 month period beginning on the date the exchange proceeds are received by the recipient company, the partial exchange will be retroactively disqualified unless one of the following events occurs* after the exchange and prior to the withdrawal, annuitization, change of ownership or surrender:

  1. Owner reaches age 59 ½
  2. Owner's death (death claim paperwork)
  3. Owner's disability (with doctor's statement)
  4. Finalization of owner's divorce (copy of divorce decree will be required)
  5. Owner's loss of employment
  6. The amount withdrawn is allocable to investment in the contract before August 14, 1982 (this investment, referred to as pre-TEFRA cost basis, carries over on a 1035 exchange)
  7. The distribution is from a qualified funding asset within the meaning of Code section 130(d) (think structured settlement annuity)
  8. Other “similar life event”

*When there is more than one owner on the contract, one of these exceptions must apply to each owner. However, the exception does not have to be the same for each owner.

Please note that amounts subject to pre-TEFRA cost basis or from qualified funding assets are not “events” that can “occur” after a particular date. However, the other listed events must occur after the partial exchange in order to avoid disqualifying it. For example, if a contract owner completes a partial 1035 exchange after he or she has reached 59 ½ and then takes a withdrawal from one of the annuity contracts within a year of the exchange, the exchange will be disqualified unless one of the other events has occurred after the exchange or exceptions number 6 or 7 above apply.

Additionally, the IRS has provided no guidance explaining what constitutes a “similar life event.”

This ruling applies to partial 1035 exchanges that are completed on or after June 30, 2008.

Effect of Violating New Rules

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If the partial exchange is disqualified, the amount originally exchanged from the source contract is subject to taxation as a withdrawal from the source contract. That amount would be taxable to the extent of any gain in the source contract, and would generally be subject to the 10% additional tax penalty unless the contractowner were 59½. Both the gain calculation and the contractowner’s age would be determined as of the date the funds were exchanged out of the source contract, not the later date when the 1035 exchange is voided. Tax consequences of the exchange being voided include:

  • The exchange will be treated as a distribution from Annuity “A”, taxable to the extent of gain in Annuity “A” on the date of the exchange.
  • The money received by Annuity “B” in the exchange will be treated as regular premium.
  • The cost bases in both contracts will have to be adjusted to account for the different treatment.
  • Additional tax reporting will be triggered for one or both companies.

Disclaimer: The above discussion of taxes in this document may not be complete or current and should not be relied upon. The laws and regulations are complex and subject to change. For complete details, consult an attorney or tax advisor. Neither Hersh Stern, immediateannuities.com, webannuities.com, its employees or representatives can give legal or tax advice.

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