The IRS, in Rev. Proc. 2011-38, has given taxpayers guidance on the tax treatment of exchanges of annuity contracts under Secs. 72 and 1035.
Under Sec. 1035(a)(3), taxpayers generally recognize no gain or loss when they exchange one annuity contract for another annuity contract. Congress provided this tax-free treatment so that individuals could exchange “one insurance policy for another better suited to their needs” (H.R. Rep’t No. 1337, 83d Cong., 2d Sess. 81 (1954)).
Rev. Proc. 2008-24 describes the tax treatment of the direct exchange by an insurance company of a portion of an existing annuity contract with an unrelated insurance company for a new annuity contract (a partial exchange). Under the revenue procedure, an exchange will be treated as a tax-free exchange if there is no withdrawal or surrender of either contract during the 12 months beginning on the date the partial exchange was completed or the taxpayer demonstrates that one of Sec. 72(q)’s conditions or a similar life event occurred between the partial exchange and the surrender or distribution. The conditions in Sec. 72(q) include the taxpayer’s attaining age 59½ or dying or becoming disabled.
Since 2008, taxpayers have told the IRS of several issues that make Rev. Proc. 2008-24 less effective. They have commented that it is unclear how the “occurred between” standard should be applied to several of the Sec. 72(q) conditions. Taxpayers have also pointed out that it is unclear how an exchange that does not qualify as tax free should be characterized. They also have complained that a 12-month waiting period is administratively difficult when an income tax return has already been filed for the year the exchange took place.
Because of these comments, Rev. Proc. 2011-38 amends Rev. Proc. 2008-24 to make the following changes:
- The 12-month period is reduced to 180 days;
- The rule requiring that one of the Sec. 72(q) conditions be met (or that a similar life event occur) is eliminated;
- Limitations on amounts withdrawn from or received under an annuity contract involved in a partial exchange do not apply to amounts received as an annuity for a period of 10 years or more or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
- The automatic characterization of a transfer as either a tax-free exchange under Sec. 1035 or a distribution taxable under Sec. 72(e) followed by a payment for a second contract is eliminated.
The IRS says that under this approach, if a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract does not meet the new 180-day test, the IRS will apply “general tax principles” to determine the transfer’s substance and tax treatment.
The new rules are effective for exchanges that are completed on or after October 24, 2011.