Annuity contract received in Sec. 1035 exchange did not retain original contract's grandfather status.

IRS Letter Ruling (TAM) 9346002 concluded that an annuity contract received in a Sec. 1035 exchange did not retain the original contract's grandfather status. Therefore, taxpayers contemplating an exchange of an older insurance or annuity contract should consider the possible loss of grandfathered benefits before such an exchange.

A taxpayer acquired a deferred variable annuity contract in 1974. In 1989, she exchanged the contract for another deferred variable annuity contract without recognizing gain or loss (pursuant to Sec. 1035). Before the new contract's starting date, the taxpayer died and the contract's benefits were distributed to her two sons in two equal lump sums.

Under Sec. 1014(b)(9)(A), annuities described in Sec. 72 acquired from a decedent do not qualify for a basis step-up under Sec. 1014(a). However, at the time the taxpayer acquired the original contract, Rev. Rul. 70-143 held that the right to the accumulated value under an annuity contract was not a Sec. 72 annuity because it would not be received on or after the annuity starting date. Therefore, a deferred annuity contract was entitled to a basis step-up under Sec. 1014(a) if the contract's owner died before the annuity starting date.

However, Rev. Rul. 79-335 revoked Rev. Rul. 70-143 and held that a variable annuity contract acquired from a decedent was a Sec. 72 annuity even if annuity payments have not yet begun. Thus, a basis step-up was precluded by Sec. 1014(b)(9)(A). Yet, this revocation was prospective since, under the authority of Sec. 7805(b), Rev. Rul. 79-335 contained the following grandfather provision:

. . . the conclusion in this revenue ruling will not be applied to deferred variable annuity contracts purchased prior to October 21, 1979, including any contributions applied to such contracts pursuant to a binding commitment entered into before that date. This revenue ruling will apply to all other amounts contributed to deferred variable annuity contracts on or after October 21, 1979. (Emphasis added.)

In TAM 9346002, the taxpayer argued that the annuity contract received in the Sec. 1035 exchange should qualify for a stepped-up basis - since it was a continuation of the original contract, carrying with it the same basis and other tax attributes, including Rev. Rul. 79-335's grandfather status. The taxpayer cited Regs. Sec. 1. 1002-1, which states that the "underlying assumption of [the tax-free exchange provisions] is that the new property is substantially a continuation of the old investment . . . ."

The Service asserted that the Sec. 1035 exchange was not entitled to this protection, in effect treating the exchange as though it were an amount contributed after Oct. 20, 1979:

The section 7805(b) relief provision contained in Rev. Rul. 79-335 was designed to protect taxpayers who had purchased annuity contracts in reliance on Rev. Rul. 70-143. The acquisition of a new annuity contract from a different insurance company (by way of an exchange) generally is within the scope of a section 1035 exchange. The new contract may provide for different contractual provisions in addition to the change in the obligor (that is, the different insurance company). Extending the protection of the section 7805(b) relief provision to an annuity contract that is received from another insurance company pursuant to a section 1035 exchange occurring subsequent to the effective date of Rev. Rul. 79-335 would go beyond the underlying protective purpose of the relief provision....

Thus, the IRS indicated that the ability to alter provisions in the original contract through the Sec. 1035 exchange was a significant factor. However, the TAM'S facts did not disclose the extent to which the terms of the two annuity contracts were materially different, nor did the Service pursue or expand this rationale.

However, this approach appears reasonable for determining whether grandfather status should be retained in a Sec. 1035 exchange. If a taxpayer merely exchanges one contract for an equivalent contract issued by another company, the new contract should be merely a continuation of the original contract. On the other hand, if the new contract is materially different from the original contract in terms, obligations or benefits, it is difficult to argue that the new contract is a mere continuation.

The IRS also drew an analogy from congressional statements, when another grandfather provision was created relating to life insurance policies, that for purposes of Sec. 264(a)(4) "a policy exchanged for a policy issued by a different insurance company would be treated as a new contract . . . ."

In addition, the General Explanation of the Deficit Reduction Act of 1984 (at 656) stated that "[c]ontracts issued in exchange for existing contracts after December 31, 1984, are to be considered new contracts issued after that date" in discussing the effective date of new Sec. 7702 (which defines a life insurance contract).

Consequently, it generally appears that a Sec. 1035 exchange jeopardizes any grandfathered tax benefits for insurance contracts.

In Letter Ruling 8845002, involving facts similar to those in TAM 9346002, the Service initially concluded that the taxpayer was entitled to the grandfather relief of Rev. Rul. 79-335 because all contributions to the contracts were made prior to the publication of Rev. Rul. 79-335 and prior to the section 1035 exchange . . . ." However, Letter Ruling 9245034 subsequently revoked Letter Ruling 8845002 without explanation.

Perhaps this new hard-line approach by the IRS is intended to frustrate those situations it considers abusive. For example, in TAM 9346002, the taxpayer had withdrawn all of her investment in the original contract before the Sec. 1035 exchange. Therefore, the remaining value of the contract consisted entirely of untaxed earnings for which her beneficiaries were trying to obtain a basis step-up.

Another abuse could occur if a Sec. 1035 exchange were used as a tool to postpone an annuity's starting date in order to retain the grandfather protection of Rev. Rul. 79-335. For example, if the annuity starting date of the original contract is Jan. 1, 1995, should the taxpayer be allowed to exchange the original contract for a different contract which has an annuity starting date of Jan. 1, 2005 - particularly if the primary purpose for the exchange is retention of the grandfather protection? This could have been a potentially valuable planning tool for wealthy individuals.

Nonetheless, the taxpayer in TAM 9346002 may have a litigable position, since Rev. Rul. 79-335's grandfather provision differs substantially from the grandfather language used by Congress for Secs. 264(a)(4) and 7702. The taxpayer neither purchased, nor made additional contributions to either of the contracts after the grandfather date. Thus, the taxpayer appears to be within the literal protection granted by Rev. Rul. 79-335. TAM 9346002 arrived at its adverse conclusion by stretching the language of Rev. Rul. 79-335's 335 to hold that a Sec. 1035 exchange is equivalent to an amount contributed to a contract. It may be judicially unacceptable for the Service to cite. legislative history containing language so different from Rev. Rul. 79-335's grandfather relief.

Regardless of the outcome of any challenge to TAM 9346002, taxpayers and their advisers should be aware that a Sec. 1035 exchange could jeopardize grandfathered tax benefits for their existing insurance or annuity contracts.