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Annuities.

General Rules

1. Starting Point--What is an annuity contract and what general rules govern the income taxation of payments received under annuity contracts?

In its most basic form, an annuity contract is a financial instrument where a premium is paid to a company or (in some cases) an individual in return for a promise to pay a certain amount for either a specific period of time, or over the lifetime of an individual. There can be different variations of this basic form. An annuity contract might allow multiple payments over a period of time before it begins to make payments. An annuity may delay making payments until some time in the future. The questions that follow will generally discuss the tax treatment of nonqualified annuities, which are annuities that are not a part of a "qualified" retirement plan (see Q 325).

The rules in IRC Section 72 govern the income taxation of all amounts received under annuity contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Except in the case of certain annuity contracts held by nonnatural persons (see Q 2), income credited on a deferred annuity contract is not currently includable in income.

Payments to which IRC Section 72 applies are of three classes: (1) "amounts not received as an annuity;" (2) payments of interest only; and (3) annuities.

The term annuity includes all periodic payments resulting from the systematic liquidation of a principal sum. Thus, the term annuity refers not only to payments for a life or lives, but also to installment payments that do not involve life contingency; for example, payments under a "fixed period" or "fixed amount" settlement option. (1) Annuity payments are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser's investment, and what portion is taxed as interest earned on the investment. The annuity rules, then, apply in taxing life income and other types of installment payments received under immediate and deferred annuity contracts. (See Q 7 to Q 19.) (2)

Payments consisting of interest only, not part of the systematic liquidation of a principal sum, are not annuity payments; hence they are not taxed under the annuity rules. Periodic payments on a principal amount that will be returned intact upon demand are interest payments. (3)

All amounts taxable under IRC Section 72 other than annuities and payments of interest are classed as amounts not received as an annuity. These include: policy dividends; lump sum cash settlements of cash surrender values; cash withdrawals and amounts received on partial surrender; death benefits under annuity contracts; and a guaranteed refund under a refund life annuity settlement. (4) "Amounts not received as an annuity" are taxable under general rules discussed in Q 3 and Q 4. The taxation of distributions from life insurance policies is discussed in Q 251 and Q 252.

IRC Section 72 also places a penalty on "premature distributions" (see Q 4) and, for contracts issued after January 18, 1985, imposes post-death distribution requirements (see Q 37).

The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules. See Q 273 to Q 281.

Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately. (See Q 111 to Q 114, Q 429 to Q 450, Q 500.)

Annuity with long-term care rider. In a private letter ruling, the Service analyzed the federal income tax treatment of a long-term care insurance rider to be offered with certain annuity contracts by an insurance company with respect to taxable years beginning after December 31, 2009. The Service ruled that: (1) the rider will constitute a qualified long-term care insurance contract; (2) to the extent that they do not exceed the per diem limitation, all long-term care benefits paid under the rider will be excludable from the recipient's gross income; and (3) the payment of long-term care benefits under the rider will not reduce the "investment in the contract." (1)

"Longevity" annuity. The Service has issued a private letter ruling explaining the tax treatment of a so-called "longevity" annuity. (2) According to the Service, the proposed annuity is a form of deferred annuity contract that provides no cash value or death benefits during the deferral period. On the deferral period end date, the contract's contingent account value becomes the cash value and is accessible by the owner through (a) the right to receive annuity payments at guaranteed rates, (b) the right to surrender the contract for its cash value, (c) the right to take partial withdrawals of the cash value, and (d) a death benefit.

The Service concluded that the proposed contract would constitute an "annuity contract" for purposes of IRC Section 72 because (1) the contract is in accordance within the customary practice of life insurance companies, and (2) the contract does not make periodic payments of interest. In support of its first conclusion, the Service noted that insurance companies have historically issued deferred annuity contracts that, like the proposed contract, did not have any cash value during the deferral stage and did not provide any death benefit or refund feature should the annuitant die during this time. Thus, in the Service's opinion, survival of the annuitant through the deferral period is not an inappropriate contingency for the vesting of cash value and the application of annuity treatment to the proposed contract. In reaching the second conclusion, the Service took note of the fact that the proposed contract: (a) provides for periodic payments designed to liquidate a fund; (b) contains permanent annuity purchase rate guarantees (which allow the contract owner to have the contingent account value applied to provide a stream of annuity payments for life or a fixed term at any time after the deferral period); and (c) provides for payments determined under guaranteed rates.

2. How are annuity contracts held by corporations and other nonnatural persons taxed?

Except as noted below, to the extent that contributions are made after February 28, 1986 to a deferred annuity contract held by a corporation or another entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract.

Income on the contract is treated as ordinary income received or accrued by the owner during the taxable year. (3) "Income on the contract" is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement. (1)

This rule does not apply to any annuity contract that (1) is acquired by the estate of a decedent by reason of the death of the decedent; (2) is held under a qualified pension, profit sharing, or stock bonus plan, as an IRC Section 403(b) tax sheltered annuity, or under an individual retirement plan; (3) is purchased by an employer upon the termination of a qualified pension, profit sharing, or stock bonus plan or tax sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to his beneficiary; (4) is an immediate annuity (i.e., an annuity that is purchased with a single premium or annuity consideration, the annuity starting date of that is no later than one year from the date of purchase, and which provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period); or (5) is a qualified funding asset (as defined in IRC Section 130(d) but without regard to whether there is a qualified assignment). (2) A qualified funding asset is any annuity contract issued by a licensed insurance company that is purchased and held to fund periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness. (3)

An annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person. (4) According to the conference report, if a nonnatural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person. (5) Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust. See Q 844.

According to the IRS, a trust that owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust's beneficiary, a natural person, was considered to hold the annuity contract as an agent for a natural person. (6) Where the trustee of an irrevocable trust purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract, the nonnatural person rule was not applicable. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. (7) Additionally, the Service concluded that the nonnatural person rule does not apply to a trust which had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust. (8)

Where a trustee's duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for his sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the Service concluded that the trustee was acting as an agent for a natural person. (9) Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person. (1) However, a charitable remainder unitrust was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year. (2)

These requirements apply "to contributions to annuity contracts after February 28, 1986." (3) It is clear that if all contributions to the contract are made after February 28, 1986 the requirements apply to the contract. It seems clear enough that if no contributions are made after February 28, 1986 to an annuity contract, a contract held by a nonnatural person is treated for tax purposes as an annuity contract and is taxed under the annuity rules. See Q 1. However, if contributions have been made both before March 1, 1986 and after February 28, 1986 to contracts held by nonnatural persons, it is not clear whether the income on the contract is allocated to different portions of the contract and whether the portion of the contract allocable to contributions before March 1, 1986 may continue to be treated as an annuity contract for income tax purposes. The Code makes no specific provision for separate treatment of contributions to the same contract made before March 1, 1986 and those made after February 28, 1986.

Amounts Not Received as an Annuity

Generally

3. What is the basic rule for taxing dividends, cash withdrawals and other amounts received under annuity contracts before the annuity starting date?

Dividends, Cash Withdrawals, Loans, Partial Surrender

Policy dividends (unless retained by the insurer as premiums or other consideration), cash withdrawals, amounts received as loans and the value of any part of an annuity contract pledged or assigned, and amounts received on partial surrender under annuity contracts entered into after August 13, 1982 are taxable as income to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract. (4)

To the extent the amount received is greater than the excess of cash surrender value over investment in the contract, the amount will be treated as a tax-free return of investment. In effect, these amounts are treated as distributions of interest first and only second as recovery of cost. (In addition, taxable amounts may be subject to a 10% penalty tax unless paid after age 59 1/2 or disability-see Q 4.)

Cash value is determined without regard to any surrender charge. (5) Investment in the contract is, under the general rule, reduced by previously received excludable amounts; however, investment in the contract is increased by loans treated as distributions to the extent the amount is includable in income, but not reduced to the extent it is excludable. (6)

Amounts received that are allocable to an investment made after August 13, 1982 in an annuity contract entered into before August 14, 1982 are treated as received under a contract entered into after August 13, 1982 and are subject to the above "interest first" rule. (7) If an annuity contract has income allocable to earnings on pre-August 14, 1982 and post-August 13, 1982 investments, the amount received is allocable first to investments made prior to August 14, 1982, then to income accumulated with respect to such investments (under the "cost recovery" rule, see next paragraph), then to income accumulated with respect to investments made after August 13, 1982 and finally to investments made after August 13, 1982 (under the "interest-first" rule). (1)

Policy dividends, cash withdrawals and amounts received on partial surrender under annuity contracts entered into before August 14, 1982 (and allocable to investment in the contract made before August 14, 1982) are taxed under the "cost recovery rule." Under the cost recovery rule, the taxpayer may receive all such amounts tax-free until he has received tax-free amounts equal to his pre-August 14, 1982 investment in the contract; the amounts are taxable only after such basis has been fully recovered. (2)

Where, as part of the purchase of a variable annuity, a taxpayer entered into an investment advisory agreement which stated that the company issuing the annuity would be solely liable for payment of a fee to an investment adviser who would manage the taxpayer's funds in the variable accounts, the fee was considered to be an amount not received as an annuity and, thus, includable in the taxpayer's income to the extent allocable to the income on the contract. (3)

For contracts issued after 1996, but only for tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract (see Q 314) that is a rider to the annuity or life contract will not be included in the gross income of the taxpayer. However, the investment in the contract for the annuity or life contract will be reduced by the amount of the charge against the cash surrender value. (4)

Special rules applicable to amounts received under pension, profit sharing or stock bonus plans, under annuities purchased by any such plan or under IRC Section 403(b) tax sheltered annuities are discussed in Q 442 to Q 444, and Q 500. The rules applicable to loans under qualified plans and under tax sheltered annuity (IRC Section 403(b)) contracts are discussed in Q 433 and Q 493 respectively.

Transfers Without Adequate Consideration

An individual who transfers any annuity contract issued after April 22, 1987, for less than full and adequate consideration will be treated as having received an "amount not received as an annuity" unless the transfer is between spouses or incident to a divorce under the IRC Section 1041 nonrecognition rule (see Q 282). The amount the transferor will be deemed to have received is the excess of the cash surrender value of the contract at the time of the transfer over the investment in the contract at that time. The transferee's investment in the contract will include the amount, if any, included in income by the transferor. (5)

Other Amounts

The purpose behind the "interest first" rule applicable to investment in contracts after August 13, 1982, is to limit the tax advantages of deferred annuity contracts to long term investment goals, such as income security, and to prevent the use of tax deferred inside build-up as a method of sheltering income on freely withdrawable short term investments.

Consistent with this purpose, other amounts, which are neither interest payments nor annuities, received under annuity contracts, regardless of when entered into, are not treated first as interest distributions but are taxed under the cost recovery rule. These amounts include lump sum settlements on complete surrender (see Q 33), annuity contract death benefits (see Q 36), and amounts received in full discharge of the obligation under the contract that are in the nature of a refund of consideration, such as a guaranteed refund under a refund life annuity settlement (see Q 18). (1)

Multiple Contracts

All annuity contracts entered into after October 21, 1988 that are issued by the same company to the same policyholder during any calendar year will be treated as one annuity contract for purposes of determining under the above rules the amount of any distribution that is includable in income. (2) An annuity that is received as part of an IRC Section 1035 exchange that was undertaken as part of a troubled insurer's rehabilitation process under Revenue Ruling 92-43 (see Q 30) is considered to have been entered into for purposes of the multiple contract rule on the date that the new contract is issued. The newly-received contract is not "grandfathered" back to the issue date of the original annuity for this purpose. (3)

This aggregation rule does not apply to distributions received under qualified pension or profit sharing plans, from an IRC Section 403(b) contract, or from an IRA. (4) The Conference Report on OBRA '89 also states the aggregation rule does not apply to immediate annuities.

If the contract is owned by a corporation or other nonnatural person, see also Q 2.

For amounts received under life insurance or endowment contracts, see Q 251. For distributions received under life insurance policies that are classified as modified endowment contracts, see Q 252.

Effect of Tax-Free Exchange

In order to give effect to the grandfathering of pre-August 14, 1982 annuity contracts, a replacement contract obtained in a tax-free exchange of annuity contracts (see Q 30) succeeds to the status of the surrendered contract, for purposes of determining when amounts are to be considered invested and for computing the taxability of any withdrawals. (5) Investment in the replacement contract is considered made on, before or after August 13, 1982 to the same extent the investment was made on, before or after August 13, 1982 in the replaced contract.

4. What penalties apply to "premature" distributions under annuity contracts?

In order to discourage the use of annuity contracts as short term tax sheltered investments, a 10% tax is imposed on certain "premature" payments under annuity contracts. (6) The tax applies to any payment received to the extent the payment is includable in income, except it does not apply to any of the following distributions:

(1) any payment made on or after the date on which the taxpayer becomes age 59 1/2;

(2) any payment attributable to the taxpayer's becoming disabled;

(3) any payment allocable to investment in the contract before August 14, 1982, including earnings on pre-August 14, 1982 investment; (7)

(4) any payment made from a qualified pension, profit sharing or stock bonus plan, or under a contract purchased by such a plan, or under an IRC Section 403(b) tax sheltered annuity, or from an individual retirement account or annuity, or from a contract provided life insurance company employees under certain retirement plans (but such payments are subject to similar premature distribution limitations and penalties--see: Q 232, IRA; Q 437, pension, profit sharing, stock bonus; Q 495, tax sheltered annuity);

(5) any payment made on or after the death of the holder (or the primary annuitant in the case where the holder is a nonnatural person);

(6) any payment made under an immediate annuity contract; (An immediate annuity contract is one that is purchased with a single premium or annuity consideration, the annuity starting date of which is no later than one year from the date of purchase, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period. (1) Where a deferred annuity contract was exchanged for an immediate annuity contract, the purchase date of the new contract for purposes of the 10% penalty tax was considered to be the date upon which the deferred annuity was purchased. Thus, payments from the replacement contract did not fall within the immediate annuity exception to the penalty tax. (2));

(7) any payment made from an annuity purchased by an employer upon the termination of a qualified plan and held by the employer until the employee's separation from service;

(8) any payment under a qualified funding asset (i.e., any annuity contract issued by a licensed insurance company that is purchased as a result of a liability to make periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness); or

(9) any payment that is part of a series of substantially equal periodic payments made (not less frequently than annually) for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of the taxpayer and his designated beneficiary. Payments excepted from the 10% penalty by reason of this exception may be subject to recapture if the series of payments is modified (other than by reason of death or disability) (a) prior to the taxpayer's reaching age 59 1/2, or (b) before the end of a five-year period beginning on the date of the first payment even if the taxpayer has reached age 59 1/2. According to the report of the Conference Committee (TRA '86), the modification that triggers recapture is a change to a method of distribution which would not qualify for the exemption. The tax on the amount recaptured is imposed in the first taxable year of the modification and is equal to the tax (as determined under regulations) that would have been imposed (plus interest) had the exception not applied. (3) The Service announced that the three methods used to avoid the 10% penalty when making substantially equal periodic payments from a qualified retirement plan (see Q 233) may also be used to qualify as substantially equal periodic payments from a nonqualified annuity. The "one time election" to change methods may also be used by owners of nonqualified annuities. Finally, there will be no penalty if an individual depletes an account by using one of the approved methods. (4)

Apparently, if the annuity contract was issued between August 13, 1982, and January 19, 1985, a distribution of income allocable to any investment made 10 or more years before the distribution is not subject to the penalty. For this purpose, amounts includable in income are allocated to the earliest investment in the contract to which amounts were not previously fully allocated. (1) To facilitate accounting, investments are considered made on January 1 of the year in which they are invested. (2)

There is also a 10% penalty tax on certain premature distributions from life insurance policies classified as modified endowment contracts. See Q 252.

The tax on premature distributions is not taken into consideration for purposes of determining the nonrefundable personal credits, general business credit, or foreign tax credit. See Q 832.

Dividends

(5.) Are the dividends payable on an annuity contract taxable income?

How dividends under annuity contracts are taxed depends on when the contract was purchased. If the annuity contract was purchased after August 13, 1982, dividends received before the annuity starting date are taxable to the extent the cash value of the contract (determined without regard to any surrender charge) immediately before the dividend is received exceeds the investment in the contract at the same time. Any excess is treated as a tax-free recovery of investment. If the annuity contract was purchased before August 14, 1982 and no additional investment was made in the contract after August 13, 1982, the dividends will be taxed like dividends received under life insurance contracts (generally tax-free until basis has been recovered; see Q 254). (3)

Dividends retained by the insurer as a premium or other consideration for the contract are not included in income. (4) Dividends left with the insurer to accumulate at interest would not be considered retained as premium or consideration.

If any investment has been made after August 13, 1982 in an annuity contract entered into before August 14, 1982, dividends allocable to that investment are includable as dividends on a contract entered into after August 13, 1982. (5) Dividends received under an annuity contract with income allocable to earnings on pre-August 14, 1982 and post-August 13, 1982 investments are allocable first to investments made prior to August 14, 1982, then to income accumulated with respect to such pre-August 14, 1982 investments, then to income accumulated with respect to investments made after August 13, 1982, and finally to investments made after August 13, 1982. (6)

Dividends received after the annuity starting date (see Q 10) are included in gross income regardless of when the contract was entered into or when any investment was made. (7)

A special exception applies to annuity contracts purchased by a qualified pension, profit sharing or stock bonus plan, an individual retirement account or annuity, or a special plan of a life insurance company for its employees, or purchased as an IRC Section 403(b) tax sheltered annuity. (See Q 436.)

See Q 4 for possible penalty tax on taxable dividends allocable to investment in the contract after August 13, 1982.

(6.) What is the tax treatment of dividends where annuity values are paid in installments or as a life income?

Only dividends that were excludable from gross income are subtracted from gross premiums to determine the net premium cost used in determining the investment in the contract for purposes of the exclusion ratio. If any excludable accumulated dividends are applied to increase the size of the income payments, they are not subtracted from gross premium but are included in investment in the contract. Any accumulated dividends and interest previously includable in income applied to increase the size of income payments are added to gross premium to determine the investment in the contract.

Amounts Received as an Annuity: Fixed Annuities

Basic Rule

(7.) What is the basic rule for taxing annuity payments?

The basic rule is designed to return the purchaser's investment in equal tax-free amounts over the payment period, and to tax the balance of the amounts received. Each payment, therefore, is part nontaxable return of cost and part taxable income. Any excess interest (dividends) added to the guaranteed payments is reportable as income for the year received.

An exclusion ratio (which may be expressed as a fraction or as a percentage) must be determined for the contract. This exclusion ratio is applied to each annuity payment to find the portion of the payment that is excludable from gross income; the balance of the guaranteed annuity payment is includable in gross income for the year received. (1)

The exclusion ratio of an individual whose annuity starting date (see Q 10) is after December 31, 1986, applies to payments received until the payment in which the investment in the contract is fully recovered. In that payment, the amount excludable is limited to the balance of the unrecovered investment. Payments received thereafter are fully includable in income. (2) The exclusion ratio as originally determined at an annuity starting date before January 1, 1987 applies to all payments received throughout the entire payment period, even if the annuitant has recovered his investment. Thus, it is possible for a long-lived annuitant to receive tax-free amounts which in the aggregate exceed his investment in the contract.

The exclusion ratio for a particular contract is the ratio that the total investment in the contract (see Q 8) bears to the total expected return (see Q 9) under the contract. By dividing the investment in the contract by the expected return, the exclusion ratio can be expressed as a percentage (which the regulations indicate should be rounded to the nearest tenth of a percent). (3) For example, assuming that the investment in the contract is $12,650 and expected return is $16,000, the exclusion ratio is $12,650/$16,000, or 79.1% (79.06 rounded to the nearest tenth of a percent). If the monthly payment is $100, the portion to be excluded from gross income is $79.10 (79.1% of $100), and the balance of the payment is included in the gross income. If 12 such monthly payments are received during the taxable year, the total amount to be excluded for the year is $949.20 (12 X $79.10), and the amount to be included is $250.80 ($1,200--$949.20). Excess interest, if any, must also be included.

If the investment in the contract equals or exceeds the expected return, the full amount of each payment is received tax-free. (4) However, if the annuity starting date is after December 31, 1986, the excludable amount is limited to the investment in the contract; thereafter, any payments are fully includable in income. (1)

There are a few circumstances that may require the computation of a new exclusion ratio for the contract (see "Withdrawals," Q 20; "Variable annuities," Q 24; and "Sale of contract," Q 29).

For application of the basic annuity rule to various types of fixed annuity payments, see Q 11 to Q 19; for variable annuity payments, see Q 21 to Q 24. If an annuity contract is owned by a nonnatural person, see Q 2.

8. How do you determine the investment in the contract for purposes of the annuity rules?

Generally speaking, the investment in the contract is the gross premium cost or other consideration paid for the contract reduced by amounts previously received under the contract to the extent they were excludable from income. (2)

Premium Cost

Unless the contract has been purchased from a previous owner, the "investment in the contract" is normally premium cost. It is not equal to the policy's cash value. (3) To arrive at the premium cost, adjustments must usually be made to gross premium cost.

Extra premiums paid for supplementary benefits such as double indemnity, waiver of premiums, and disability income, must be excluded from premium cost. (4) (But see Moseley v. Comm., (5) where life insurance policy premium payments paid into a special reserve account were added to the aggregate premiums for purposes of calculating taxable income when a lifetime distribution was made.) Further, it might seem that premiums waived on account of disability should be treated as part of the premium cost. However, in the only case on the subject, a case dealing with the computation of gain on a matured endowment, the court held that waived premiums could not be included in the taxpayer's cost basis. The court refused to accept the view of the taxpayer that the waived premiums had been constructively received as a tax-free disability benefit and then applied to the payment of premiums. Instead, the court treated as the tax-free disability benefit a portion of the proceeds--the difference between the amount of premiums actually paid and the face amount of the endowment. (6)

Investment in the contract is increased by any amount of a policy loan that was includable in income as an amount received under the contract. (7) See Q 3. Any unrepaid policy loans must be subtracted from gross premiums in determining the investment in the contract for purposes of the exclusion ratio. (8)

If premiums were deposited in advance and discounted, only the amount actually paid is includable in premium cost. However, any increment in the advance premium deposit fund that has been reported as taxable income may be added to the discounted premiums in determining cost. (9)

In the case of a participating contract, dividends must be taken into account as follows:

If dividends have been received in cash or used to reduce premiums, the aggregate amount of such dividends received or credited before the annuity payments commenced must be subtracted from gross premiums to the extent the dividends were excludable from gross income (see Q 3, Q 251). Also, any dividends that have been applied against principal or interest on policy loans must be subtracted but only to the extent they were excludable from gross income. (1) (Excludable dividends are considered as a partial refund of premiums and therefore as a reduction in the cost of the contract.)

But if excludable dividends have been left on deposit with the insurance company to accumulate at interest, and the dividends and interest are used to produce larger annuity payments, such dividends are not subtracted from gross premiums (they are part of the cost of the larger payments). In this situation, gross premiums plus accumulated interest constitute the cost of the contract. (The interest is included as additional cost since it has already been taxed to the policyholder as it was credited from year to year-see "Dividends.") Likewise, any terminal dividend that is applied to increase the annuity payments should not be subtracted from gross premium cost.

Similarly, where dividends have been applied to purchase paid-up additional insurance, and the annuity payments include income from the paid-up additions, gross premiums are used as the cost of the contract. (In effect, the dividends constitute the cost of the income from the paid-up additions.)

Cost Other than Premium Cost

However, the investment in the contract is not always premium cost. For example, it is the maturity value or cash surrender value of the contract if such value has been constructively received by the policyholder (see Q 34, Q 267). If the contract has been purchased from a previous owner, the investment in the contract is the consideration paid by the purchaser (see Q 29, Q 264). Also, special rules apply in computing the investment in the contract with respect to employee annuities-that is, annuities on which an employer has paid all or part of the premiums (see Q 114, Q 444, Q 500).

Long-Term Care Rider Premiums

For contracts issued after 1996, but only for tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract (see Q 314) that is a rider to the annuity or life insurance contract will reduce the investment in the contract of the annuity or life insurance contract. However, this charge against the cash surrender value will not cause the taxpayer to recognize gross income. (2)

Adjustment for Refund or Period-Certain Guarantee

If the annuity is a life annuity with a refund or period-certain guarantee, a special adjustment must be made to the investment in the contract (whether premium cost or other cost). The value of the refund or period-certain guarantee (as determined by use of a prescribed annuity table, Table III or Table VII, or a formula, depending on when the investment in the contract was made, see Appendix A) must be subtracted from the investment in the contract. It is this adjusted investment in the contract that is used in the exclusion ratio (see Q 11, Q 14). (3)

9. How do you compute expected return under the annuity rules?

Generally speaking, expected return is the total amount that the annuitant (or annuitants) can expect to receive under the contract.

If payments are for a fixed period or a fixed amount with no life expectancy involved, expected return is the sum of the guaranteed payments (see Q 19). (1)

If payments are to continue for a life or lives, expected return is arrived at by multiplying the sum of one year's annuity payments by the life expectancy of the measuring life or lives. The life expectancy multiple or multiples must be taken from the Annuity Tables prescribed by the IRS. (2) (See Appendix A for IRS Annuity Tables.)

Generally, gender-based Tables I--IV are to be used if the investment in the contract does not include a post-June 30, 1986 investment. Unisex Tables V--VIII are to be used if the investment in the contract includes a post-June 30, 1986 investment. However, transitional rules permit an irrevocable election to use the unisex tables even where there is no post-June 1986 investment and, if investment in the contract includes both a pre-July 1986 investment and a post-June 1986 investment, an election may be made in some situations to make separate computations with respect to each portion of the aggregate investment in the contract using with respect to each portion the tables applicable to it. (3) See Appendix A for details.

The life expectancy for a single life is found in Table I or in Table V, whichever is applicable. See Q 11. The life expectancy multiples for joint and survivor annuities are taken from Tables II and IIA or Tables VI and VIA, whichever are applicable. See Q 13 to Q 16. (4)

The AnnuityTables are entered with the age of the measuring life as of his or her birthday nearest the annuity starting date (see Q 10).The multiples in the AnnuityTables are based on monthly payments. Consequently, where the annuity payments are to be received quarterly, semi-annually or annually, the multiples from Tables I, II, and IIA or, as applicable, Tables V, VI, and VIA must be adjusted. This adjustment is made by use of the Frequency of Payment Adjustment Table (Appendix A). No adjustment is required if the payments are monthly.

10. What is the annuity starting date?

The exclusion ratio for taxing annuity payments under a particular contract is determined as of the annuity starting date. This is the "first day of the first period for which an amount is received as an annuity." (5) For example, suppose that a person purchases an immediate annuity on July 1 providing for monthly payments beginning August 1. His annuity starting date is July 1 (the first payment is for the one-month period beginning July 1st). Payments under settlement options usually commence immediately rather than at the end of the month or other payment period; hence the annuity starting date is the date of the first payment.

Life Annuity: Single

11. How do you compute the excludable portion of payments under a single life annuity?

Following are the steps to be taken in applying the basic annuity rule:

(1) Determine the investment in the contract (see Q 8).

(2) Find the life expectancy multiple in Table I or V, whichever is applicable for a person of annuitant's age (and sex, if applicable). (See Appendix A). Multiply the sum of one year's guaranteed annuity payments by the applicable Table I or Table V multiple. This is the expected return under the contract.

(3) Divide the investment in the contract by the expected return under the contract, carrying the quotient to three decimal places. This is the exclusion ratio expressed as a percentage (exclusion percentage).

(4) Apply the exclusion percentage to the annuity payment. The result is the portion of the payment that is excludable from gross income. The balance of the payment must be included in gross income. If the annuity starting date is after December 31, 1986, the exclusion percentage applies to payments received only until the investment in the contract is recovered. However, if the annuity starting date was before January 1, 1987, the same exclusion percentage will apply to all payments received throughout the annuitant's lifetime. (1)

Example 1. On October 1, 2009, Mr. Brown purchased an immediate nonrefund annuity that will pay him 125 a month ($1,500 a year) for life, beginning November 1, 2009. He paid $16,000 for the contract. Mr. Brown's age on his birthday nearest the annuity starting date (October 1st) was 68. According to Table V (which he uses because his investment in the contract is post-June 1986), his life expectancy is 17.6 years. Consequently, the expected return under the contract is $26,400 (12 X $125 X 17.6). And the exclusion percentage for the annuity payments is 60.6% ($16,000/$26,400). Since Mr. Brown received 2 monthly payments in 2009 (a total of $250), he will exclude $151.50 (60.6% of $250) from his gross income for 2009, and he must include $98.50 ($250-$151.50). Mr. Brown will exclude the amounts so determined for 17.6 years. In 2009, he could exclude $151.50; each year thereafter through 2026, he could exclude $909, for a total exclusion of $15,604.50 ($151.50 excluded in 2009 and $15,453 excluded over the next 17 years). In 2027, he could exclude only $395.50 ($16,000-$15,604.50). In 2027, he would include in his income $1,104.50 ($1,500-$395.50) and $1,500 in 2028 and in each year thereafter.

Example 2. If Mr. Brown purchased the contract illustrated above on October 1, 1986 (so that it had an annuity starting date before January 1, 1987), he would exclude $151.50 (60.6% of $250) from his 1986 gross income and would include $98.50 ($250-$151.50). For each succeeding tax year in which he receives 12 monthly payments (even if he outlives his life expectancy of 17.6 years), he will exclude $909 (60.6% of $1,500), and he will include $591 ($1,500-$909).

Refund or Period-Certain Guarantee

The computation above is for a straight life annuity (without a refund or period-certain guarantee). The exclusion ratio for a single life refund or period-certain guarantee is determined in the same way, but the investment in the contract must first be adjusted by subtracting the value of the refund or period-certain guarantee. The value of the refund or period-certain guarantee is computed by the following steps.

(1) Determine the duration of the guaranteed amount (number of years necessary for the total guaranteed return to be fully paid). In the case of a period-certain life annuity, the duration of the guaranteed amount, in years, is known (e.g., 10, 15, or 20 "years certain"). To find the duration of the guaranteed amount, in years, for a cash or installment refund life annuity, divide the total guaranteed amount by the amount of one year's annuity payments, and round the quotient to the nearest whole number of years.

(2) Find the factor in Table III or VII (whichever is applicable, depending on when the investment is made in the contract) under the whole number of years (as determined above) and the age and (if applicable) the sex of the annuitant (see Appendix A). This Table III or Table VII factor is the percentage value of the refund or period-certain guarantee.

(3) Apply the applicable Table III or Table VII percentage to the SMALLER of (a) the investment in the contract, or (b) the total guaranteed return under the contract. The result is the present value of the refund or period-certain guarantee.

(4) Subtract the present value of the refund or period-certain guarantee from the investment in the contract. The remainder is the adjusted investment in the contract to be used in the exclusion ratio. (1)

Example 3. On January 1, 2009, a husband, age 65, purchased for $21,053 an immediate installment refund annuity which pays $100 a month for life. The contract provides that in the event the husband does not live long enough to recover the full purchase price, payments will be made to his wife until the total payments under the contract equal the purchase price. The investment in the contract is adjusted for the purpose of determining the exclusion ratio as follows:
Unadjusted investment in the contract            $21,053
Amount to be received annually                    $1,200
Duration of guaranteed amount ($21,053 : $1,200)  17.5 yrs.
Rounded to nearest whole number of years          18
Percentage value of guaranteed refund             15%
(Table VII for age 65 and 18 years)
Value of refund feature rounded to                $3,158
nearest dollar (15% of $21,053)
Adjusted investment in the contract               $17,895
($21,053-$3,158)


Example 4. Assume the contract in Example 3 was purchased as a deferred annuity and the pre-July 1986 investment in the contract is $10,000 and the post-June 1986 investment in the contract is $11,053. If the annuitant elects (as explained in Appendix A) to compute a separate exclusion percentage for the pre-July 1986 and the post-June 1986 amounts, separate computations must be performed to determine the adjusted investment in the contract. The pre-July 1986 investment in the contract and the post-June 1986 investment in the contract are adjusted for the purpose of determining the exclusion ratios in the following manner:
Pre-July 1986 adjustment:

Unadjusted investment in the contract                 $10,000

Allocable part of amount to be received annually
(($10,000 / $21,053) x $1,200)                        $570

Duration of guaranteed amount ($10,000 / $570)        17.5 yrs.

Rounded to nearest whole number of years                 18

Percentage in Table III for age 65 and 18 years          30%

Present value of refund feature rounded to nearest
dollar (30% of $10,000)                              $3,000

Adjusted pre-July 1986 investment in the               $7,000
contract ($10,000-$3,000)

Post-June 1986 adjustment:

Unadjusted investment in the contract                 $11,053

Allocable part of amount to be received annually
(($11,053 / $21,053) x $1,200).                       $630

Duration of guaranteed amount ($11,053 / $630)        17.5 yrs.

Rounded to nearest whole number of years                 18

Percentage in Table VII for age 65 and 18 years          15%

Present value of refund feature rounded to nearest
dollar) (15% of $11,053)                             $1,658

Adjusted post-June 1986 investment in the contract     $9,395
($11,053-$1,658)


Once the investment in the contract has been adjusted by subtracting the value of the refund or period-certain guarantee, an exclusion ratio is determined in the same way as for a straight life annuity. Expected return is computed; then the adjusted investment in the contract is divided by expected return. Taking the two examples above, the exclusion ratio for each contract is determined as follows.

Example (3) above.
Investment in the contract (adjusted for refund guarantee)   $17,895

One year's guaranteed annuity payments (12 x $100)           $1,200

Life expectancy from Table V, age 65                         20 yrs.

Expected return (20 x $1,200)                                $24,000

Exclusion ratio ($17,895 / $24,000)                          74.60%

Amount excludable from gross income each year in which 12
payments are received (74.6% of $1,200) *                    $895.20

Amount includable in gross income ($1,200-$895.20) *         $304.80


* Since the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income. However, if the annuity has a refund or guarantee feature, the value of the refund or guarantee feature is not subtracted when calculating the unrecovered investment. (1)

Example (4) above.
Pre-July 1986 investment in the contract (adjusted for
period certain guarantee)                                  $7,000

One year's guaranteed annuity payments (12 x $100)         $1,200

Life expectancy from Table I, male age 65                 15 yrs.

Expected return (15 x $1,200)                             $18,000

Exclusion ratio ($7,000 / $18,000)                         38.90%

Post-June 1986 investment in the contract (adjusted for
period certain guarantee)                                  $9,395

One year's guaranteed annuity payments (12 x $100)         $1,200

Life expectancy from Table V, age 65                      20 yrs.

Expected return (20 x $1,200)                             $24,000

Exclusion ratio ($9,395 / $24,000).                        39.10%

Sum of pre-July and post-June 1986 ratios.                    78%

Amount excludable from gross income each year in which
twelve payments are received (78% of $1,200) *               $936

Amount includable in gross income ($1,200-936) *             $264


* Since the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income.

Life Annuity: Temporary

12. How is a temporary life annuity taxed?

A temporary life annuity is one that provides for fixed payments until the death of the annuitant or until the expiration of a specified number of years, whichever occurs earlier. The basic annuity rule (Q 7) applies. That is, the investment in the contract is divided by the expected return under the contract to find the portion of each payment that can be excluded from gross income (the exclusion ratio). However, expected return is determined by multiplying one year's annuity payments by the multiple in Table IV or Table VIII (whichever is applicable, as explained in Appendix A) of the IRS Annuity Tables for the annuitant's age (as of the annuity starting date) and sex (if applicable) and the whole number of years in the specified period. (2) Tables IV and VIII are not included in this book but can be found in [section] 1.72-9 of the Treasury Regulations.

A penalty tax may be imposed on payments received under the contract unless one of the exceptions listed in Q 4 is met.

Life Annuity: Joint and Survivor

13. How do you find the excludable portion of payments under a joint and survivor annuity that continues the same income to the survivor as is payable while both annuitants are alive?

The basic annuity rule (Q 7) applies: the investment in the contract is divided by the expected return under the contract to find the portion of each payment that can be excluded from gross income (the exclusion ratio). But expected return must be computed by using a life expectancy multiple from Table II or Table VI of the IRS Annuity Tables (see Appendix A). With respect to an annuity with a starting date after December 31, 1986, the exclusion ratio applies to payments received until the investment in the contract is recovered. However, if the annuity starting date was before January 1, 1987, the exclusion ratio as originally computed applies to all payments received under the contract: to those received by the survivor as well as to those received while both annuitants are alive.1 The steps in the computation of the exclusion ratio are as follows:

(1) Determine the investment in the contract (see Q 8).

(2) Find the joint and survivor life expectancy multiple in Table II or Table VI (depending on when the investment in the contract was made-see Appendix A) under the sexes (if applicable) and ages of the annuitants. Multiply one year's guaranteed annuity payments by the applicable Table II or Table VI multiple. This is the expected return under the contract.

(3) Divide the investment in the contract by the expected return, carrying the quotient to three decimal places. This is the exclusion ratio expressed as a percentage (the exclusion percentage).

(4) Apply the exclusion percentage to the annuity payment. The result is the portion of the payment that is excludable from gross income. The balance of the payment must be included in gross income.

Example. After June 30, 1986, Mr. and Mrs. Black purchase an immediate joint and survivor annuity. The annuity will provide payments of $100 a month while both are alive and until the death of the survivor. Mr. Black's age on his birthday nearest the annuity starting date is 65; Mrs. Black's, 63. The single premium is $22,000.
Investment in the contract                         $22,000

One year's annuity payments (12 x $100)            1,200

Joint and survivor life expectancy multiple from
Table VI (ages 65,                                 26

Expected return (26 x $1,200).                     $31,200

Exclusion ratio ($22,000 / $31,200)                70.50%

Amount excludable from gross income each year in
which 12 payments are received
(70.5% of $1,200) *                                $846

Amount includable in gross income each year        $354
($1,200-$846) *


* If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income.

14. How do you find the excludable portion of payments under a level payment joint and survivor annuity with refund or period certain guarantee?

The exclusion ratio is determined as in Q 13, except that the investment in the contract must first be adjusted by subtracting the value of the refund or period certain guarantee. This value is determined by the following steps.

Investment in the Contract Before July 1986

If Table II is used to determine the expected return for pre-July 1986 investment, the following method is used to determine the adjustment to the investment in the contract. (2) If Table VI is used to determine expected return for pre-July 1986 investment, investment in the contract is adjusted using the formula for post-July 1986 investment (see subhead below). (3)

(1) Determine the duration of the guaranteed amount (the number of years necessary for the guaranteed amount to be fully paid). In the case of a period certain and life annuity, this is the number of years in the guaranteed period (e.g., 10, 15, or 20 "years certain"). To find the duration of the guaranteed amount, in years, for a cash or installment refund annuity, divide the total amount guaranteed under the contract by the amount of one year's annuity payments. Round the quotient to the nearest whole number of years.

(2) If the annuitants are not of the same sex, substitute for the female a male five years younger (or for the male, a female five years older). Then find the refund percentage factors in Table III under the whole number of years, as determined in (1), and the age of each annuitant of the same sex. (For Table III factors, see Appendix A). Add these two Table III factors.

(3) Using ages of the same sex, as adjusted in (2), add to the age of the older annuitant the number of years indicated in the table below opposite the number of years by which the ages differ.
                                               Addition to
Number of years difference in age (two male    older age
annuitants or two female annuitants)           in years

0 to 1, inclusive                                  9
2 to 3, inclusive                                  8
4 to 5, inclusive                                  7
6 to 8, inclusive                                  6
9 to 11, inclusive                                 5
12 to 15, inclusive                                4
16 to 20, inclusive                                3
21 to 27, inclusive                                2
28 to 42, inclusive                                1
Over 42                                            0


(4) Find the refund percentage factor in Table III under the whole number of years as determined in (1) and the age of the older annuitant as adjusted in (3).

(5) Subtract the Table III factor found in (4) from the sum of the Table III factors found in (2). The balance, if any, is the percentage value of the refund or period certain guarantee. If there is no balance, no adjustment in the investment in the contract need be made for the value of the refund or period certain guarantee. If there is a balance, continue as follows:

(6) Apply the percentage value of the refund or period certain guarantee as determined in (5) to the SMALLER of: (a) the investment in the contract (see Q 8), or (b) the total guaranteed return under the contract. The result is the dollar value of the refund or period certain guarantee.

(7) Subtract the dollar value of the refund or period certain guarantee from the investment in the contract. The remainder is the adjusted investment in the contract to be used in determining the exclusion ratio.

Example. Mr. and Mrs. Green purchase an immediate joint and survivor annuity that will pay $200 a month for 10 years certain and as long thereafter as either is alive. Mr. Green is 70 years old as of his birthday nearest the annuity starting date. Mrs. Green is 65. The single premium is $35,000. The total guaranteed amount is $24,000.
Investment in the contract (unadjusted)                   $35,000

Percentage factor from Table III for male,
  age 70, and 10-year guarantee                    21%

Percentage factor from Table III for male, age
  60, and 10-year guarantee                        11%

Sum of percentage refund factors

Difference in years of age between two males,
  age 70 and 60                                    10

Addition in years to older age (Table above)        5

Percentage refund factor from Table III for
  male, age 75 and 10-year guarantee               29%

Difference between percentages.                    3%

Dollar value of period certain guarantee                    720
  (3% of $24,000).

Adjusted investment in the contract.                      $34,280

Table II multiple for male, age 70, and                    20.7
female, age 65

Expected return (20.7 x $2,400).                          $49,680

Exclusion ratio ($34,280 / $49,680).                        69%

Excludable from gross income each year                    $ 1,656
(69% of $2,400) *

Includible in gross income each year                       $ 744
($2,400-$1,656) *


* If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income. However, if the annuity has a refund or guarantee feature, the value of the refund or guarantee feature is not subtracted when calculating the unrecovered investment. (1)

Investment in the Contract After June 1986

Where investment in the contract has been made after June 30, 1986, the regulations provide a complex formula for determining the percentage factor that was developed for pre-July 1986 investment using the first five steps above. That percentage factor is then applied as explained in steps 6 and 7 above. (2) The IRS will determine the amount of the adjustment on request. (3)

15. How do you compute the tax exempt portion of payments under a joint and survivor annuity where the size of the payments will increase or decrease after the first death?

Some joint and survivor annuities provide that the size of the annuity payment will decrease after the first death-regardless of which annuitant dies first (e.g., joint and V or joint and % survivor annuity). Sometimes, but rarely, the joint and survivor annuity will provide for increased payments after the first death. The exclusion ratio is determined in the usual way, by dividing the investment in the contract by the expected return under the contract (see Q 7). However, expected return must be computed in the following manner. (4)

(1) Find the joint and survivor multiple in Table II or Table VI (depending on when the investment in the contract was made, as explained in Appendix A) under both annuitants' ages and, if applicable, appropriate sexes. (For Table II or Table VI factor, see Appendix A.) Multiply the amount of one year's annuity payments to the survivor by this Table II or Table VI multiple.

(2) Find the joint life multiple in Table IIA or Table VIA (depending on when the investment in the contract was made) under both annuitants' ages and, if applicable, appropriate sexes. (For Table IIA or VI A factor, see Appendix A.) Determine the difference between the amount of one year's annuity payments before the first death and the amount of one year's annuity payments after the first death. Multiply this difference in amount by the multiple from Table IIA or VIA, whichever is applicable.

(3) If payments are to be smaller after the first death, expected return is the sum of (1) and (2). If payments are to be larger after the first death, expected return is the difference between (1) and (2).

After computing expected return, determine the exclusion ratio under the basic annuity rule: divide the investment in the contract (see Q 8) by the expected return under the contract (as computed above). This same exclusion ratio is applied to payments received before the first death and to payments received by the survivor. However, with respect to an annuity having a starting date after December 31, 1986, the exclusion ratio is applied to payments only until the investment in the contract is recovered. (1)

Example 1. After July 30, 1986, Mr. and Mrs. Brown buy an immediate joint and survivor annuity which will provide monthly payments of $117 ($1,404 a year) for as long as both live, and monthly payments of $78 ($936 a year) to the survivor. As of the annuity starting date he is 65 years old; she is 63. The expected return is computed as follows.
   Joint and survivor multiple from                    26
   Table VI (ages 65,63)

   Portion of expected return (26 x $936)              $24,336.00

   Joint life multiple from Table VIA (ages 65, 63)    15.6

   Difference between annual annuity payment before
   the  first death and annual annuity payment         $468
   to the survivor ($1,404-$936)

   Portion of expected return (15.6 x $468)            $7,300.80
   Expected return.                                    $31,636.80


Assuming that Mr. Brown paid $22,000 for the contract,the exclusion ratio is 69.5% ($22,000 4 $31,636.80). During their joint lives the portion of each monthly payment to be excluded from gross income is $81.31 (69.5% of $117), or $975.72 a year. The portion to be included is $35.69 ($117--$81.31), or $428.28 a year. After the first death, the portion of each monthly payment to be excluded from gross income will be $54.21 (69.5% of $78), or $650.52 a year. And $23.79 of each payment ($78--$54.21), or $285.48 a year, will be included. If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract. Thus, if Mr. Brown lives for 2 3 years, he may exclude $81.31 from each payment for 22 years ((12 X 22) X $81.31 = $21,465.84). In the 23rd year he may exclude $534.16 ($22,000--$21,465.84) or $81.31 from each of the first six payments, but only $46.30 from the seventh. The balance is entirely includable in his income, and on his death, his widow must include the full amount of each payment in income.

Example2. Assume that in the example above, there is a pre-July 1986 investment in the contract of $12,000 and a post-June 1986 investment in the contract of $10,000. Mr. Brown elects to calculate the exclusion percentage for each portion. The pre-July exclusion ratio would be 44.6% ($12,000 4 $26,910--the expected return on the contract determined by using Tables II and IIA and the age and sex of both annuitants). The post-June 1986 exclusion ratio is $10,000 4 $31,636.80 or 31.6%. The amount excludable from each monthly payment while both are alive would be $89.15 (44.6% of $117 plus 31.6% of $117) and the remaining $27.85 would be included in gross income. If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract.

16. How is the tax exempt portion of payments determined for a joint and survivor annuity where the size of the payments will be reduced only if a specified annuitant dies first?

For example, the settlement may provide payments of a stipulated amount for so long as the husband lives, but payments of a reduced amount to his wife if she survives him. But if she dies first, payments to the husband will remain the same. The exclusion ratio for such an annuity is determined in the usual way, by dividing the investment in the contract by the expected return under the contract (see Q 7). However, expected return must be computed in the following manner. (2)

(1) Find the joint and survivor multiple in Table II or VI (whichever is applicable, depending on when the investment in the contract was made, as explained in Appendix A) under the ages and (if applicable) the sexes of the annuitants. Then find the single life expectancy multiple in Table I or V whichever is applicable, under the age and (if applicable) the sex of the first (specified) annuitant. (See Appendix A for Annuity Tables.) Subtract the applicable Table I or Table V multiple from the applicable Table II or Table VI multiple, and multiply the amount payable annually to the second annuitant (the reduced payment) by the difference between the multiples.

(2) Multiply the amount payable annually to the first annuitant by the Table I or Table V multiple (whichever is applicable).

(3) Add the results of (1) and (2). This is the expected return under the contract.

Then proceed in the usual manner: divide the investment in the contract (see Q 8) by the expected return under the contract (as computed above).

Example. After June 30, 1986, a husband and wife purchase a joint and survivor annuity providing payments of $100 a month for his life and, after his death, payments to her of $50 a month for the remainder of her life. As of the annuity starting date he is 70 years old and she is 67.
   Multiple from Table VI (ages 70, 67)                         22

   Multiple from Table V (age 70).                              16

   Difference (multiple applicable to second annuitant).        6

   Portion of expected return, second annuitant (6 x $600)      $3,600

   Portion of expected return, first annuitant (16 x $1,200).   19,200

   Expected return under the contract                           $22,800


Assuming that the investment in the contract is $14,310, the exclusion ratio is 62.8% ($14,310 4 $22,800). While the husband lives, $62.80 of each monthly payment (62.8% of $100) is excluded from gross income, and the remaining $37.20 of each payment must be included in gross income. After the husband's death, the surviving wife will exclude $31.40 of each payment (62.8% of $50), and the remaining $18.60 of each payment will be includable in her gross income. If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract. Thus, if the husband lives 15 years and receives 180 payments, the unrecovered investment in the contract at his death is $3,006 ($14,310-(180 X $62.80)). The surviving wife can exclude $31.40 for 95 payments, and $23 from the 96th payment ($3,006-(95 X 31.40) = $23). She may exclude nothing thereafter.

17. What are the income tax consequences to the surviving annuitant under a joint and survivor annuity?

The survivor continues to exclude from gross income the same percentage of each payment that was excludable before the first annuitant's death. With respect to annuities having a starting date after December 31, 1986, the total exclusion by the first annuitant and the survivor may not exceed the investment in the contract. See Q 13 to Q 16.

In addition, if the value of the survivor annuity was subject to estate tax, the survivor may be entitled to an income tax deduction for part of the tax paid. (1) The deduction in most cases will be small. In a general way, it is computed as follows: The portion of the guaranteed annual payment that will be excluded from the survivor's gross income (under the exclusion ratio) is multiplied by the survivor's life expectancy at date of first annuitant's death. The result is subtracted from the estate tax value of the survivor's annuity. The total income tax deduction allowable is the tax attributable to the remainder of the value of the survivor's annuity. This total deduction is prorated over the survivor's life expectancy as of the date of the first annuitant's death, and a prorated amount is deductible from the survivor's gross income each year. But no further deduction is allowable after the end of the survivor's life expectancy. The foregoing treatment applies only where the primary annuitant died after 1953. (2)

Life Annuity: Refund Beneficiary

(18.) If the annuitant dies before receiving the full amount guaranteed under a refund or period certain life annuity, is the balance of the guaranteed amount taxable income to the refund beneficiary?

The beneficiary will have no taxable income unless the total amount the beneficiary receives when added to amounts that were received tax-free by the annuitant (the excludable portion of the annuity payments) exceeds the investment in the contract. In other words, all amounts received by the beneficiary are exempt from tax until the investment in the contract has been recovered tax-free; thereafter, receipts (if any) are taxable income. For purposes of calculating the unrecovered investment in the contract, the value of the refund or guarantee feature is not subtracted. (1)

The amount received by the beneficiary is considered paid in full discharge of the obligation under the contract in the nature of a refund of consideration and therefore comes under the cost recovery rule regardless of when the contract was entered into or when investments were made in the contract. (2) This rule applies whether the refund is received in one sum or in installments.

However, if the refund or commuted value of remaining installments certain is applied anew under an annuity option for the beneficiary, the payments will be taxed under the annuity rules. A new exclusion ratio will be determined for the beneficiary. (3)

If the refund beneficiary of an annuitant whose annuity starting date is after July 1, 1986 does not recover the balance of the investment in the contract that was not recovered by the annuitant, he may take a deduction for the unrecovered balance. (4) See Q 27.

Any payment made on or after the death of an annuity holder is not subject to the 10% premature distribution tax. See Q 4.

Fixed Period or Fixed Amount Installments

19. How is the excludable portion of an annuity payment under a fixed period or fixed amount option computed?

The basic annuity rule (Q 7) applies: divide the investment in the contract (Q 8) by the expected return under the contract to determine the exclusion ratio for the payments. Apply this ratio to each payment to find the portion that is excludable from gross income. The balance of the payment is includable in gross income.

If payments are for a fixed number of years (without regard to life expectancy), expected return is the guaranteed amount receivable each year multiplied by the fixed number of years. (5)

If payments are for a fixed amount (without regard to life expectancy) expected return is the total guaranteed return. Additional payments made after the guaranteed period (due to excess interest) are fully taxable. (6)

To compute the excludable portion of each payment by a short method, divide the investment in the contract by the number of guaranteed payments. The result will never vary more than slightly from the exact computation.

Example 1. The owner of a maturing $25,000 endowment elects to receive the proceeds in equal annual payments of $2,785 for a fixed 10-year period. Assuming that his investment in the contract is $22,500, he may exclude $2,250 ($22,500 / 10) from gross income each year. He must include the balance of amounts received during the year in gross income.

Example 2. The owner of a maturing $25,000 endowment elects to take the proceeds in monthly payments of $200. The company's rate book shows that payments of $200 are guaranteed for 144 months. Assuming that his investment in the contract is $22,500, he can exclude $156.25 ($22,500 / 144) of each payment from gross income, and must include $43.75 ($200-$156.25). Thus, for a full 12 months' payments, he excludes $1,875 (12 X $156.25) and includes $525 ($2,400-$1,875). Additional payments received after the 144 month period are fully taxable.

If the payee dies before the guaranteed period expires, his beneficiary will exclude the same portion of each payment as originally computed. (1)

A penalty tax may be imposed on any payments received under the contract unless one of the exceptions listed in Q 4 is met.

Annuity Reduced by Partial Withdrawal

20. What are the income tax results when an annuitant makes a partial lump sum withdrawal and takes a reduced annuity for the same term or the same payments for a different term?

Reduced annuity for same term. The nontaxable portion of the lump sum withdrawn is an amount that bears the same ratio to the unrecovered investment in the contract as the reduction in the annuity payment bears to the original payment. The original exclusion ratio will apply to the reduced payments; that is, the same percentage of each payment will be excludable from gross income. (2)

Example. Mr. Gray pays $20,000 for a life annuity paying him $100 a month. At the annuity starting date his life expectancy is 20 years. His total expected return is therefore $24,000 (20 X $1,200), and the exclusion ratio for the payment is 5/6 ($20,000/$24,000). He receives annuity payments for five years (a total of $6,000) and excludes a total of $5,000 ($1,000 a year) from gross income. At the beginning of the next year, Mr. Gray agrees with the insurer to take a reduced annuity of $75 a month and a lump sum cash payment of $4,000. He will continue to exclude 5/6 of each annuity payment from gross income; that is, $62.50 (5/6 of $75). Of the lump sum, he will include $250 in gross income and exclude $3,750, determined as follows:
Investment in the contract.              $20,000

Less amounts previously excluded.             5,000

Unrecovered investment                      $15,000

Ratio of reduction in payment to original   1/4
payment ($25/$100)
Lump sum received                            $4,000

Less Va of unrecovered investment             3,750
(14 of $15,000).
Portion of lump sum taxable.                   $250


Same payments for different term. If the annuity contract was purchased before August 14, 1982 (and no additional investment was made after August 13, 1982 in the contract), the lump sum withdrawn is excludable from gross income as "an amount not received as an annuity" that is received before the annuity starting date. Thus, the lump sum is subtracted from the unrecovered premium cost, and the balance used as the investment in the contract. A new exclusion ratio must be computed for the annuity payments. (3)

However, if the lump sum withdrawn is allocable to investment in an annuity contract made after August 13, 1982, it would appear there may be a taxable withdrawal of interest if the cash surrender value of the contract exceeds investment in the contract (see Q 3, Q 4) and a new exclusion ratio must be computed, using an investment in the contract reduced by any amount of the lump sum excludable as a return of investment.

Annuity Rules: Variable Annuities

21. Is the purchaser of a deferred variable annuity taxed on any income during the accumulation period?

An annuity owner who is a natural person will pay no income tax until he either surrenders the annuity for cash or starts to receive an income under the contract. Amounts received "not as an annuity" prior to the annuity starting date are subject to the rules discussed in Q 3, Q 4.

However, a variable annuity contract will not be treated as an annuity and taxed as explained in this and the following questions (Q 22 to Q 24) unless the underlying investments of the segregated asset account are "adequately diversified," according to regulations prescribed by the IRS. (1) See Q 25.

If the owner of the contract is a person other than a natural person (a corporation, for example) see Q 2.

22. How are the payments under a variable annuity taxed?

Both fixed dollar and variable annuity payments are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser's investment, and the balance is taxable as ordinary income. In the case of a variable annuity however, the excludable portion is not determined by calculating an "exclusion ratio" as it is for a fixed dollar annuity (see Q 7). Since the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid. (2)

If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made, as explained in Appendix A) of the IRS annuity tables (Appendix A). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table VI, whichever is applicable (depending on when the investment in the contract is made--see Appendix A). (The regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death.) The life expectancy multiple need not be adjusted if payments are monthly. But if they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted (see Frequency of Payment Adjustment Table, Appendix A). (3)

The amount so determined may be excluded from gross income each year for as long as the payments are received if the annuity starting date is before January 1, 1987 (even after the annuitant has outlived his life expectancy and recovered his cost tax-free). In the case of an annuity starting date after 1986, the amount determined may be excluded from gross income only until the investment in the contract is recovered. (4)

Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of a year's exclusion. (1)

If the annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period (see Q 23).

23. How is the value of a refund or period-certain guarantee determined under a variable annuity contract?

If the variable annuity settlement provides a refund or period-certain guarantee, the investment in the contract must be reduced by the value of the guarantee before being prorated for the yearly exclusion. (2) The value of such a guarantee in connection with a single life annuity is determined as follows:

Find the refund percentage factor in Table III or Table VII (whichever is applicable, depending on the date the investment in the contract was made, as explained in Appendix A) under the age and (if applicable) sex of the annuitant and the number of years in the guaranteed period (see Tables in Appendix A). Where the settlement provides that proceeds from a given number of units will be paid for a period-certain and life thereafter, we already have the number of years in the guaranteed period (e.g., 10, 15, 20 "years certain"). But if the settlement specifies a guaranteed amount, we divide this guaranteed amount by an amount determined by placing payments received during the first taxable year (to the extent that such payments reduce the guaranteed amount) on an annual basis. (Thus, if monthly payments begin in August, the total amount received in the first taxable year is divided by 5, then multiplied by 12.) The quotient is rounded to the nearest whole number of years, and is used in entering Table III or Table VII, as applicable. The appropriate Table III or Table VII multiple is applied to whichever is smaller: (a) the investment in the contract, or (b) the product of the payments received in the first taxable year, placed on an annual basis, multiplied by the number of years for which payment of the proceeds of a unit or units is guaranteed. The following illustration is taken from the regulations: (3)

Example: Mr. Brown, a 50-year-old male, purchases for $25,000, a contract which provides for variable monthly payments to be paid to him for his life. The contract also provides that if he should die before receiving payments for 15 years, payments shall continue according to the original formula to his estate or beneficiary until payments have been made for that period. Beginning with the month of September, Mr. Brown receives payments which total $450 for the first taxable year of receipt. This amount, placed on an annual basis, is $1,350 ($450 divided by 4 or $112.50; $112.50 multiplied by 12, or $1,350).

If there is no post-June 1986 investment in the contract, the guaranteed amount is considered to be $20,250 ($1,350 X 15), and the multiple from Table III (for male 50, 15 guaranteed years), nine percent, applied to $20,250 (since this amount is less than the investment in the contract), results in a refund adjustment of $1,822.50. The latter amount, subtracted from the investment in the contract of $25,000, results in an adjusted investment in the contract of $23,177.50. If Mr. Brown dies before receiving payments for 15 years and the remaining payments are made to Mr. Green, his beneficiary, Mr. Green shall exclude the entire amount of such payments from his gross income until the amounts so received by Mr. Green, together with the amounts received by Mr. Brown and excludable from Mr. Brown's gross income, equal or exceed $25,000. Any excess and any payments thereafter received by Mr. Green shall be fully includable in gross income.

Assume the total investment in the contract was made after June 30, 1986. The applicable multiple found in Table VII is three percent. When this is applied to the guaranteed amount of $20,250, it results in a refund adjustment of $607.50. The adjusted investment in the contract is $24,392.50 ($25,000-$607.50).

24. If payments from a variable annuity drop below the excludable amount for any year, is the balance of the exclusion lost?

No. If the amount received in any taxable year is less than the excludable amount as originally determined, the annuitant may elect to redetermine the excludable amount in a succeeding taxable year in which he receives another payment. The aggregate loss in exclusions for the prior year (or years) is divided by the number of years remaining in the fixed period or, in the case of a life annuity, by the annuitant's life expectancy computed as of the first day of the first period for which an amount is received as an annuity in the taxable year of election. The amount so determined is added to the originally determined excludable amount. (1)

Example 1: Mr. Brown is a male 65 years old as of his birthday nearest July 1, 1985, the annuity starting date of a contract he purchased for $21,000. There is no investment in the contract after June 30, 1986. The contract provides variable monthly payments for Mr. Brown's life. Since Mr. Brown's life expectancy is 15 years (Table I), he may exclude $1,400 of the annuity payments from his gross income each year ($21,000 4 15). Assume that in each year before 1988, he receives more than $1,400; but in 1988, he receives only $800--$600 less than his allowable exclusion. He may elect, in his return for 1989, to recompute his annual exclusion. Mr. Brown's age, as of his birthday nearest the first period for which he receives an annuity payment in 1989 (the year of election) is 69, and the life expectancy for that age is 12.6. Thus, he may add $47.61 to his previous annual exclusion, and exclude $1,447.61 in 1989 and subsequent years. This additional exclusion is obtained by dividing $600 (the difference between the amount he received in 1988 and his allowable exclusion for that year) by 12.6.

Example 2: Mr. Green purchases a variable annuity contract which provides payments for life. The annuity starting date is June 30, 2009, when Mr. Green is 64 years old. Mr. Green receives a payment of $1,000 on June 30, 2010, but receives no other payment until June 30, 2012. Mr. Green's total investment in the contract is $25,000. Mr. Green's pre-July 1986 investment in the contract is $12,000. Mr. Green may redetermine his excludable amount as above, using the Table V life expectancy. If, instead, he elects to make separate computations for his pre-July 1986 investment and his post June-1986 investment (see Appendix A), his additional excludable amount is determined as follows.
Pre-July 1986 investment in the contract allocable to   $1,589.40
taxable years 2010 and 2011 ($12,000 4 15.1
[multiple from Table I for a male age 64] = $794.70;

Less: portion of total payments allocable to pre-July         480
1986 investment in the contract
actually received as an annuity in 2010 and 2011
($12,000/$25,000 x $1,000)

Difference                                              $1,109.40

Post-June 1986 investment in the contract allocable     $1,280.78
to taxable years 2010 and
2011 ($13,000 4 20.3 [multiple from
Table V for male age 64] = $640.39;
$640.39 x 2 years = $1,280.78

Less portion of total payments allocable to post-July      520
1986 investment in the
contract actually received as an annuity in
2010 and 2011 ($13,000/$25,000 x $1,000)

Difference                                                $760.78


Because the applicable portions of the total payment received in 2010 under the contract ($480 allocable to the pre-July 1986 investment in the contract and $520 allocable to the post-June 1986 investment in the contract) do not exceed the portion of the corresponding investment in the contract allocable to the year ($794.70 preJuly 1986 and $640.39 post-June 1986) the entire amount of each applicable portion is excludable from gross income and Mr. Green may redetermine his excludable amounts as follows:
Divide the amount by which the portion of total payment
actually received allocable to pre-July 1986 investment in
the contract is less than the pre-July 1986 investment in
the contract allocable to 2010 and 2011 ($1,109.40)
by the life expectancy  under Table I for Mr. Green, age 66
(14.4-.5 [frequency multiple]; $1,109.40 4 13.9)               $79.81

Add the amount originally determined with respect to            794.7
pre-July 1986 investment in the contract                      $874.51

Divide the amount by which the portion of total payment        $40.68
actually  received allocable to post-June 1986
investment in the contract  is less than the
post-June 1986 investment in the contract allocable
to 2010 and 2011 ($760.78) by the life expectancy
under Table V for  Mr. Green, age 66 (19.2-.5
[frequency multiple]; $760.78 4 18.7)

Add the amount originally determined with respect to           640.39
post-June  1986 investment in the contract.

Amount excludable with respect to post-June 1986              $681.07
investment.


25. What is a "wraparound" or "investment" annuity? How is the owner taxed prior to the annuity starting date?

"Investment annuity" and "wraparound annuity" are terms for arrangements under which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a custodian or by investment solely in specifically identified assets, such as XY Mutual Fund, held in a segregated account of the insurer. The IRS has ruled that under these arrangements sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company. (1)

However, in some instances the policyholder's degree of control over the investment decisions has been insufficient, so that the IRS considered the insurance company, rather than the policyholder, the owner of the contracts. For example, the Service has ruled that the contract owner of a variable annuity can invest in sub-accounts that invest in mutual funds that are available only through the purchase of variable contracts without losing the variable annuity's tax deferral. (2)

The Service has ruled on whether the "hedge funds" within the sub-accounts of variable annuities and variable life insurance contracts will be treated as owned by the insurance company or the contract owner. Generally, if the hedge funds are available to the general public, the sub-account will be treated as owned by the contract owner and therefore not entitled to tax deferral. However, if the hedge funds are available only through an investment in the variable annuity, tax deferral is available. (3) The Service has also clarified who is considered the "general public." (4)

With the exception of certain contracts grandfathered under Revenue Rulings 77-85 and 81225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in regulations. (5)

Loss

26. Does the surrender or sale of an annuity contract ever result in a deductible loss?

A loss deduction can be claimed only if the loss is incurred in connection with the taxpayer's trade or business or in a transaction entered into for profit. (6) Generally, the purchase of a personal annuity contract is considered a transaction entered into for profit. Consequently, if a taxpayer sustains a loss upon surrender of a refund annuity contract, he may claim a deduction for the loss, regardless of whether he purchased the contract in connection with his trade or business or as a personal investment. The amount of the loss is determined by subtracting the cash surrender value from the taxpayer's "basis" for the contract. His "basis" is gross premium cost less all amounts previously received tax-free under the contract (e.g., any excludable dividends (see Q 3) and the excludable portion of any prior annuity payments). The loss is ordinary loss, not capital loss. (1) But if the taxpayer purchased the contract for purely personal reasons, and not for profit, no loss deduction will be allowed. For example, in one case, the taxpayer purchased annuities on the lives of relatives, giving the relatives ownership of the contracts. Later he acquired the contracts by gift and surrendered them at a loss. The court disallowed a loss deduction on the ground that the contracts were not bought for profit but to provide financial security for the relatives. (2)

Where a loss from an annuity is actually taken by the taxpayer on Form 1040 has generated a great deal of discussion. Some say that the loss should be treated as a miscellaneous itemized deduction that is not subject to the 2% floor on miscellaneous itemized deductions. Others, say it is a miscellaneous itemized deduction subject to the 2% floor. And finally, others take a more aggressive approach and say that the loss can be taken on the front of the Form 1040 on the line labeled "Other gains or (losses)."

Note that in the 2009 edition of IRS Publication 575 (Pension and Annuity Income), the IRS says that a loss under a variable annuity is treated as a miscellaneous itemized deduction subject to the 2% floor. (3)

27. Is a deductible loss sustained under a straight life annuity if the annuitant dies before payments received equal the annuitant's cost?

If the annuitant's annuity starting date is after July 1, 1986, a deduction may be taken on the individual's final income tax return for the unrecovered investment in the contract. (4) Similarly, a refund beneficiary may deduct any unrecovered investment in the contract in excess of the excludable refund. (5) For purposes of determining if the individual has a net operating loss, the deduction is treated as if it were attributable to a trade or business. (6)

If an annuitant's annuity starting date was before July 2, 1986, there is no deductible loss since the annuitant has received all that the contract called for. (7) For example, no loss deduction was allowed where a husband purchased a single premium nonrefundable annuity on the life of his wife, and his wife died before his cost had been recovered. Deduction was disallowed on the ground that the transaction was not entered into for profit. (8)

Disposition Sale or Purchase of a Contract

28. If the owner of an annuity contract sells the contract, what are the income tax consequences to the seller?

Gain is taxed to the seller as ordinary income--not as capital gain. Thus, where deferred annuities were sold shortly before maturity, the gain was held to be ordinary income. (9) According to the decided cases, the amount of taxable gain is determined in the same way as upon surrender of a contract (see Q 33). In other words, gain is determined by subtracting net premium cost (gross premiums less dividends to the extent excludable from income) from the sale price.

However, where an annuity contract is sold after maturity, the cost basis of the contract (for purpose of computing the seller's gain) must be reduced by the aggregate excludable portions of the annuity payments that have been received. But the adjusted cost basis cannot be reduced below zero (for example, where the annuitant has outlived his life expectancy and was able to exclude amounts in excess of his net premium cost). (1) The taxable gain, that is, cannot be greater than the sale price. Where an annuity contract is sold for less than its cost basis, apparently the seller realizes an ordinary loss. (See Q 26.)

If the contract sold is subject to a nonrecourse loan, the transferor's obligation under the loan is discharged and the amount of the loan is considered an amount received on the transfer. (2)

29. How is the purchaser of an annuity contract taxed?

If the purchaser receives lifetime proceeds under the contract, he is taxed in the same way as an original owner would be taxed, but with the following differences. His cost basis is the consideration he paid for the contract, plus any premiums he paid after the purchase, and less any excludable dividends and unrepaid excludable loans received by him after the purchase. If the contract is purchased after payments commence under a life income or installment option, a new exclusion ratio must be determined, based on the purchaser's cost and expected return computed as of the purchaser's annuity starting date. The purchaser's annuity starting date is the beginning of the first period for which the purchaser receives an annuity payment under the contract (see Q 7 to Q 9). (3) If the purchaser of an annuity is a corporation, or other nonnatural person, see Q 2.

Policy Exchanges

30. Does tax liability arise when a policyholder exchanges one annuity contract for another?

The Code provides that the following are nontaxable exchanges: (1) the exchange of a life insurance policy for another life insurance policy or for an endowment or annuity contract; (2) the exchange of an endowment contract for an annuity contract, or for an endowment contract under which payments will begin no later than payments would have begun under the contract exchanged; (3) the exchange of an annuity contract for another annuity contract. (4) These rules do not apply to any exchange having the effect of transferring property to any non-United States person. (5)

For exchanges after 2009, an annuity contract may be exchanged for a qualified long-term care insurance contract. (6)

If an annuity is exchanged for another annuity, the contracts must be payable to the same person or persons. Otherwise, the exchange does not qualify as a tax-free exchange under IRC Section 1035(a). (7) The Code defines an annuity for this purpose as a contract with an insurance company that may be payable during the life of the annuitant only in installments. (8) Despite the singular reference in IRC Section 1035(a)(3) to "an annuity contract for an annuity contract," the Service concluded that one annuity could properly be exchanged under IRC Section 1035 for two annuities, issued by either the same or a different insurance company. (9)

Further, the exchange of two life insurance policies for a single annuity contract has also been considered a proper IRC Section 1035 exchange. (1) The exchange of one annuity for a second annuity with a term life insurance rider attached was afforded income tax-free treatment under IRC Section 1035. (2) A proper IRC Section 1035 exchange also occurred where an annuity holder transferred directly a portion of the funds in one annuity to a second newly-issued annuity. (3) An assignment of an annuity contract for consolidation with a pre-existing annuity contract is a tax-free exchange under section 1035, even though the two annuities were issued by different insurance companies. (4)

The exchange of a life insurance policy, endowment contract, or fixed annuity contract for a variable annuity contract with the same company or a different company qualifies as a tax-free exchange under IRC Section 1035(a). (5) (Although the exchange of a variable annuity for a fixed annuity is not specifically addressed in this ruling, there does not appear to be any evidence that would prohibit such an exchange from qualifying for IRC Section 1035 treatment.) Additionally, the exchange of an annuity contract issued by a domestic insurer for an annuity contract issued by a foreign insurer was considered a permissible IRC Section 1035 exchange. (6)

The Definition of "Exchange"

The distinction between an "exchange" and a surrender and purchase is not always clear. Where an annuity contract of one insurer was assigned, prior to maturity, to another insurer for a new contract of the second insurer, the transaction was considered an "exchange." (7) The "exchange" of an annuity contract received as part of a distribution from a terminated profit-sharing plan for another annuity with similar restrictions as to transferability, spousal consent, minimum distribution, and the incidental benefit rule was granted IRC Section 1035 treatment. (8) Further, the surrender of a non-assignable annuity contract distributed by a pension trust and immediate endorsement of the check by the annuitant to the new insurer in a single integrated transaction under a binding exchange agreement with the new insurer has been privately ruled by IRS an "exchange." (9) On the other hand, where the contract is assignable, IRS has required a direct transfer of funds between insurance companies. (10) However, the Tax Court allowed an exchange where the taxpayer surrendered an annuity contract for cash and then purchased another annuity contract.11 The exchange of nontransferable tax sheltered (12) annuity contracts is discussed in Q 488. The Service has ruled that a taxpayer's receipt of a check issued by an insurance company will be treated as a distribution (and thus, not an exchange), even if the check is endorsed to a second insurance company for the purchase of a second annuity. (13)

The IRS has also ruled privately that a valid exchange did not occur where the taxpayer surrendered one life insurance policy and then placed the funds in a second policy purchased one month earlier.14 In another instance, the Service viewed several transactions as "steps" in one integrated exchange. The taxpayer purchased an annuity contract then later withdrew an amount equal to his basis from the contract, placing the funds in a single premium life insurance policy. Next, he exchanged the annuity for another annuity, treating this part of the transaction as a tax-free exchange under IRC Section 1035. The IRS disagreed, characterizing the events as a single exchange, with the value of the life insurance policy received as taxable boot. (1)

Partial exchanges. As discussed above, the Tax Court, in Conway v. Commissioner, (2) held that a 1035 exchange occurred when the taxpayer transferred a portion of the funds from one annuity to a second newly-issued annuity. The Service later ruled that the proper way to allocate investment in the contract when one annuity is "split up" into two annuities is on a pro rata basis based on the cash surrender value of the annuity before and after the partial exchange. For example, if 60% of an annuity's cash surrender value is transferred to a new annuity, the investment in the contract of the "new" annuity will be 60% of the investment in the contract of the "old" annuity, and the investment in the contract of the "old" annuity will be 40% of what it was before the partial exchange. (3)

In 2008, the Service released a revenue procedure concerning certain tax-free partial exchanges of annuity contracts (under Section 1035 and Section 72(q)). The revenue procedure applies to the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract, regardless of whether the two annuity contracts are issued by the same or different companies.

A transfer will be treated as a tax-free exchange under Section 1035 if either:

(1) no amounts are withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date on which amounts are treated as received as premiums or other consideration paid for the contract received in the exchange (the date of the transfer); or

(2) the taxpayer demonstrates that one of the conditions described by Section 72(q) (i.e., Sections 72(q)(2)(A)--(C), 72(q)(2)(E)--(H), and 72(q)(2)(J)), or any similar life event (such as divorce or loss of employment), occurred between (a) the date of the transfer, and (b) the date of the withdrawal or surrender. Note, however, that this cannot be satisfied based on: (1) a distribution that is part of a series of substantially equal periodic payments (under Section 72(q)(2)(D)); or (2) a distribution under an immediate annuity (under 72(q)(2)(I)).

If the direct transfer of a portion of an annuity contract for a second annuity contract does not qualify as a tax-free exchange, it will be treated as a taxable distribution followed by a payment for the second contract.

The Service will not require aggregation of two annuity contracts that are the subject of a taxfree exchange (under Section 1035 and this guidance) even if both contracts were issued by the same insurance company. (4)

Exchanges Where the Insurer is Under Rehabilitation

The Service will allow a valid exchange where funds come into the contract or policy in a series of transactions if the insurer issuing the contract or policy to be exchanged is subject to a "rehabilitation, conservatorship, or similar state proceeding." (1)

Funds may be transferred in this "serial" manner if: (1) the old policy or contract is issued by an insurer subject to a "rehabilitation, conservatorship, insolvency, or similar state proceeding" at the time of the cash distribution; (2) the policyowner withdraws the full amount of the cash distribution to which he is entitled under the terms of the state proceeding; (3) the exchange would otherwise qualify for IRC Section 1035 treatment; and (4) the policyowner transfers the funds received from the old contract to a single new contract issued by another insurer not later than 60 days after receipt. If the amount transferred is not the full amount to which the policyowner is ultimately entitled, the policyowner must assign his right to any subsequent distributions to the issuer of the new contract for investment in that contract. (2) If a nonqualified annuity contract is exchanged under IRC Section 1035 within the scope of Revenue Ruling 92-43 (i.e., as part of a rehabilitation proceeding), the annuity received will retain the attributes of the annuity for which it was exchanged for purposes of determining when amounts are to be considered invested and for computing the taxability of any withdrawals (see Q 3). (3)

Recognition of Gain

If no cash or other non-like kind property is received in connection with an exchange, any gain will not be recognized. But the cost basis of the new policy will be the same as the cost basis of the old policy (plus any premiums paid and less any excludable dividends received after the exchange).

If cash or other non-like kind property is received in connection with any of the above exchanges, any gain will be recognized to the extent of the cash or other property received. (4) The amount of any policy loan that the other party to the exchange takes property subject to or assumes (reduced by any loan taken subject to or assumed by the first party) is treated as money received on the exchange. (5)

Taxable Exchanges

All other kinds of exchanges are taxable. For example, if a policyholder exchanges an endowment or annuity contract for a whole life policy, gain will be fully taxable to him in the year of exchange. The gain is ordinary income--not capital gain. (6) Apparently the government's position (that these exchanges are taxable) is based on the fact that life insurance death proceeds are exempt from income tax. Consequently, the government views any exchange that increases the possibility of eliminating the tax by extending the period of life insurance protection, or by providing life insurance protection where none existed as a method of tax avoidance.

The amount of taxable gain is determined by subtracting (1) net premium cost (gross premiums less any excludable dividends) from (2) the value of the new policy plus any cash or the fair market value of any other property received in the exchange. The value of the new policy, for this purpose, is not cash surrender value but fair market value. Thus, if the new policy is single-premium or paid-up, its value is replacement cost (the price that a person of the same age and sex as the insured would have to pay for a similar policy with the same company on the date of exchange). (1) If the new policy is premium-paying, apparently its value is its interpolated terminal reserve plus any unearned premium as of the date of exchange (see Q 305). (2)

An exchange where both contracts or policies are issued by the same insurer (i.e., an "in-house" exchange) is not subject to the reporting requirements for IRC Section 1035 exchanges (3) provided that the exchange does not result in a designated distribution and the insurer's records are sufficient to determine the policyholder's basis. (4)

The effect of a tax free exchange of annuity contracts on taxation of amounts received under the replacing contract is discussed in Q 3 and Q 37.

Gift of an Annuity or Endowment Contract

31. Can the owner of an annuity contract avoid income and penalty taxes by assigning the right to receive the payments to another individual while retaining ownership of the contract?

No. It is a basic tax principle that "fruit" is attributed to the "tree" on which it grows. Without the transfer of the underlying contract, a gift or gratuitous assignment of income will not shift the taxability of the income away from the owner of the contract. This applies to income accumulated on the contract before the assignment as well as any accruing after. (5) Thus, withdrawals and annuity payments are taxable to the owner, even if paid to a third party. It would apparently follow that any liability for a premature distribution penalty would be the owner's and would be based on the owner's age, death or disability. Where the owner makes a gift of the underlying contract, see Q 32.

32. What are the income tax results when an unmatured annuity contract is transferred as a gift?

An individual who transfers an annuity contract issued after April 22, 1987, for less than full and adequate consideration is treated as having received as "an amount not received as annuity" (see Q 3) an amount equal to the excess of the cash surrender value of the contract at the time of transfer over the investment in the contract at that time. Thus, the individual realizes in the year of the transfer any gain on the contract allocable to investment in the contract after August 13, 1982. (6) The IRS has ruled privately that the distribution of an annuity contract by a trust to a trust beneficiary will not be treated as an assignment for less than full and adequate consideration since, for purposes of this rule, the trust is not considered to be an individual. (7) This rule does not apply to transfers between spouses (or between former spouses incident to a divorce and pursuant to an instrument executed or modified after July 18, 1984), except that it does apply to a gift of a contract in trust for such a spouse to the extent that gain must be recognized because of any loan to which the contract is subject. See Q 282.

If the cash surrender value of an annuity contract issued prior to April 23, 1987 at the time of gift exceeds the donor's cost basis, and the donee subsequently surrenders the contract, the donor must report as taxable income the "gain" existing at the time of gift. In other words, the donor is taxed on the difference between the premiums he has paid (less any excludable dividends he has received) and the cash surrender value of the contract at the time of gift. The balance of the gain, if any, is taxed to the donee. The proper year for the donor to include the gain in his gross income is the year in which the contract is surrendered by the donee. (1)

Annuity payments under a contract that has been transferred as a gift are taxed under the annuity rules (see Q 7 to Q 24). With respect to gifts of annuities issued after April 22, 1987, the amount of gain, if any, that is included in the transferor's income as a result of the transfer will increase the transferee's investment in the contract. (2) If the contract was issued before April 23, 1987, all premiums paid and excludable dividends received by both donor and donee prior to the commencement of the annuity payments are taken into account in determining the investment in the contract. The annuity starting date and expected return are determined as though no transfer has taken place. (3) However, the IRS has not ruled on whether, if the contract was transferred when the cash surrender value exceeded the donor's cost basis, the donor must include any portion of the payments in his gross income or how such portion would be determined.

Where a gift is conditioned on payment by the donee of the donor's gift tax liability, the Supreme Court has ruled that income is realized by the donor to the extent the gift tax exceeds the donor's basis in the property. (4) The gain is included in the donor's income for the year in which the gift tax is paid by the donee.(5) However, payment of federal or state gift tax by the donee (or agreement to pay such tax) does not result in income to the donor in the case of net gifts made before March 4, 1981. (6)

If the contract transferred is subject to a nonrecourse loan, the transferor's obligation under the loan is discharged and the amount of the loan is treated as an amount received with the result that gain is recognized to the extent the loan exceeds the adjusted basis. (7)

If the gift is to a corporation or other nonnatural person, see Q 2.

Surrender, Redemption, or Maturity

33. What are the income tax results when the owner of an annuity contract takes the lifetime maturity proceeds or cash surrender value in a one sum cash payment?

Amounts received on complete surrender, redemption or maturity are taxed under the cost recovery rule (see Q 3, Q 251). (8) If the maturity proceeds or cash surrender value exceeds the investment in the contract, the excess is taxable income in the year of maturity or surrender even if proceeds are not received until a later tax year. (9)

The investment in the contract is the aggregate premiums or other consideration paid for the annuity minus amounts paid out that were excluded from income. (10) The gain is ordinary income, not capital gain. (11)

34. If a policyholder elects to receive endowment maturity proceeds or cash surrender values under a life income or installment option, is the gain on the policy taxable to him in the year of maturity or surrender?

Ordinarily, a cash basis taxpayer is treated as having constructively received an amount of cash when it first becomes available to him without substantial limitations or restrictions. He must report this amount as taxable income even though he has not actually received it. (1)

When an endowment contract matures, or any type of contract is surrendered, generally a lump sum payment becomes available to the policyholder unless, before the maturity or surrender date, he has elected to postpone receipt of the proceeds under a settlement option. However, such a lump sum will not be considered constructively received in the year of maturity or surrender if, within 60 days after the lump sum becomes available and before receiving any payment in cash, the policyholder exercises an option or agrees with the insurer to take the proceeds as an annuity. (2) The 60-day extension is allowed only for the election of a life income or other installment-type settlement (those considered "annuities" under the income tax law, see Q 1). It does not apply to an election to leave the proceeds on deposit at interest--such an election must be made before maturity or surrender to avoid constructive receipt (see Q 253).

If there is a gain on the contract but the proceeds are not constructively received, the policyholder is not taxed on the gain in the year of maturity or surrender. For the purpose of taxing the annuity payments, however, his investment in the contract (cost) is premium cost--not the maturity or cash surrender value. In effect, then, the policyholder's taxable gain will be spread ratably over the payment period.

If there is a gain on the contract and the proceeds are constructively received (as where the election is made after the 60-day period), the full gain is taxable to the policyholder in the year of constructive receipt as if he had actually received a one-sum cash payment (see Q 266). For the purpose of taxing the annuity payments, his investment in the contract (cost) would then be, not premium cost, but the entire lump sum applied under the settlement option. Although the larger cost would result in a larger excludable portion for the annuity payments, usually it is advisable for the policyholder to avoid being taxed on the entire gain in one year.

Even where the cash surrender value is less than net premium cost, it appears that net premiums may be used as "cost" in determining the exclusion ratio for the annuity payments--provided the cash surrender value is not constructively received in the year of surrender. (3)

35. Is the full gain on a deferred annuity or retirement income contract taxable in the year the contract matures?

If the contract provides for automatic settlement under an annuity option, the lump sum proceeds are not constructively received in the year of maturity (see Q 34). (4) The annuity payments (whether life income or installment) are taxed under the regular annuity rules (see Q 7 to Q 24). In computing the exclusion ratio for the payments, the amount to be used as the investment in the contract is premium cost--not the maturity value (see Q 8). Of course, if the contract owner takes a one-sum settlement at maturity, he must include the gain in gross income for the year in which he receives the payment (see Q 33). For election to leave life insurance proceeds on deposit at interest, see Q 253.

See Q 2 if the deferred annuity contract is owned by a person other than a natural person, such as a corporation.

Death

36. If the annuitant dies before his deferred annuity matures, is the amount payable at his death subject to income tax?

Yes. Generally, an annuity contract provides that if the annuitant dies before the annuity starting date, the beneficiary will be paid as a death benefit the amount of premium paid or the accumulation value of the contract. The gain, if any, is taxable as ordinary income to the beneficiary. The death benefit under an annuity contract does not qualify for tax exemption under IRC Section 101(a) as life insurance proceeds payable by reason of insured's death. Gain is measured by subtracting (1) total gross premiums from (2) the death benefit plus aggregate dividends and any other amounts that have been received under the contract which were excludable from gross income (see Q 3). (1) In addition, the death benefit paid upon the death of the owner/annuitant is income in respect of a decedent (IRD) to the extent that the death benefit amount exceeds the basis in the annuity contract, and may be eligible for a special income tax deduction for the estate tax attributable to the IRD (see Q 827). (2) The IRS has ruled that an assignment of an annuity from a decedent's estate to a charity will not cause the estate, or its beneficiaries, to be taxed on the proceeds of the annuity. (3)

However, the beneficiary will not be taxed on the gain in the year of death if he or she elects, within 60 days after the death benefit is payable, to apply the death benefit under a life income or installment option (see Q 34). (4) The periodic payments will then be taxable to the beneficiary under the regular annuity rules (see Q 7 to Q 19). The exclusion ratio for the contract will be based on the decedent's investment in the contract and the beneficiary's expected return. (5)

The same rules apply to variable annuity contracts purchased after October 20, 1979 and to contributions made after October 20, 1979 to variable annuities issued prior to this date. However, if the owner of a variable annuity contract acquired prior to October 21, 1979 (including any contributions applied to such an annuity contract pursuant to a binding commitment entered into before that date) dies prior to the annuity starting date, the contract acquires a new cost basis. The basis of the contract in the hands of the beneficiary will be the value of the contract at the date of the decedent's death (or the alternate valuation date). If that basis equals the amount received by the beneficiary there will be no income taxable gain and the appreciation in the value of the contract while owned by the decedent will escape income tax entirely. (6) But where a variable annuity contract purchased before October 21, 1979 had been exchanged for another variable annuity contract under IRC Section 1035 after October 20, 1979 and the annuity owner died prior to the annuity starting date, the beneficiary was not entitled to a step-up in basis. (7)

Normally the death benefit is payable at death. If it is not payable until a later time and the annuitant was also the owner of the annuity contract, see Q 37.

37. What distributions are required when the owner of an annuity contract dies before the entire interest in the contract has been distributed?

A contract issued after January 18, 1985, will not be treated as an annuity contract and taxed under IRC Section 72 unless it provides that if any owner dies (1) on or after the annuity starting date and before the entire interest in the contract has been distributed, the remaining portion will be distributed at least as rapidly as under the method of distribution being used as of the date of the owner's death and (2) before the annuity starting date, the entire interest in the contract will be distributed within 5 years after the owner's death.1 In the case of joint owners of a contract issued after April 22, 1987, these distribution requirements are applied at the first death. (2)

Planning Point: Avoid naming a client's revocable living trust (or any trust, as a general rule) as the beneficiary of a non-qualified annuity if any stretch out of taxation of the gain is desired. A surviving spouse of the holder can annuitize over his/her lifetime or treat the annuity as his/her own; if that same spouse is the trustee of the decedent's trust, both opportunities are probably unavailable. John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

For purposes of meeting these requirements, if any portion of the owner's interest is to be distributed to a designated beneficiary over the life of such beneficiary (or over a period not extending beyond the life expectancy of the beneficiary) and such distribution begins within one year after the owner's death, that portion will be treated as distributed on the day such distribution begins.

Example: A (age 50) buys an annuity contract and is the owner. He names his son (age 25) as the annuitant, with annuity payments to begin when his son becomes age 45. The father dies at age 58 and the son (now age 33) becomes the new owner of the contract. Under the provisions, there must be a distribution of the entire interest in the contract within five years of the father's death or there must be annuitization of the contract within one year of such date. (Example taken from the General Explanation of the Deficit Reduction Act of 1984 at p. 660.)

If the designated beneficiary (that is, the person who becomes the new owner) is the surviving spouse of the owner, then the distribution requirements are applied by treating the spouse as the owner. (3)

Amounts distributed under these requirements are taxed under the general rules applicable to amounts distributed under annuity contracts. These rules are intended to prevent protracted deferral of tax on the gain in the contract through successive ownership of the contract.

Where the owner of a contract issued after April 22, 1987, is a corporation or other nonnatural person, the primary annuitant will be treated as the owner of the contract. Primary annuitant means the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract (e.g., the measuring life). (4) For purposes of the distribution requirements, a change in the primary annuitant of such a contract will be treated as the death of the owner. (5) Where the owner is a corporation or other nonnatural person, see also Q 2.

These requirements do not apply to annuities purchased to fund periodic payment of damages on account of personal injuries or sickness. (6) While these requirements do not apply with respect to qualified pension, profit sharing and stock bonus plans, IRC Section 403(b) tax sheltered annuities, and individual retirement annuities, similar distribution requirements do apply (see Q 236, Q 346, Q 499).

Effect of Exchange

According to the report of the conference committee (TRA '84), an annuity contract issued after January 18, 1985, in exchange for one issued earlier will be considered a new contract and subject to the distribution requirements. (1)

Divorce

38. If an individual purchases an annuity contract to meet alimony payments, how are the payments taxed to the recipient? What are the tax results to the purchaser?

If incident to a divorce, an annuity contract payable to the former spouse is transferred or assigned to the former spouse after July 18, 1984 (unless the transfer is pursuant to an instrument in effect on or before such date), legislative history states that he "will be entitled to the usual annuity treatment, including recovery of the transferor's investment in the contract ... notwithstanding that the annuity payments ... qualify as alimony .. .." (2) (If both spouses elected, the same treatment applied to a transfer made after December 31, 1983, and on or before July 18, 1984.)

There is nothing in the Code that directly supports this resolution of the conflict between the rules that "[g]ross income includes amounts received as alimony .. ." (3) and that amounts received as an annuity under an annuity contract are taxable under rules that permit tax free recovery of cost over the payment period. (4) If the recipient of the annuity contract is permitted to recover the purchaser's "investment in the contract," there should be no deduction allowed for the alimony by the purchaser. There is no gain taxable to the purchaser on the transfer. (5)

With respect to annuity contracts transferred before July 19, 1984 or pursuant to instruments in effect before July 19, 1984 (unless the election referred to above applies), payments under the contract to a recipient spouse in discharge of the payor spouse's alimony obligations are fully taxable to the recipient and he cannot recover the payor's investment in the contract tax free. (6) The payor spouse cannot take an income tax deduction for the payments even though they are taxable to the recipient spouse. (7) Where there is no transfer, but the payor spouse purchases an annuity, retaining ownership of the contract and receiving the payments himself, he can recover his investment under the annuity rule. If he then makes periodic alimony payments directly to his former spouse, he can deduct the payments. (8) The recipient spouse, of course, would include the full amount of the alimony payments in gross income. (9)

Charitable Gifts

39. May a charitable contribution deduction be taken for the gift of a maturing annuity or endowment contract?

Yes, subject to the limits on deductions for gifts to charities (see Q 824).

If a policyholder gives an annuity contract that was issued after April 22, 1987, whether in the year it matures or in a year prior to maturity, he is treated as if he received at that time the excess of the cash surrender value at the time of the transfer over his investment in the contract. (1) Thus, he must recognize in the year of the gift his gain on the contract. Consequently, his charitable gift need not be reduced by the amount of ordinary gain he would realize on a sale at the time of the gift. (2)

If a policyholder gives a maturing annuity contract that was issued prior to April 23, 1987 or gives any endowment contract to a charity in the year it matures he must include in gross income the excess of the maturity value over his basis. (3) However, he may take a deduction for the full maturity value (within the limits discussed in Q 824). (4) Where an endowment contract (or annuity contract issued before April 23, 1987) is contributed in years before the year the contract matures, Revenue Ruling 69-102 (above) holds that the donor must include in his income in the year the contract is surrendered or matures the excess of the cash surrender value at the time of the gift over the donor's basis; however, the Code limits his deduction to his cost basis. (5) (The ruling concerned a gift in the year immediately before the contract matured but may not be limited to that year.) This ruling, if accepted at face value, means the donor must include in income amounts given to the charity that are not deductible.

Planning Point: A potential tax trap exists where an annuity issued before April 23, 1987 is given to a charity near the end of the donor's tax year. If the charity surrenders the annuity after the end of the donor's tax year, the donor may not deduct the value of the gift, only the donor's investment in the contract. What's more, the donor will incur income taxation to the extent of the donor's gain in the contract in the year in which the charity takes distributions from or surrenders the annuity. Fred Burkey, CLU, APA, The Union Central Life Insurance Company.

For a gift to a charity in connection with purchase of an annuity from the charitable organization, see Q 43.

Withholding

40. Are amounts received under commercial annuity contracts subject to withholding?

Yes; however, the payee generally may elect not to have anything withheld. Only the amount it is reasonable to believe is includable in income is subject to withholding. Amounts are to be withheld from periodic payments at the same rate as wages. Payments are periodic, even if they are variable, if they are payable over a period of more than a year. If payments are not periodic, 10% of the includable amount is withheld. Payments made to the beneficiary of a deceased payee are subject to withholding under the same rules. (6)

An election out of withholding will be ineffective, generally, if a payee does not furnish his taxpayer identification number (TIN, usually his Social Security number) to the payor or furnishes an incorrect TIN to the payor and the payor is so notified by the IRS. (7)

Payments under qualified pension, profit sharing and stock bonus plans are discussed in Q 449; payments under IRC Section 403(b) tax sheltered annuities are discussed in Q 500 and Q 501; private annuities are discussed in Q 41.

Private Annuity

41. How are payments received under a private annuity taxed?

A private annuity is an unsecured promise of one person (the obligor) to make fixed payments to another person (the annuitant) for life in return for the transfer of property from the annuitant to the obligor. According to a general counsel memorandum, an unsecured promise to make fixed payments until a stated monetary amount is reached or until the annuitant's death, whichever occurs first, will be treated as a private annuity (instead of an installment sale with a contingent price) if the stated monetary amount would not be received by the annuitant before the expiration of his life expectancy (as determined under the appropriate annuity table and as determined at the time of the agreement--see Appendix A). (1) A private annuity is to be distinguished from a commercial annuity issued by a life insurance company and from an annuity payable by an organization (e.g., a charity) that issues annuities "from time to time." For treatment of the latter see Q 43 and Q 44. The typical private annuity involves the transfer of appreciated property (usually a capital asset) from parents or grandparents to one or more children or grandchildren.

Private Annuities Issued After October 18, 2006

The Treasury and IRS have issued proposed regulations that would dramatically alter the tax treatment of private annuities. Under the proposed regulations, the receipt of an annuity contract for property will be treated as the receipt of property in an amount equal to the fair market value of the annuity contract. (2) The fair market value of an annuity contract is determined under the rules of IRC Section 7520. See Q 909. Therefore, all of the gain on the property will be recognized at the time of the exchange. The private annuity's investment in the contract will be the amount paid for the contract. Thus, where the value of the property exchanged and the value of the annuity are the same, the investment in the contract will be fair market value of the property exchanged for the private annuity.

These proposed regulations are intended to be effective for exchanges of property for annuity contracts that occur after October 18, 2006. However, for certain transactions a later effective date for transactions occurring after April 18, 2007 has been proposed. This delayed effective date would be for exchanges where: (1) the issuer of the annuity is an individual; (2) the obligations under the contract are not secured; and (3) the property transferred in the exchange is not sold or otherwise disposed of during the two year period beginning on the date of the exchange. A disposition includes a transfer to a trust or any other entity, even if wholly owned by the transferor.

Private Annuities Issued Before October 19, 2006

The basic rules for taxing the payments received by the annuitant under a private life annuity are set forth in Revenue Ruling 69-74. (3) According to this ruling, the payments must be divided into three elements: (1) a "recovery of basis" element; (2) a "gain element" eligible for capital gain treatment for the period of the annuitant's life expectancy, but taxable as ordinary income thereafter; and (3) an "annuity element" that is taxable as ordinary income.

(1) The portion of each payment that is to be excluded from gross income as a recovery of basis is determined by applying the basic annuity rule (see Q 7). Thus, an exclusion percentage is obtained by dividing the investment in the contract by the expected return under the contract. The investment in the contract in a private annuity situation is the adjusted basis (see Q 816) of the property transferred. However, if the adjusted basis of the property transferred is greater than the present value of the annuity, the annuitant's investment in the contract for purposes of IRC Section 72(b) is the present value of the annuity on the date of the exchange. (1) Expected return and annuity starting date are the same as explained in Q 9 and Q 10. Thus, expected return is obtained by multiplying one year's annuity payments by the appropriate multiple from Table I or Table V of the income tax Annuity Tables (see Appendix A), whichever is applicable depending on when the investment in the contract is made, as explained in Appendix A.

If the annuity starting date is before January 1, 1987, the amount determined above to be excludable from income as a recovery of basis is excluded from all payments received, even if the annuitant outlives his life expectancy. However, if the annuity starting date is after December 31, 1986, then the exclusion percentage is applied only to payments received until the investment in the contract is recovered. Thereafter, the portion excludable under the percentage is included as ordinary income. (2)

(2) The capital gain portion, if any, is determined by dividing the gain by the life expectancy of the annuitant. Gain is the excess of present value of the annuity (it may not be the same as fair market value of the property) over the adjusted basis of the property. The present value of the annuity is obtained from the Estate and Gift Tax Valuation Tables (see Q 909). The life expectancy of the annuitant is obtained from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made (Appendix A). This portion is reportable as capital gain for the period of the annuitant's life expectancy, and thereafter as ordinary income. Recovery of capital gain may not be deferred until the entire investment in the contract has been recovered. (3)

(3) The remaining portion of each payment is ordinary income.

If the fair market value of the property transferred exceeds the present value of the annuity (as determined from the applicable Estate and Gift Tax Valuation Tables), the difference is treated as a gift to the obligor (see Q 705). (4)

Example. Mrs. White is a widow, age 66, with two adult children. She owns a rental property with an adjusted basis of $30,000 and a fair market value of $135,000. On January 1, she transfers this building to her children in exchange for their unsecured promise to pay her $1000 a month ($12,000 a year) for life beginning January 31.

Assume that the valuation table interest rate for January is 5.0%; therefore, the present value of the annuity equals $126,078: $12,000 X 10.2733 (annuity factor) X 1.0227 (annuity adjustment factor). (For an explanation of the valuation table factors, see Appendix D and Example 2 thereunder.) The fair market value of the property exceeds the present value of the annuity by $8,922: $135,000-$126,078. This is a gift by Mrs. White to her children and subject to gift tax. Mrs. White's life expectancy (Table V in Appendix A) is 19.2 years.

(1) Mrs. White will exclude from gross income as a recovery of basis $130, or 13% of each payment (until she recovers $30,000, since her annuity starting date is after December 31, 1986). The 13% exclusion percentage is obtained by dividing $30,000 (investment in the contract) by $230,400 (expected return: 19.2 X $12,000). (See Q 11.)

(2) She will report $417 of each payment as capital gain for 19.2 years. This portion is obtained by dividing her gain of $96,078 (excess of present value of annuity [$126,078] over adjusted basis of the property [$30,000]) by 19.2, her life expectancy ($96,078 / 19.2 = $5,004 a year or $417 a month). After 19.2 years, she will report this $417 as ordinary income.

(3) She will report the balance of each payment, or $453 ($1,000-($130 + $417)) as ordinary income. (Since her annuity starting date is after December 31, 1986, she will also report as ordinary income the portion of each payment no longer excludable as recovery of capital after her investment in the contract has been recovered.)

In Katz v. Commissioner, the Tax Court held that a taxpayer who had exchanged shares of common stock and put options for a private annuity (on February 3, 2000) was entitled to defer recognition of capital gain relating to the transfer until the taxpayer received annuity payments. (1)

According to the Tax Court, Revenue Ruling 69-74 is not applicable if the promise to pay the annuity is secured; securing the promise will cause the entire capital gain on the transfer of the property to be taxable to the annuitant in the year of transfer and the investment in the contract would be the present value of the annuity, but not more than the fair market value of the property transferred. (2) In a private letter ruling a private annuity arrangement was still taxed as such despite the presence of a cost-of-living adjustment applicable to the monthly annuity payments and a minimum payment provision which stated that if the annuitant had not received a specified dollar amount prior to her death, the remaining amount would be paid to her estate. The annuitant also had the option to accelerate the payments and receive a lump sum amount equal to the minimum payment amount less annuity payments previously received. (3)

When a private annuity became worthless the determination that the loss was a capital loss not an ordinary loss was upheld in McIngvale v. Comm. (4)

Whether a transfer to a trust will be treated as a sale in exchange for a private annuity or a transfer in trust with a right to income retained depends on the circumstances in the case. However, properly done, a transfer to a trust will be treated as a private annuity transaction. (5) Purported transfers in trust were held sham transactions in Horstmier v. Comm. (6)

Amounts received under a private annuity contract are not subject to withholding because such amounts are not paid under a "commercial annuity," that is, one issued by a licensed insurance company.

For estate tax implications of a private annuity, see Q 608.

42. What are the tax consequences to the obligor in a private annuity transaction?

The annuity payments made by the obligor are treated as capital expenditures for the acquisition of the property. No interest deduction is allowed with respect to the payments. (7) However, depreciation deductions may be taken if the property is depreciable. The initial basis for depreciation is the present value of the annuity (as determined by the appropriate Estate and Gift Tax Valuation Tables, see Q 909). When actual payments exceed the initial basis, the basis for depreciation is the actual payments made less prior depreciation. (8)

When payments exceed the initial basis, loss is not deductible until the property is sold. (1) If the property is sold after the annuitant's death, the obligor's basis for determining gain or loss is the total of annuity payments made less depreciation taken, if any.

If the property is sold before the annuitant's death, the obligor's basis for gain is the total payments actually made plus the actuarial value, as of the date of sale, of payments to be made in the future. The obligor's basis for loss is the total amount of payments made as of the date of sale. If the selling price is less than the basis for gain but more than the basis for loss, the obligor realizes neither gain nor loss. Adjustment for annuity payments made after the sale may be made by deducting loss or by reporting additional gain. (2)

Charitable Gift Annuity

43. How are payments received under a charitable gift annuity agreement taxed?

A charitable gift annuity agreement is a contractual obligation undertaken by a charity to pay an annuity to an individual in return for an amount transferred by the individual, notwithstanding the fact that the payments might exceed the amount transferred. The contractual obligation is backed by the charity's assets. The typical charitable gift annuity, like the private annuity, can involve the transfer of appreciated property.

The tax consequences of a charitable gift annuity involve (1) an immediate charitable gift, deductible within the limits of IRC Section 170 (see Q 824), (2) income tax on a portion of the annuity payments, and (3) a recovery of principal element, which will be made up of part taxable gain and part excludable adjusted basis if appreciated property is transferred for the annuity. (3)

(1) A charitable contribution is made in the amount by which cash or the fair market value of property transferred to the charity exceeds the present value of the annuity. The American Council on Gift Annuities, a voluntary group sponsored by charitable organizations, recommends uniform annuity rates based on the annuitant's age at the date of the gift. See Table on Uniform Gift Annuity Rates in Appendix A. The uniform annuity rate is applied to the transfer and determines the amount of the annuity paid to the annuitant each year. The present value of a charitable gift annuity issued is determined under Estate and Gift Tax Valuation Tables (see Q 909).

(2) When the annuitant receives annuity payments, a percentage of each payment reflects a return of principal. This percentage (the "exclusion ratio") is determined by the basic annuity rule, that is, by dividing the investment in the contract by the expected return. The investment in the contract in the charitable annuity situation is the lesser of the present value of the annuity or the fair market value of the property transferred to the charity. The expected return is the annual annuity amount multiplied by the years of life expectancy of the donor at the time of the gift (using the applicable income tax Annuity Tables in Appendix A). If the annuity starting date is after December 31, 1986, the return of principal portion is excludable only until the investment in the contract is fully recovered. Thereafter, that portion is included in income as ordinary income. (4)

If, however, the donor has transferred appreciated property to the charity, he has a gain (either capital gain or ordinary gain depending on the property) to the extent the fair market value of the property exceeds his adjusted basis. In this situation, the bargain sale rules apply. Under these rules, proportionate portions of the donor's basis are considered part of the charitable gift and part of the investment in the annuity contract. Thus, his return of principal element of each payment consists of two segments: one represents return of gain which is taxed as capital or ordinary gain; the other represents return of his adjusted basis and is excluded from his income. The portion of the gain that is taxed is the percentage that the investment in the contract bears to the total amount transferred. As long as the annuity is nonassignable, the donor may take the gain into income ratably over his life expectancy. After all the gain is reported, that portion of his annuity payment is excluded from income as well as the return of basis portion, if his annuity starting date was before January 1, 1987. However, if his annuity starting date is after December 31, 1986, the Code provides that amounts are not excludable after the investment in the contract has been recovered. Thus, it appears that once the annuitant has outlived his life expectancy, and recovered his investment in the contract, the entire payment is included in income as ordinary income.

If the donor dies before all of the gain is reported (and he is the sole annuitant), no further gain is reported. If the annuity starting date is after July 1, 1986, the Code provides that if annuity payments cease by reason of the death of the sole annuitant before the investment in the contract has been recovered, the unrecovered investment in the contract may be deducted. (1) See Q 27. Because the unrecovered investment in the contract where appreciated property has been given for the annuity includes the unrecognized gain portion, it is likely the deduction will be limited to the unrecovered basis.

(3) The portion of each payment in excess of the return of principal element is ordinary income.

Example. Ed White is a widower, age 70. He owns securities with an adjusted basis of $6,000 and a fair market value of $10,000. On June 1 he transfers the securities to ABC Charity in exchange for a life annuity, payable in semiannual installments. For purposes of this example, assume that the uniform annuity rate (recommended by the American Council on Gift Annuities as shown in Appendix A) is 5.7%, and thus the annuity payment is $570 per year.

(1) According to the applicable Estate and Gift Tax Valuation Tables (see Q 909), the present value of the annuity for Mr. White is $6,261 (10.9031 [annuity factor] X 1.0074 [annuity adjustment factor for semiannual payments] X $570 [the donor's annual annuity]). (Mr.White elected to use an interest rate for a month as explained in Q 909 with an interest rate that is assumed to be 3.0% for purposes of this example; Appendix D explains the derivation of Valuation Table factors from the interest rate.) The difference between the $10,000 fair market value of the property and the $6,261 value of the annuity, or $3,739, is the charitable contribution portion of the transfer. According to Table V (Appendix A), Mr. White has a life expectancy of 16 years which is adjusted to 15.8 (16-.2) to reflect the frequency of payments (adjustment factor for semiannual payments with 6 months from the annuity starting date to the first payment date is -.2, see introduction to Appendix A).

(2) Of each $305 semiannual payment, 69.5%, or $198 represents return of principal. This percentage is found by dividing $6,261 (the value of the annuity, or investment in the contract) by $9,006 (the expected return: $570 X 15.8). Of this principal amount, $79 is gain ([$6,261--($6,000 X ($6,261 4 $10,000))] 4 [15.8 X 2]). Mr.White must report the $79 as capital gain until all his gain is recognized, or until he dies, if that is earlier. Mr. White will exclude the balance of the principal, $119 ($198-$79), as return of adjusted basis.

(3) The balance of each annuity payment, $87, is the amount that Mr.White must report as ordinary income ($285-$198). After all the gain and investment in the contract has been recovered (approximately 15.8 years), each payment is fully taxable as ordinary income.

The Service has ruled that in the case of a deferred charitable gift annuity, no amount will be considered constructively received until the annuitant begins receiving payments. (2)

The gift portion of the transfer qualifies for a gift tax charitable deduction (see Q 920). With respect to estate taxes, a donor who designates an annuity only for himself will not have any amount relative to the gift annuity transfer included in his gross estate. (3)

In two private letter rulings, the Service approved of "reinsured" charitable gift annuities. (1)

44. What are the tax consequences to the obligor in a charitable annuity transaction?

Property transferred in return for a charitable gift annuity could fall into the general definition of "debt financed property" found in IRC Section 514(b)(1) since the charity acquires the gift subject to the promise to pay the donor an annuity. However, in a private letter ruling, the Service has held that issuing a charitable gift annuity will not result in income from an unrelated trade or business nor will income earned by the charitable organization from investing the charitable gift annuity funds be considered unrelated debt-financed income. (2)

A charity's obligation to pay an annuity will be exempt from the debt financed property rules of IRC Section 514 if the following conditions are met: the annuity must be the sole consideration paid for the property transferred; the present value of the annuity must be less than 90% of the value of the property received in exchange; it must be payable over the lives of one or two annuitants; the contract must not guarantee a minimum number of payments or specify a maximum number of payments; and the contract must not provide for adjustments to the amount of annuity paid based on income earned by the transferred property or any other property. (3)

Issuing charitable gift annuities does not affect the tax exempt status of the organization if the annuity meets the requirements above and a portion of the amount transferred in return for the annuity is allowable as a charitable deduction. (4)

Planning Point: From a practical standpoint, it would appear imprudent for an individual younger than age 45 to attempt to qualify for this exception. A period longer than 15 years may afford too much time in which a "material change" could occur. Also, the taxpayer might forget the importance of continuing to satisfy the conditions for this exception to the penalty tax. Fred Burkey, CLU, APA, The Union Central Life Insurance Company.

Planning Point: Joint ownership of non-qualified annuities creates more problems than it solves--including forced distribution at EITHER owner's death. Avoid joint ownership whenever possible. John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

Planning Point: Although the rules under IRC section 1035 now cover a broader array of annuity exchanges, funds in nonqualified annuities are not freely movable. For example, the IRS does not provide guidance on the transfer of a portion of the funds in one annuity to a second existing annuity. It is not certain that such a transaction is covered under Section 1035 and therefore this type of transaction may not receive tax-free treatment. Fred Burkey, CLU, APA, The Union Central Life Insurance Company.

Planning Point: The owner of a non-qualified annuity should generally be named as the annuitant. Where the owner and annuitant are two different individuals, problems can result--especially if the annuity is annuitant-driven. (All annuities issued since 1986 are "owner driven;" the death benefit is triggered by death of the owner. Some are also annuitant-driven; the death benefit is triggered by death of the annuitant). If the owner and annuitant are the same person, the type does not matter; if they are not, it does. John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

(1.) Treas. Regs. [section] 1.72-1(b), [section] 1.72-2(b).

(2.) IRC Sec. 72(a); Treas. Reg. [section] 1.72-1.

(3.) Rev. Rul. 75-255, 1975-2 CB 22.

(4.) Treas. Reg. [section] 1.72-11.

(1.) IRC Secs. 72, 104, 7702B.

(2.) Let. Rul. 200939018.

(3.) IRC Sec. 72(u).

(1.) IRC Sec. 72(u)(2).

(2.) IRC Sec. 72(u)(3).

(3.) IRC Sec. 130.

(4.) IRC Sec. 72(u)(1).

(5.) H.R. Conf. Rep. No. 99-841 (TRA '86) reprinted in 1986-3 CB Vol. 4 401.

(6.) Let. Rul. 9204014.

(7.) Let. Rul. 199905015.

(8.) Let. Rul. 9752035.

(9.) Let. Rul. 9639057.

(1.) Let. Rul. 199933033.

(2.) Let. Rul. 9009047.

(3.) TRA '86 Sec. 1135(b).

(4.) IRC Sec. 72(e).

(5.) IRC Sec. 72(e)(3).

(6.) IRC Sec. 72(e)(4).

(7.) IRC Sec. 72(e)(5).

(1.) Rev. Rul. 85-159, 1985-2 CB 29.

(2.) IRC Sec. 72(e)(5).

(3.) Let. Rul. 9342053.

(4.) IRC Sec. 72(e)(11).

(5.) IRC Sec. 72(e)(4)(C).

(1.) IRC Sec. 72(e)(5).

(2.) IRC Sec. 72(e)(12).

(3.) Let. Rul. 9442030.

(4.) IRC Sec. 72(e)(12)(A).

(5.) Rev. Rul. 85-159, 1985-2 CB 29.

(6.) IRC Sec. 72(q).

(7.) Rev. Rul. 85-159, 1985-2 CB 29. See also H.R. Conf. Rep. 97-760 (TEFRA '82) reprinted in 1982-2 CB 685-686.

(1.) IRC Sec. 72(u)(4); See Let. Ruls. 200818018 (variable annuity), 200036021.

(2.) Rev. Rul. 92-95, 1992-2 CB 43.

(3.) H.R. Conf. Rep. No. 99-841 (TRA '86) reprinted in 1986-3 CB Vol. 4 403.

(4.) Notice 2004-15, 2004-9 IRB 526.

(1.) Sec. 72(q)(1) prior to amendment by DEFRA 1984, Sec. 222(a).

(2.) DEFRA 1984, Sec. 222(c).

(3.) IRC Sec. 72(e).

(4.) IRC Sec. 72(e)(4)(B).

(5.) IRC Sec. 72(e)(5).

(6.) Rev. Rul. 85-159, 1985-2 CB 29.

(7.) IRC Sec. 72(e)(2)(A).

(1.) IRC Sec. 72(b)(1).

(2.) IRC Sec. 72(b)(2).

(3.) Treas. Reg. [section] 1.72-4(a)(2).

(4.) Treas. Reg. [section] 1.72-4(d)(2).

(1.) IRC Sec. 72(b)(2).

(2.) IRC Sec. 72(c).

(3.) Stoddard v. Comm., TC Memo 1993-400.

(4.) Rev. Rul. 55-349, 1955-1 CB 232; Est. of Wong Wing Non v. Comm., 18 TC 205 (1952).

(5.) 72 TC 183 (1979).

(6.) Est. of Wong Wing Non, supra.

(7.) IRC Sec. 72(e)(4).

(8.) Treas. Reg. [section] 1.72-6.

(9.) Rev. Rul. 65-199, 1965-2 CB 20.

(1.) Treas. Reg. [section] 1.72-6.

(2.) IRC Sec. 72(e)(11).

(3.) IRC Sec. 72(c)(2); Treas. Reg. [section] 1.72-7.

(1.) IRC Sec. 72(c)(3)(B); Treas. Reg. [section] 1.72-5(c).

(2.) IRC Sec. 72(c)(3).

(3.) Treas. Reg. [section] 1.72-9.

(4.) Treas. Regs. [section] [section] 1.72-5(a), 1.72-5(b).

(5.) IRC Sec. 72(c)(4); Treas. Reg. [section] 1.72-4(b).

(1.) IRC Sec. 72(b)(2).

(1.) IRC Sec. 72(b)(2).

(2.) Treas. Reg. [section] 1.72-7(c)(2).

(3.) Treas. Reg. [section] 1.72-7(c)(1).

(1.) IRC Sec. 72(b)(4).

(2.) Treas. Reg. [section] 1.72-7(c)(1)(i).

(3.) Treas. Reg. [section] 1.72-7(c)(4).

(4.) Treas. Reg. [section] 1.72-5(b)(5).

(1.) IRC Sec. 72(b)(2).

(2.) Treas. Reg. [section] 1.72-5(b)(2)

(1.) IRC Sec. 691(d)

(2.) Treas. Reg. [section] 1.691(d)-1.

(1.) IRC Sec. 72(b)(4).

(2.) IRC Sec. 72(e)(5); Treas. Regs. [section] [section] 1.72-11(a), 1.72-11(c).

(3.) IRC Sec. 72(e)(5)(E); Treas. Regs. [section] [section] 1.72-11(c), 1.72-11(e).

(4.) IRC Sec. 72(b)(3).

(5.) Treas. Reg. [section] 1.72-5(c).

(6.) Treas. Reg. [section] 1.72-5(d).

(1.) Treas. Reg. [section] 1.72-11(c)(2), Ex. 4.

(2.) Treas. Reg. [section] 1.72-11(f).

(3.) Treas. Reg. [section] 1.72-11(e).

(1.) IRC Sec. 817(h); Treas. Reg. [section] 1.817-5.

(2.) Treas. Reg. [section] 1.72-2(b)(3).

(3.) Treas. Regs. [section] [section] 1.72-2(b)(3), 1.72-4(d).

(4.) IRC Sec. 72(b)(2).

(1.) Treas. Reg. [section] 1.72-2(b)(3).

(2.) Treas. Reg. [section] 1.72-7(d).

(3.) Treas. Reg. [section] 1.72-7(d)(2).

(1.) Treas. Reg. [section] 1.72-4(d)(3).

(1.) Ciristoffersen v. U.S., 84-2 USTC [paragraph]19990 (8th Cir. 1984), revg 84-1 USTC [paragraph]19216 (N.D. Iowa 1984), cert. denied, 473 U.S. 905 (1985); Rev. Rul. 81-225, 1981-2 CB 12 (as clarified by Rev. Rul. 82-55, 1982-1 CB 12); Rev. Rul. 80-274, 1980-2 CB 27. Rev. Rul. 77-85, 1977-1 CB 12.

(2.) Rev. Rul. 2005-7, 2005-6 IRB 464. See also Rev. Rul. 2003-91, 2003-33 CB 347; Rev. Rul. 82-54 1982-1 CB 11.

(3.) Rev. Rul. 2003-92, 2003-33 CB 350.

(4.) Rev. Rul. 2007-7, 2007-7 IRB 468.

(5.) IRC Sec. 817(h); Treas. Reg. [section] 1.817-5.

(6.) IRC Sec. 165.

(1.) Rev. Rul. 61-201, 1961-2 CB 46; Cohan v. Comm., 39 F.2d 540 (2nd Cir. 1930), aff'g 11 BTA 743.

(2.) Early v. Atkinson, 175 F.2d 118 (4th Cir. 1949).

(3.) IRS Pub. 575 (2009), p. 11.

(4.) IRC Sec. 72(b)(3)(A).

(5.) IRC Sec. 72(b)(3)(B).

(6.) IRC Sec. 72(b)(3)(C).

(7.) Industrial Trust Co. v. Broderick, 94 F.2d 927 (1st Cir. 1938); Rev. Rul. 72-193, 1972-1 CB 58.

(8.) White v. U.S., 19 AFTR 2d 658 (N.D. Tex. 1966).

(9.) First Natl Bank of Kansas City v. Comm., 309 F.2d 587 (8th Cir. 1962); Roffv. Comm., 304 F.2d 450 (3rd Cir. 1962).

(1.) Treas. Reg. [section] 1.1021-1.

(2.) Treas. Reg. [section] 1.1001-2(a).

(3.) Treas. Regs. [section] [section] 1.72-4(b)(2), 1.72-10(a).

(4.) IRC Sec. 1035(a).

(5.) IRC Sec. 1035(c).

(6.) IRC Sec. 1035(a)(3).

(7.) Treas. Reg. [section] 1.1035-1.

(8.) IRC Sec. 1035(b)(2).

(9.) Let. Rul. 199937042.

(1.) Let. Rul. 9708016.

(2.) Let. Rul. 200022003.

(3.) Conway v. Comm., 111 TC 350 (1998), acq. 1999-2 CB xvi.

(4.) Rev. Rul. 2002-75, 2002-2 CB 812.

(5.) Rev. Rul. 72-358, 1972-2 CB 473.

(6.) Let. Rul. 9319024.

(7.) Rev. Rul. 72-358, 1972-2 CB 473.

(8.) Let. Rul. 9233054.

(9.) Let. Ruls. 8526038, 8501012, 8344029, and 8343010.

(10.) See Let. Rul. 8741052. Compare Let. Ruls. 8515063 and 8310033.

(11.) Greene v. Comm., 85 TC 1024 (1985), acq. 1986-2 CB 1.

(12.) IRC Section 403(b).

(13.) Rev. Rul. 2007-24, 2007-21 IRB 1282.

(14.) Let. Rul. 8810010.

(1.) TAM 8905004. See also Let. Rul. 9141025.

(2.) 111 TC 350 (1998), acq. 1999-2 CB xvi.

(3.) Rev. Rul. 2003-76, 2003-33 CB 355.

(4.) Rev. Proc. 2008-24, 2008-13 IRB 684, superseding, Notice 2003-51, 2003-33 CB 361.

(1.) Rev. Rul. 92-43, 1992-1 CB 288.

(2.) Rev. Proc. 92-44, 1992-1 CB 875, as modified by Rev. Proc. 92-44A, 1992-1 CB 876.

(3.) Let. Rul. 9442030.

(4.) Treas. Reg. [section] 1.1031(b)-1(a).

(5.) Treas. Reg. [section] 1.1031(b)-1(c).

(6.) Treas. Reg. [section] 1.1035-1; Rev. Rul. 54-264, 1954-2 CB 57; Barrett v. Comm., 16 AFTR2d 5380 (1st Cir. 1965) affg42 TC 993.

(1.) Parsons v. Comm., 16 TC 256 (1951); Barrett, supra; Rev. Rul. 54-264, supra.

(2.) See Rev. Rul. 59-195, 1959-1 CB 18.

(3.) See IRC Sec. 6047(d).

(4.) Rev. Proc. 92-26, 1992-1 CB 744.

(5.) See Helvering v. Eubank, 311 U.S. 112 (1940); Lucas v. Earl, 281 U.S. 111 (1930).

(6.) IRC Sec. 72(e)(4)(C).

(7.) Let. Ruls. 9204010, 9204014.

(1.) Rev. Rul. 69-102, 1969-1 CB 32.

(2.) IRC Sec. 72(e)(4)(C)(iii).

(3.) Treas. Reg. [section] 1.72-10(b).

(4.) Diedrich v. Comm., 82-1 USTC [paragraph] 9419 (1982).

(5.) Weeden v. Comm., 82-2 USTC [paragraph] 9556 (9th Cir. 1982).

(6.) TRA '84, Sec. 1026.

(7.) Treas. Reg. [section] 1.1001-2(a).

(8.) IRC Sec. 72(e)(5)(E).

(9.) Kappel v. U.S., 34 AFTR 2d 74-5025 (W.D. Pa. 1974).

(10.) IRC Sec. 72(e)(6).

(11.) IRC Sec. 72(e); Treas. Reg. [section] 1.72-11(d); Bodine v. Comm., 103 F.2d 982 (3rd Cir. 1939); Cobbs v. Comm., 39 BTA 642 (1939).

(1.) Treas. Reg. [section] 1.451-2.

(2.) IRC Sec. 72(h); Treas. Reg. [section] 1.72-12.

(3.) IRC Sec. 72(c)(1); Treas. Reg. [section] 1.72-6(a)(1).

(4.) IRC Sec. 72(h); Treas. Reg. [section] 1.72-12.

(1.) IRC Sec. 72(e)(5)(E); Treas. Reg. [section] 1.72-11(c).

(2.) Rev. Rul. 2005-30, 2005-20 IRB 1015.

(3.) Let. Rul. 200618023.

(4.) IRC Sec. 72(h).

(5.) Treas. Regs. [section] [section] 1.72-11(a), 1.72-11(e).

(6.) Rev. Rul. 79-335, 1979-2 CB 292.

(7.) TAM 9346002; Let. Rul. 9245035.

(1.) IRC Sec. 72(s)(1).

(2.) TRA '86, Sec. 1826.

(3.) IRC Sec. 72(s)(3).

(4.) IRC Sec. 72(s)(6).

(5.) IRC Sec. 72(s)(7).

(6.) IRC Sec. 72(s)(5)(D).

(1.) H.R. Conf. Rep. No. 98-861 (TRA '84) reprinted in 1984-3 CB Vol. 2 331-332.

(2.) General Explanation of the Deficit Reduction Act of 1984, at p. 711.

(3.) IRC Sec. 71(a).

(4.) IRC Sec. 72.

(5.) IRC Sec. 1041.

(6.) IRC Sec. 72(k), as then in effect; Treas. Reg. [section] 1.72-14(b); Treas. Reg. [section] 1.71-1(c)(2).

(7.) IRC Sec. 71(d), as then in effect; IRC Sec. 215, as then in effect.

(8.) IRC Sec. 72; IRC Sec. 215.

(9.) IRC Sec. 71.

(1.) IRC Sec. 72(e)(4)(C).

(2.) Treas. Reg. [section] 1.170A-4(a).

(3.) Friedman v. Comm., 15 AFTR 2d 1174 (6th Cir. 1965); Rev. Rul. 69-102, 1969-1 CB 32.

(4.) Treas. Reg. [section] 1.170A-4(a).

(5.) IRC Sec. 170(e)(1)(A).

(6.) IRC Secs. 3405(a), 3405(b); Temp. Treas. Reg. [section] 35.3405-1T (A-9, A-10, A-12, A-17, F-19 through 24).

(7.) IRC Sec. 3405(e)(12).

(1.) GCM 39503 (5-7-86).

(2.) Prop. Treas. Reg. [section] 1.1001-1(j).

(3.) 1969-1 CB 43.

(1.) LaFargue v. Comm., 86-2 USTC [paragraph] 9715 (9th Cir. 1986), aff'g,TC Memo 1985-90; Benson v. Comm., 80 TC 789 (1983).

(2.) IRC Sec. 72(b)(2).

(3.) Garvey, Inc. v. U.S., 83-1 USTC [paragraph] 9163 (U.S. Cl. Ct. 1983), aff'd, 84-1 USTC [paragraph] 9214 (Fed. Cir. 1984), cert. denied.

(4.) Benson v. Comm., supra; LaFargue v. Comm., supra.

(1.) Katz v. Comm., TC Memo 2008-269, citing Rev. Rul. 69-74, 1969-1 CB 43.

(2.) Est. of Bell v. Comm., 60 TC 469 (1973); 212 Corp. v. Comm., 70 TC 788 (1978).

(3.) Let. Rul. 9009064.

(4.) 936 F.2d 833 (5th Cir. 1991) affgTC Memo 1990-340.

(5.) See Est. of Fabric v. Comm., 83 TC 932 (1984); Stern v. Comm., 84-2 USTC [paragraph] 9949 (9th Cir. 1984); LaFargue v. Comm., 50 AFTR 2d 82-5944 (9th Cir. 1982) (followed by the Tax Court in Benson v. Comm., above, because an appeal would go to the Ninth Circuit).

(6.) TC Memo 1983-409.

(7.) Garvey, Inc. v. U.S., 83-1 USTC [paragraph] 9163 (U.S. Cl. Ct. 1983), affd 84-1 USTC [paragraph] 9214 (Fed Cir.), cert. den., 469 U.S. 823 (1984); Bell v. Comm., 76 TC 232 (1981).

(8.) Rev. Rul. 55-119, 1955-1 CB 352.

(1.) Perkins v. U.S., 83-1 USTC [paragraph] 9250 (9th Cir. 1983).

(2.) Rev. Rul. 55-119, supra.

(3.) See Treas. Reg. [section] 1.1011-2(c) Ex. 8.

(4.) IRC Sec. 72(b)(2).

(1.) IRC Sec. 72(b)(3).

(2.) Let. Rul. 200742010.

(3.) See Rev. Rul. 80-281, 1980-2 CB 282; Let. Rul. 8045010. Also, see IRC Sec. 2522(a) and IRC Sec. 2503(a).

(1.) See Let. Ruls. 200847014, 200857023.

(2.) Let. Rul. 200449033.

(3.) IRC Sec. 514(c)(5).

(4.) IRC Sec. 501(m).
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Title Annotation:FEDERAL INCOME TAX ON INSURANCE AND EMPLOYEE BENEFITS
Publication:Tax Facts on Insurance and Employee Benefits
Date:Jan 1, 2010
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