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Direct Transfer of Some Annuity Funds into Another Annuity Is Nontaxable.

In 1994, a taxpayer purchased an annuity contract for $195,643 from insurance company A. Payments under the contract would begin February 4, 2029. Later that year, the taxpayer asked company A to withdraw $119,000 from the annuity contract and to issue a check in favor of, and to directly transfer the funds to, insurance company B. The funds were to be used to purchase a new annuity contract from company B. Company A complied with the taxpayer's request, and retained $10,000 from the $119,000 as a "surrender charge." Upon receipt of the check from company A for $109,000, company B opened an annuity contract for the taxpayer with a principal amount invested of $109,000. The terms and provisions of the company B annuity were substantially similar to those of the company A annuity. The taxpayer's application to company B expressly requested that the transfer of funds and purchase of another annuity were to be treated as a Section 1035 exchange. The IRS claimed it was not a Section 1035 exchange because the entir e company A annuity was not replaced by the company B annuity. The taxpayer argued that it was a nontaxable exchange because: 1) company A did not distribute any of the funds to her personally, but to company B instead, and 2) she gave up a portion of her company A annuity solely in exchange for the company B annuity.

The Tax Court found that the direct transfer of a portion of the funds invested in the company A annuity contract into the company B annuity contract qualifies as a nontaxable exchange under Section 1035. The court found that neither Section 1035 nor the regulations require the exchange of an entire annuity contract for nonrecognition treatment. The legislative history of the section states that it was enacted to provide nonrecognition treatment for taxpayers "who merely exchanged one (annuity contract) ... for another better suited to their needs and who have not actually realized gain." The court concluded that because 1) the taxpayer was in essentially the same position after the exchange as she was before, 2) the funds were still in annuity contracts, and 3) the taxpayer had not received use or benefit from the funds, the transaction qualifies as a nontaxable exchange.

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Publication:CPA Client Bulletin
Date:Oct 1, 1999
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