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Partial exchange of annuity contract is nontaxable.

In Conway 111 TC No. 20 (1998), the Tax Court held that a partial exchange of an existing annuity contract for a new annuity contract is a nontaxable exchange under Sec. 1035. This decision rejects the IRS's long-standing position that partial exchanges of an annuity contract are not contemplated under Sec. 1035(a)(3).

In Conway, the taxpayer purchased a deferred annuity contract from Fortis Benefits Life Insurance Company in 1992 for $195,643. In 1994, the taxpayer instructed Fortis to withdraw $119,000 of her investment and transfer the funds to Equitable Life Insurance Company for the purchase of a new annuity contract. Fortis reduced the taxpayer's annuity account value by $119,000, withheld $10,000 as a surrender charge and remitted $109,000 directly to Equitable Life. The terms and provisions of the Fortis and the Equitable annuity contracts were substantially equivalent. The taxpayer's express intention in purchasing the new contract was to qualify the transfer of the funds between the two contracts (from the Fortis contract to the Equitable contract) as tax-free under Sec. 1035.

For 1994, the taxpayer treated the exchange as nontaxable under Sec. 1035, despite receiving a Form 1099-R, Distributions From Pensions,Annuities, Retirement or Profit-sharing Plans, IRA's, Insurance Contracts, etc., from Fortis reporting $30,535 of taxable income. (This amount represented the accumulated income on the Fortis annuity contract which, under the "income first" rule of Sec. 72(e)(2)(B), is included in gross income when there is a withdrawal or partial surrender under a deferred annuity contract.) On audit, the Service asserted that the exchange was a taxable event, because the entire Fortis annuity contract was not replaced by the Equitable annuity contract. Accordingly, the IRS made a $30,535 adjustment to the taxpayer's income and further asserted that she was subject to the 10% excise tax on premature dispositions imposed by Sec. 72(q).

While the Service has long maintained that Sec. 1035 "contemplates the contemporaneous exchange of the entire old contract and simultaneous funding of a single, new contract" (see, e.g., Letter Ruling 8741052), the Tax Court concluded that:

Neither Sec. 1035 nor the regulations condition nonrecognition treatment upon the exchange of an entire annuity contract. Respondent cites no authority to support respondent's position that nonrecognition treatment under Sec. 1035 is limited to exchanges involving replacement of entire annuity contracts. Neither the statute nor the regulations contain[s] any such requirement, either expressly or by any necessary implication.

The court then stated that Sec. 1035 was enacted to provide nonrecognition treatment for taxpayers who have "merely exchanged" annuity contracts and "have not actually realized gain." Finding that the taxpayer was in "essentially the same position after the exchange as she was before the exchange, and the same funds are still invested in annuity contracts (less the surrender fee)," the court held that the partial exchange was a valid Sec. 1035 exchange, with no gain (and no taxable income) realized by the taxpayer.

The Service is concerned that the separation of an annuity contract into two annuity contracts in a tax-free Sec. 1035 exchange blunts the effect of the income first rule in Sec. 72(e)(2)(B). Under the Sec. 1031(d) basis carryover rules, the partial exchange at issue in Conway shifted perhaps more than half of the deferred income under the Fortis contract into the Equitable contract. Although the Tax Court felt that the taxpayer was in essentially the same position before and after the exchange, she actually was in a potentially more favorable tax position after the exchange, because a subsequent withdrawal or partial surrender for cash under one of the contracts would take into account only the portion of the accumulated income attributable to that single contract rather than the entire income accumulated under the original contract prior to its division. If the partial exchange had not been made, a withdrawal by the taxpayer of $30,535 from the original contract would have been entirely taxable under the Sec. 72(e)(2)(B) income first rule. However, after the exchange, she could have made an identical cash withdrawal from one of the deferred annuity contracts and recognized only that contract's allocable share of deferred income, with the balance of the withdrawal treated as a return of basis in the contract.

Congress recognized the possibility that taxpayers could partially evade the income first rule by establishing a number of different deferred annuity contracts. Accordingly, Sec. 72(e)(11) provides an anti-abuse rule stating that, for purposes of determining the amount includible in gross income under Sec. 72(e), all annuity contracts issued by the same company to the same policyholder during any calendar year shall be treated as one annuity contract. Obviously, it is not too difficult to circumvent this anti-abuse rule (e.g., purchase annuity contracts from two different insurers or from the same insurer in two different calendar years), and it could be argued that the taxpayer in the Conway case wound up in the same position from a tax standpoint as if she had originally bought deferred annuity contracts from both Fortis and Equitable. However, the Service clearly takes a different view and can be expected to continue to contest this issue.

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Author:Decredico, David
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jun 1, 1999
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