New IRS Guidance Provides Benefits to Partial 1035 Exchanges of Non-Qualified Annuity Contracts
1/ Part One: New IRS Guidance
As you know, Section 1035 of the Internal Revenue Code allows taxpayers to exchange one non-qualified annuity contract for another without having to pay tax on the gain of the original contract. If the provisions of Section 1035 are not followed, the transaction is treated as a surrender of the original contract (with tax due on any gain) followed by a purchase of a new contract.
Section 1035 is important because it provides policyholders the opportunity to upgrade their annuity contract if their existing contract is no longer competitive by exchanging it for a new one. But what if a client wants to retain a portion of the funds in the existing contract and exchange the balance for a new contract. This is referred to as a partial exchange, and up until 1999, the IRS viewed this as a transaction that did not qualify under Section 1035. Consequently, it was treated as a surrender with tax due on any gain followed by a purchase of a new contract.
The IRS’s position changed for the better in 1999 when it announced agreement with a tax court case (Conway v. Commissioner) that recognized partial exchanges as qualifying for tax deferred treatment under Section 1035.
So why would someone want to make a partial exchange? Partial exchanges can be beneficial in situations where a policyholder wants to enter into an exchange to take advantage of higher interest rates, but doesn’t want to subject all of their funds to new surrender charges. For example, Client A purchased a non-qualified annuity with $100,000 that has now grown to $200,000 (gain of $100,000). Client A wants to exchange $150,000 into a new contract paying a more competitive rate, but wants to leave $50,000 in the existing contract to serve as an emergency fund since those funds are no longer subject to surrender charge.
2/ Part Two: A More Favorable Tax Treatment
So far, so good. We know now that this type of partial exchange can qualify for tax deferred treatment under Section 1035. But the story gets even better. Because of the way the cost basis is allocated between the two contracts, it is now possible for withdrawals that occur after the partial exchange to receive more favorable tax treatment than they would have without the partial exchange.
To appreciate this, it’s important to understand how the cost basis is allocated between the two contracts. Remember, the cost basis is used to calculate taxable gain on a distribution. Fortunately the allocation is straightforward. The cost basis is allocated proportionately based on the values transferred and the values retained. In our example, the cost basis of $100,000 is split between the old contract (50,000/200,000 or 25%) and the new contract (150,000/200,000 or 75%). Therefore, the cost basis in the old contract is $25,000 ($100,000 x 25%) and the cost basis in the new contract is $75,000 ($100,000 x 75%).
Now that we have allocated our basis between the two contracts, let’s look at how a withdrawal that occurs after the partial exchange is taxed. Suppose Client A after completing the partial exchange, surrenders his original contract and receives $50,000.
Is his taxable gain:
a. $25,000. The difference between the amount received and the allocated cost basis.
b. $50,000. The full amount received in the surrender.
c. $100,000. The full amount of gain in the original contract.
So what is the taxable gain?
The answer of course is that it depends. But at least the IRS recently issued more specific guidance in Revenue Procedure 2008-24 that helps with the answer. Let’s look at each answer.
a. $25,000. This answer is correct provided the withdrawal (from either contract) occurs more than 12 months after the date of the partial exchange. There is also an exception for withdrawals that occur during the 12 month period if the taxpayer can demonstrate a “life changing” event has occurred between the date of the transfer and the date of the withdrawal. Obviously, it would be better to rely on the more objective 12 month test.
b. $50,000. Incorrect, although this would be the answer if Client A had never done the partial exchange and simply made a withdrawal of $50,000 from the original contract. In that case, the full $50,000 would have been taxable. This is because the annuity rules treat withdrawals as taxable to the extent of gain in the policy (remember the gain in the original contract is $100,000).
c. $100,000. Unfortunately this answer can also be correct. If the withdrawal occurs during the 12 month period following the transfer (and you don’t satisfy the life changing event test), then the partial exchange does not qualify for tax deferred treatment under Section 1035. The IRS treats it as a surrender of $150,000 followed by the purchase of a new contract. The full amount of gain ($100,000) would be taxable.
In summary, partial exchanges of non-qualified contracts can not only offer your clients the opportunity to enhance their crediting rates, but also (if the rules are followed), the opportunity for more favorable tax treatment on subsequent withdrawals.
Before taking any action, always check with the companies involved to make sure they are prepared to administer the contracts correctly. If they are unaware of the change in rules, refer them to Revenue Procedure 2008-24 (see pages 20 & 21).
One should always consult with a tax professional. The information available on this website is not intended to constitute and should not be considered as legal or tax advice, nor is it intended to substitute for obtaining legal or tax advice from competent, independent, legal or tax professionals.