IRS provides guidance about partial 1035 exchanges (Revenue Procedure 2008-24)
Under Section 1035 of the IRC, annuity owners may exchange one annuity contract for another annuity contract and the exchange may qualify as a tax-free exchange. The IRS recently issued Revenue Procedure 2008-24, which alters the subsequent tax treatment of the two annuity contracts (the original contract and the new contract) if the exchange involved is not a full exchange of the original contract. In other words, if all the proceeds in the original contract are not exchanged into one or more acceptable contracts, then this "partial" exchange may not be tax-free under Section 1035.
New Ruling from the IRS
Revenue Procedure 2008-24 provides that if amounts are withdrawn or surrendered from either contract for a 12 month period beginning on the date the exchange proceeds are received by the recipient company, the partial exchange will be retroactively disqualified unless one of the following events occurs after the exchange and prior to the withdrawal, annuitization, change of ownership or surrender: (Note- When there is more than one owner on the contract, one of the following exceptions must apply to each owner. However, the exception does not have to be the same for each owner.)
Owner reaches age 59 ½
Owner's death (death claim paperwork)
Owner's disability (with doctor's statement)
Finalization of owner's divorce (copy of divorce decree will be required)
Owner's loss of employment
The amount withdrawn is allocable to investment in the contract before August 14, 1982 (this investment, referred to as pre-TEFRA cost basis, carries over on a 1035 exchange)
The distribution is from a qualified funding asset within the meaning of Code section 130(d) (think structured settlement annuity)
Other “similar life event”
Please note that amounts subject to pre-TEFRA cost basis or from qualified funding assets are not “events” that can “occur” after a particular date. However, the other listed events must occur after the partial exchange in order to avoid disqualifying it. For example, if a contract owner completes a partial 1035 exchange after he or she has reached 59 ½ and then takes a withdrawal from one of the annuity contracts within a year of the exchange, the exchange will be disqualified unless one of the other events has occurred after the exchange or exceptions number 6 or 7 above apply.
Additionally, the IRS has provided no guidance explaining what constitutes a “similar life event.”
This ruling applies to partial 1035 exchanges that are completed on or after June 30, 2008.
Effect of Violating the New Rules
If the partial exchange is disqualified, the amount originally exchanged from the source contract is subject to taxation as a withdrawal from the source contract. That amount would be taxable to the extent of any gain in the source contract, and would generally be subject to the 10% additional tax penalty unless the contractowner were 59½. Both the gain calculation and the contractowner’s age would be determined as of the date the funds were exchanged out of the source contract, not the later date when the 1035 exchange is voided. Tax consequences of the exchange being voided include:
The exchange will be treated as a distribution from Annuity “A”, taxable to the extent of gain in Annuity “A” on the date of the exchange.
The money received by Annuity “B” in the exchange will be treated as regular premium.
The cost bases in both contracts will have to be adjusted to account for the different treatment.
Additional tax reporting will be triggered for one or both companies.
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