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Take Care With Section 1035 Exchanges

We take a closer look at exchanges involving multiple annuity contracts, partial exchanges, and suitability issues.

Judith A. Hasenauer and William E. Hasenauer, 07/05/2013

Co-authored by William E. Hasenauer, JD

In this last installment on Section 1035 exchanges, we are going to address exchanges involving multiple annuity contracts, exchanges of only a part of an annuity contract (“partial exchanges”), and suitability issues related to Section 1035 exchanges of annuity contracts.

The actual language of Code Section 1035 refers to the exchange of an "annuity contract for an annuity contract," seemingly expressing the intent that an exchange should only involve one annuity for another. However, in a number of private letter rulings, the IRS has recognized tax-free exchanges involving multiple contracts including the exchange of two contracts for one contract and the exchange of one contract for two new contracts.

Before entering into a transaction involving one contract being exchanged for two contracts, consideration should be given to the potential application and effect of the annuity aggregation rules for any withdrawals, further exchanges, or annuitizations under the new contracts. Properly structuring a multiple contract exchange can avoid adverse tax consequences.

Historically, the IRS had taken the position that in order for an exchange to be tax-free under Section 1035, the original annuity contract must be exchanged in its entirety for the new contract. However, following a Tax Court case that allowed a tax-free partial exchange, the IRS issued a series of rulings providing guidance as to the appropriate structure and tax treatment of such exchanges.

In a partial exchange, the contract owner transfers a portion of the contract value of the original annuity contract to the issuer of the new contract. As in a regular 1035 exchange, it is imperative that the transferred value be sent directly to the new company and not be sent to the contract owner. The IRS guidance provides that the original contract cost basis is to be allocated proportionately between the original contract and the new contract based on the percentage of contract value left in the original contract and the percentage of contract value transferred to the new contract.

Under the rules applicable to tax-free partial exchanges, the contract owner may not surrender or withdraw from either annuity contract involved in the exchange within 180 days of the date the exchange. This restriction does not apply to distributions resulting from a partial annuitization under Section 72 for a period of 10 years or more, or over one or more lives.

Furthermore, the contracts involved in the partial exchange will not be required to be aggregated (treated as one contract) for purposes of the tax treatment of distributions, even if the annuity contracts are issued by the same insurance company. In the event there is a withdrawal or surrender from either of the contracts within 180 days of the date of the exchange (other than a permitted partial annuitization), the IRS has stated that it will apply general tax principles to determine the treatment of the transfer. Obviously, it is important that a contract owner be aware of these issues and the potential tax consequences before entering into a partial exchange transaction.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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