Annuity Swap Is Tax-Free
The Service has ruled that the exchange of one annuity contract for two
others will qualify as a tax-free exchange under section 1035.
Document Type: IRS Letter Rulings
Tax Analysts Document Number: Doc 2002-24027 (6 original pages) [PDF]
Tax Analysts Electronic Citation: 2002 TNT 208-73
Citations: LTR 200243047 (
=============== SUMMARY ===============
The Service has ruled that the exchange of one annuity contract for two others
will qualify as a tax-free exchange under section 1035.
The taxpayer owns a deferred annuity contract and will exchange it for two
deferred annuity contracts offered by the same company. The two annuities will
represent a single aggregate investment, and there will be a monthly transfer
of amounts between the annuities.
The Service ruled that the exchange will qualify as a section 1035 tax-free
exchange, and that the two annuity contracts will be treated as one for
purposes of section 72. Further, the transfer of funds between the annuities
will not be treated as a taxable distribution, the Service said.
=============== FULL TEXT ===============
Index Number: 72.00-00, 1035.03-01
Release Date:
Date:
Refer Reply to:
CC:FIP:4 PLRs118246-02 & 118244-02
LEGEND:
Company A = * * *
Policyholder = * * *
Policy A = * * *
Annuity = * * *
Policy B = * * *
Policy C = * * *
Date A = * * *
State A = * * *
Number C = * * *
Dear * * * :
[1] This is in reply to a letter dated Date A requesting rulings, on behalf
of Company A and Policyholder, concerning the federal income tax treatment
under § 72 and § 1035 of the Internal Revenue Code and the regulations thereunder
of the exchange of one annuity contract for two annuity contracts.
FACTS
[2] Company A is a stock life insurance company, as defined in section
816(a) and is subject to taxation under Part I of Subchapter L of the Code.
Company A is organized and operated under the laws of State A and is licensed
to engage in the insurance business in Number C states.
[3] Policyholder will exchange Policy A for Policy B and Policy C in a
single transaction with Company A. All three policies are deferred annuity
contracts. Company A and Policyholder represent that Policy A, Policy B and
Policy C qualify as annuity contracts under §§ 72(s) and 1035(b)(2). Upon the
exchange, part of the amount transferred will be applied to the first scheduled
payment of Policy B and the balance will be applied to Policy C. The exchange
of Policy A for Policy B and Policy C will not involve a change in the insured.
[4] Policy B is specifically aimed at providing retirement income. Policy B
will offer a Guaranteed Minimum Income payment feature, under which a specified
level of monthly annuity payments beginning at the contract's Annuity
Commencement Date will be guaranteed by Company A upon issuance regardless of
the investment performance of the assets supporting Annuity, provided certain
conditions are met. The Guaranteed Minimum Income payments will apply only to
Policy B. The Guaranteed Minimum Income payments will be guaranteed for the
greater of the annuitant's life or a minimum period certain of ten years. The
Guaranteed Minimum Income payments are contingent on Policyholder making each
scheduled purchase installment when due until the Annuity Commencement Date,
which is at least 10 years from the date of issuance. The Guaranteed Minimum
Income payment feature is fixed upon issuance of Policy B and cannot be changed
without giving up the right to the Income payment. Company A will be able to
provide a guaranteed minimum level of monthly annuity payments despite the
variable investment risks associated with the underlying assets because the
payments will be available only if amounts are invested in the variable
subaccount supporting Policy B in level monthly installments over the period
from Policy B's date of issuance until the Annuity Commencement Date.
Policyholder may satisfy the scheduled purchase installment by making a series
of these payments in a specified amount until the Annuity Commencement Date or
by making unscheduled purchase payments. The unscheduled purchase payments will
be placed in a separate account and predetermined amounts will be transferred
from this separate account to the variable subaccount. Company A represents
that all of these segregated asset accounts will satisfy the diversification
requirements of §817(h) and the regulations thereunder. Policyholder may
surrender Policy B rather than annuitize Policy B.
[5] Policy C is a variable annuity issued by Company A. Policy C will invest
in equity securities, debt securities, and foreign securities. Policyholder
will have the option of choosing one of the investment options available under
Policy C. The investment risks associated with Policy C's variable investment
options will be borne by Policyholder. Scheduled monthly amounts will be
transferred from Policy C to Policy B.
[6] Company A represents that with respect to Policy B and Policy C there is
a single aggregate investment. Transfers between Policy C and Policy B will not
result in any change in the investment in the aggregated investment. Thus,
amounts includible in Policyholder's income will be determined on the basis
that there is a single aggregate investment in Policy B and Policy C.
[7] On the Annuity Commencement Date, Policy B's Contract Value will be
converted into a variable monthly income benefit that will have been selected
by the contract owner at the time Policy B is issued, which must be a life
annuity plan with a period certain feature of at least ten years, or if there
are joint annuitants, a joint life and survivor income plan with a period
certain feature of at least ten years. Policy C's Contract Value will also be
converted to either a fixed or variable monthly income plan beginning on the
Annuity Commencement Date. Under Policy C, a policyholder may generally select
one of the following plans: (1) a life income with a period certain, (2) income
for a fixed period not longer than 30 years, (3) income of a definite amount
paid until the proceeds are exhausted, with any remaining balance paid to the
estate of the payee on the payee's death, or (4) a joint and last survivor
income with a ten-year period certain. Distributions from Policy B and Policy C
will be aggregated in accordance with the provisions of § 1.72-2. The
proportionate part of the amounts received as an annuity and which is not
taxable will be determined under the provisions of §§ 1.72-4, 1.72-5 and 1.72-6
of the regulations. Specifically, in a situation where a fixed monthly income
plan is selected for Policy C and variable annuity payments are made under
Policy B § 1.72-4(e)(2) with respect to determining the exclusion ratio will
apply.
[8] The Annuity Commencement Date will be the same for both Policy B and
Policy C. Policyholder will be required to sign a declaration upon issuance of
Policy B and Policy C that the Annuity Commencement Date will be the same. The
Annuity Commencement Date for Policy B may not be changed after issuance. The
Annuity Commencement Date for Policy C may be changed after issuance. It is
also possible to accelerate the annuitization of Policy B. In the event that
the annuitization of Policy B is accelerated, the policyholder would lose the
right to the Guaranteed Minimum Income payments. The declaration will advise
policyholder that either changing the Annuity Commencement Date of Policy C or
accelerating the annuitization of 4 Policy B may have adverse tax consequences.
No opinion is offered, however, regarding the adverse tax consequences that may
arise with respect to either Policy C or Policy B.
[9] Policy B and Policy C will have two different policy numbers. However,
Policy B and Policy C will be tracked together as a single contract for tax
reporting purposes.
LAW & ANALYSIS
[10] Section 72 of the Code prescribes the tax treatment of amounts received
under an annuity contract. Generally, the rules under section 72 provide that
amounts subject to the provisions of section 72 are includible in the
recipient's gross income to the extent they represent amounts earned on the
purchaser's investment. For this purpose, the provisions § 72 distinguish
between "amounts received as an annuity" and "amounts not
received as an annuity". Section 72(b) provides that a certain portion of
each "amount received as an annuity" will be excluded from gross
income.
Section 1.72-2(a)(2) of the Income Tax Regulations provides, in part, that
if two or more annuity obligations or elements to which § 72 applies are
acquired for a single consideration for both obligations (whether paid by one
or more persons in equal or different amounts, and whether paid in a single sum
or otherwise) such annuity elements will be considered to comprise a single
contract for the purpose of the application of § 72 and the regulations
thereunder. Therefore, the movement of funds within the underlying annuity
obligations supporting the single contract does not result in a distribution under
the contract nor a receipt of monies by a policyholder. As a result of the
application of this regulation, Policy B and Policy C will be treated as
comprising one single contract (Annuity). Furthermore, any transfer of funds
from Policy C to Policy B will not be treated as "amounts received"
but rather an internal transfer from one element of Annuity to another element
of Annuity.
[11] Section 1.72-2(b)(2)(i) provides that amounts subject to section 72 are
considered "amounts received as an annuity" only in the event that
the amounts are received on or after the annuity starting date and if the
amounts are payable in periodic installments at regular intervals over a period
of more than one full year from the annuity starting date.
[12] Section 1.72-4(b)(1)(i) defines the annuity starting date as the first
day of the first period for which an amount is received as an annuity. The
first day of the first period for which an amount is received as an annuity is
the later of the date upon which the obligations under the contract become
fixed or the first day of the period which ends on the date of the first
annuity payment.
[13] Section 72(b) provides an exclusion ratio for determining the
proportionate part of the total amount received each year as an annuity which
is excludable from the gross income of a recipient in the taxable year of
receipt. Generally, the exclusion ratio is determined by dividing the
investment in the contract by the expected return of the contract. Section
1.72-4 further provides that in the situation where a single consideration is
given for a particular contract which provides for two or more annuity
elements, an exclusion ratio is determined for the contract as a whole by
dividing the investment in the contract by the aggregate of the expected
returns under all the annuity elements.
[14] If an amount is received prior to annuitization of the contract, then
under § 72(e)(2)(B) such amount is considered an "amount not received as
an annuity" and it is included in income to the extent of the excess of
the cash value in the annuity contract over the investment in the contract.
Thus, any payments received by a taxpayer prior to the annuity starting date
will be taxed under the provisions of § 72(e).
[15] An "amount not received as an annuity" after an annuity has
begun is taxed under §72(e)(2)(A) and §1.72-1(d). Specifically, these
provisions provide that an amount not received as an annuity and received on or
after the annuity starting date is included in gross income of the recipient.
[16] Section 72(e)(11)(ii) provides that with respect to "amounts not
received as an annuity", in determining the amount includible in gross
income, all annuity contracts issued by the same company to the same
policyholder during any calendar year shall be treated as one annuity contract.
This provision is consistent with the application of §1.72-2(a)(2) to the facts
of this ruling. Accordingly, section 72(e)(11) applies.
[17] Section 1035(a)(3) of the Code provides that no gain or loss is
recognized on the exchange of an annuity contract for an annuity contract. For
this purpose, § 1035(b)(2) defines an annuity contract. Section 1.1035-1 of the
regulations provides that a tax-free exchange of an annuity contract for
another annuity contract under § 1035 of the Code is limited to cases where the
same person or person is the obligee or obligees under the contract received in
exchange as under the original contract.
[18] The House Committee Report to the Internal Revenue Code of 1954
indicates that § 1035 was designed to eliminate the taxation of individuals
"who merely exchanged one insurance policy for another better suited to
their needs but who have actually recognized no gain." H.R. Rep. No. 1337,
83rd Cong., 2d Sess. 81 (1954). Thus, § 1035 operates as the insurance analogue
to §1031, which relates to like-kind exchanges of certain types of property
held for productive use in a trade or business or for investment. The
similarity of § 1031 and § 1035 are evidenced in § 1035(c)(1), which provides
that the recognition of gain or loss on an exchange that is not solely
like-kind will be made under the terms of § 1031(b) and (c).
[19] Section 1031 permits exchanges of one property for more than one
property. See 1.1031(j)-1 (relating to exchanges of multiple
properties). See also Rev. Rul. 85-135, 1985-2 C.B. 181 (exchange of
assets of two television stations for the assets of another television
station).
[20] Because § 1035(a)(3) is written in the singular, one might argue that
it does not apply to exchanges of one annuity contract for two annuity
contracts. Section 7701(n)(1),however, cross-references Title I, § 1 of the
United States Code, which provides that "[i]n determining the meaning of
any Act of Congress, unless the context indicates otherwise, words importing
the singular includes and apply to several persons, parties, and things."
Thus, just as § 1031 applies to exchanges of multiple properties, § 1035(a)(3)
applies to exchanges of multiple annuities.
RULINGS
[21] Accordingly, based on the facts, representations, law and arguments
presented we conclude the following:
1) the exchange of Policy A for Policy B and Policy C will qualify as a
tax-free exchange under § 1035; and
2) Policy B and Policy C will be treated as one
annuity contract for purposes of § 72 and the regulations thereunder;
3) the transfer of funds within Annuity, that is
from Policy C to Policy B, will not be treated as a taxable distribution under
§72(e) of the Code.
[22] We express no opinion as to the tax treatment of the Policies under the
provisions of any other sections of the Code and Regulations that may also be
applicable thereto.
[23] This ruling is directed only to the Taxpayers who requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.
[24] A copy of this letter should be attached to the next federal income tax
return to be filed by Company A and Policyholder.
Sincerely yours,
/S/
MARK S. SMITH
Chief, Branch 4
Office of Associate Chief Counsel
(Financial Institutions &
Products)
Code Section: Section 1035 -- Exchanges
of Insurance Policies; Section 72 -- Annuities
Geographic Identifier:
Subject Area: Benefits and pensions
Financial instruments tax issues
Insurance company taxation
Industry Group: Insurance
Cross Reference:
Institutional Author: Internal Revenue Service