IRS Issues Guidance On Partial 1035 Exchanges Of Annuities

The IRS and the Treasury department are considering regulations that would preclude the usefulness of the second transaction.

Specifically, the regulations will presume that certain distributions and surrenders that occur after a partial 1035 exchange will have been made for tax avoidance purposes. This presumption might be able to be overcome in different ways. One way the presumption could be overcome is if the subsequent distribution is not subject to the 10% penalty tax on certain annuity distributions. Examples of distributions not subject to the 10% penalty are distributions after the taxpayer reaches age 59, distributions made upon the death of the owner, distributions to a disabled taxpayer and distributions that are part of equal periodic payments.

The IRS also is considering whether events that are described in the regulations describing "unforeseen circumstances" with regard to whether the sale of a primary residence is tax-free will also allow a taxpayer to overcome the tax avoidance presumption. These unforeseen circumstances include divorce and a change in employment status.

Until these regulations are finalized, the IRS issued interim guidance on distributions from annuities following a partial 1035 exchange. The IRS will consider all the facts and circumstances to determine whether a partial exchange and a subsequent withdrawal or surrender within 24 months of the partial exchange should be considered one transaction.

However, the taxpayer can show that one of the circumstances that would preclude the 10% penalty tax, or some other similar life event occurred between the partial exchange and the subsequent surrender or distribution that was not thought of at the time of the partial exchange. If the taxpayer can show that one of these events occurred, he will not be considered to have entered into the partial exchange for tax avoidance purposes.

Joseph F. Stenken, J.D., CLU, ChFC, is an assistant editor of Tax Facts, a National Underwriter Company publication.

Reproduced from National Underwriter Life & Health/Financial Services Edition, November 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.