11 more annuity tax facts you need to know

February 07, 2014 at 11:30 AM

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An annuity is a complicated beast — and during tax season, your clients' questions can pile up faster than hospitality complaints from the crowds at Sochi. How are payments under a variable immediate annuity taxed? When is the exchange of one annuity contract for another a nontaxable exchange? Read on to find answers to these and other queries.

1. What general rules govern the income taxation of payments received under annuity contracts?

The rules in IRC Section 72 govern the income taxation of all amounts received under nonqualified annuity contracts.(Nonqualified annuities are annuities that are not held within a "qualified" retirement plan or an IRA.) IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Qualified annuity contracts are governed by the tax rules of the retirement account in which they are held.

The term "annuity" includes all periodic payments resulting from the systematic liquidation of a principal sum and refers not only to payments for a life or lives, but also to installment payments that do not involve life contingency, such as payments under a "fixed period" or a "fixed amount" settlement option.

All "amounts received" under an annuity contract are either "amounts received as an annuity" or "amounts not received as an annuity."

"Amounts received as an annuity" (annuity payments) are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser's investment and what portion is taxed as interest earned on the investment. They apply to life income and other types of installment payments received under both immediate annuity contracts, and deferred annuity contracts that have been annuitized.

Payments consisting of interest only are not annuity payments and thus are not taxed as "amounts received as an annuity." Periodic payments on a principal amount that will be returned intact on demand are interest payments. Such payments, and all amounts taxable under IRC Section 72 other than regular annuity payments, are classed as "amounts not received as an annuity." These include amounts actually received as policy dividends, lump sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender, death benefits under annuity contracts, a guaranteed refund under a refund life annuity settlement, and policy loans, as well as amounts received by imputation (annuity cash value pledged as collateral for a loan).

Except in the case of certain annuity contracts held by non-natural persons, income credited on a deferred annuity contract is not currently includable in a taxpayer's income. There is no specific IRC section granting this "tax deferral." Instead, it is granted by implication. The increase in cash value of an annuity contract, other than by application of dividends, is neither an "amount received as an annuity" nor an "amount not received as an annuity." As a result, an increase in cash value is not a distribution and is not includable in the taxpayer's income, except where the IRC specifically provides otherwise.

IRC Section 72 places a penalty on "premature distributions."

Contracts issued after January 18, 1985 have post-death distribution requirements. These post-death distribution requirements also apply to contributions made after January 18, 1985, to contracts that were issued before that date. Contracts issued before January 18, 1985, with contributions that were made before that date are not subject to post-death distribution requirements.

The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of life insurance death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules. On the other hand, as noted earlier, death proceeds under an annuity contract (i.e., from some form of guaranteed death benefit) are taxed as amounts not received as an annuity.

Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately.

Annuity with long-term care rider: Under the Pension Protection Act of 2006, qualified long term care insurance can be provided as a rider to an annuity contract, beginning after December 31, 2009.

2. How are annuity contracts held by corporations and other non-natural persons taxed?

Except as noted below, to the extent that contributions are made after February 28, 1986 to a deferred annuity contract held by a corporation or another entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract.

When an annuity contract is no longer treated as an annuity for tax purposes, income on the contract is treated as ordinary income received or accrued by the owner during the taxable year. "Income on the contract" is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (the amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement.

This rule does not apply to any annuity contract that is:

acquired by the estate of a decedent by reason of the death of the decedent;
held under a qualified pension, profit sharing, or stock bonus plan, as an IRC Section 403(b) tax sheltered annuity, or under an individual retirement plan;
purchased by an employer upon the termination of a qualified pension, profit sharing, or stock bonus plan or tax sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to the employee's beneficiary;
an immediate annuity (i.e., an annuity that is purchased with a single premium or annuity consideration, the annuity starting date of which is no later than one year from the date of purchase, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period); or
a qualified funding asset (as defined in IRC Section 130(d) but without regard to whether there is a qualified assignment). A qualified funding asset is any annuity contract issued by a licensed insurance company that is purchased and held to fund periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness.

In addition, an annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person. If a non-natural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person. Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust.

In a letter ruling, the IRS decided that a trust was considered to hold an annuity contract as an agent for a natural person where the trust owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust's beneficiary, a natural person.

In another ruling, the IRS considered an irrevocable trust whose trustee purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. The IRS held that the non-natural person rule was not applicable.

The IRS concluded that the non-natural person rule does not apply to a trust that had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust.

Where a trustee's duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for that individual's sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the IRS concluded that the trustee was acting as an agent for a natural person.

Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person.

A charitable remainder unitrust, however, was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year.

Although it is not entirely clear that all permissible beneficiaries of a trust named as owner of a deferred annuity must be natural persons, it is significant that, as of June 2010, all private letter rulings addressing whether a trust named as owner of a deferred annuity was acting as "the agent of a natural person" have specified that all beneficiaries were, in fact, natural persons.

If all beneficiaries of a trust owning a deferred annuity must be natural persons, must the term "beneficiary" be taken literally? In the case of a "special needs" trust (such as an OBRA "D(4)(A)" trust), it is not clear whether the position of creditor occupied by the state Medicaid agency (to the extent of any Medicaid payments made to the trust beneficiary) will constitute the interest of a "beneficiary," where the state Medicare statute does not specify that the state's interest is that of a "beneficiary."

These requirements apply "to contributions to annuity contracts after February 28, 1986." It is clear that if all contributions to the contract are made after February 28, 1986, the requirements apply to the contract. It seems clear enough that if no contributions are made after February 28, 1986 to an annuity contract, such contract held by a non-natural person is treated for tax purposes as an annuity contract and is taxed under the annuity rules. If contributions have been made both before March 1, 1986, and after February 28, 1986, to contracts held by non-natural persons, however, it is not clear whether the income on the contract is allocated to different portions of the contract and whether the portion of the contract allocable to contributions before March 1, 1986, may continue to be treated as an annuity contract for income tax purposes. The IRC makes no specific provision for separate treatment of contributions to the same contract made before March 1, 1986, and those made after February 28, 1986.

3. How can the investment in the contract be determined for purposes of the annuity rules?

Generally speaking, the investment in the contract is the gross premium cost or other consideration paid for the contract, reduced by amounts previously received under the contract to the extent they were excludable from income.

Unless the contract has been purchased from a previous owner, the investment in the contract normally is premium cost. It is not equal to the policy's cash value.

To arrive at the premium cost, adjustments usually must be made to gross premium cost.

Extra premiums paid for supplementary benefits such as accidental death benefit, disability income benefit, and disability waiver of premiums must be excluded from premium cost. (But see Moseley v. Comm., where life insurance policy premium payments paid into a special reserve account were added to the aggregate premiums for purposes of calculating taxable income when a lifetime distribution was made). Further, it might seem that premiums waived on account of disability should be treated as part of the premium cost. In the only case on the subject, however, a case dealing with the computation of gain on a matured endowment, the court held that waived premiums could not be included in the taxpayer's cost basis. The court refused to accept the view of the taxpayer that the waived premiums had been constructively received as a tax-free disability benefit and then applied to the payment of premiums. Instead, the court treated a portion of the proceeds as the tax-free disability benefit: the difference between the amount of premiums actually paid and the face amount of the endowment.

Investment in the contract is increased by any amount of a policy loan that was includable in income as an amount received under the contract. Any un-repaid policy loans must be subtracted from gross premiums in determining the investment in the contract for purposes of the exclusion ratio.

If premiums were deposited in advance and discounted, only the amount actually paid is includable in premium cost. However, any increment in the advance premium deposit fund that has been reported as taxable income may be added to the discounted premiums in determining cost.

In the case of a participating contract, dividends must be taken into account as follows:

If dividends have been received in cash or used to reduce premiums, the aggregate amount of such dividends received or credited before the annuity payments commenced must be subtracted from gross premiums to the extent the dividends were excludable from gross income. Also, any dividends that have been applied against principal or interest on policy loans must be subtracted, but only to the extent they were excludable from gross income. (Excludable dividends are considered as a partial refund of premiums and therefore as a reduction in the cost of the contract).

If excludable dividends have been left on deposit with the insurance company to accumulate at interest and the dividends and interest are used to produce larger annuity payments, such dividends are not subtracted from gross premiums but are part of the cost of the larger payments. In this situation, gross premiums plus accumulated interest constitute the cost of the contract. (The interest is included as additional cost because it already has been taxed to the policyholder as it was credited from year to year). Likewise, any terminal dividend that is applied to increase the annuity payments should not be subtracted from gross premium cost.

Similarly, where dividends have been applied to purchase paid-up additional insurance, and the annuity payments include income from the paid-up additions, gross premiums are used as the cost of the contract. (In effect, the dividends constitute the cost of the income from the paid-up additions).

Cost Other than Premium Cost

Investment in the contract is not always equal to premium cost. For example, investment in the contract may be the maturity value or cash surrender value of the contract if such value has been constructively received by the policyholder. If the contract has been purchased from a previous owner, the investment in the contract is the consideration paid by the purchaser. Also, special rules apply in computing the investment in the contract with respect to employee annuities, that is, annuities on which an employer has paid all or part of the premiums.

Long-Term Care Rider Premiums

For contracts issued after 1996, but only for tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract that is a rider to the annuity or life insurance contract reduces the investment in the contract of the annuity or life insurance contract. This charge against the cash surrender value, however, does not cause the taxpayer to recognize gross income. On the other hand, such charges are also not eligible for a medical expense deduction under Section 213(a).

Adjustment for Refund or Period-Certain Guarantee

If an annuity is a life annuity with a refund or period-certain guarantee, a special adjustment must be made to the investment in the contract (whether premium cost or other cost). The value of the refund or period-certain guarantee (as determined by use of a prescribed annuity table, Table III or Table VII, or a formula, depending on when the investment in the contract was made) must be subtracted from the investment in the contract. It is this adjusted investment in the contract that is used in the exclusion ratio.

4. What are the income tax consequences to the surviving annuitant under a joint and survivor annuity?

The survivor continues to exclude from gross income the same percentage of each payment that was excludable before the first annuitant's death. With respect to annuities having a starting date after December 31, 1986, the total exclusion by the first annuitant and the survivor may not exceed the investment in the contract; that is, when the entire investment in the contract has been received tax-free, the entire amount of all subsequent payments will be taxed as ordinary income. However, for annuities with starting dates prior to January 1, 1987, the exclusion ratio continues to apply indefinitely to annuity payments, even if the amount of principal recovered exceeds the original investment in the contract.

In addition, if the value of the survivor annuity was subject to estate tax, the survivor may be entitled to an income-in-respect-of-a-decedent income tax deduction for a portion of the estate tax paid. This deduction, in most cases, will be small. Generally, it is computed as follows: The portion of the guaranteed annual payment that will be excluded from the survivor's gross income (under the exclusion ratio) is multiplied by the survivor's life expectancy at the date of the first annuitant's death. The result is subtracted from the estate tax value of the survivor's annuity. The total income tax deduction allowable is the estate tax attributable to this remainder of the value of the survivor's annuity. This total deduction is prorated over the survivor's life expectancy as of the date of the first annuitant's death, and a prorated amount is deductible from the survivor's gross income each year as payments are received. But no further deduction is allowable after the end of the survivor's life expectancy. The foregoing treatment applies only where the primary annuitant died after 1953.

Planning Point: Joint ownership of non-qualified annuities creates more problems than it solves, including forced distribution at either owner's death. Where the designated beneficiary of each owner is other than the other owner, payment, at either owner's death, generally will be made to that beneficiary, effectively (and surprisingly) "disinheriting" the surviving owner. Some annuity contracts contain language stating that if the contract is jointly owned (with a right of survivorship), the surviving owner will be deemed to be the deceased owner's primary beneficiary, notwithstanding any beneficiary designation to the contrary. Some insurers will not issue deferred annuities with joint ownership unless the owners are a married couple.

It is worth noting that joint ownership often is unnecessary to achieve the objective that the policy owners may believe requires such ownership. For example, if a husband owns, and is the annuitant of, a deferred annuity of which the wife is primary beneficiary, the death of either will leave the survivor in complete control of the contract. If the husband dies, the wife, as the surviving spouse and primary beneficiary, may receive the death benefit or treat the contract as her own under IRC §72(s)(3). If the wife dies first, the husband remains in full control of the contract. — John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

5. If an annuitant dies before receiving the full amount guaranteed under a refund or period-certain life annuity, is the balance of the guaranteed amount taxable income to the refund beneficiary?

The beneficiary will have no taxable income until the total amount the beneficiary receives, when added to amounts that were received tax-free by the annuitant (i.e., the excludable portion of the annuity payments), exceeds the investment in the contract. In other words, all amounts received by the beneficiary under a refund guarantee are exempt from tax until the investment in the contract has been recovered tax-free. Thereafter, receipts (if any) are taxable income. For purposes of calculating the unrecovered investment in the contract, the value of the refund or guarantee feature is not subtracted. This "FIFO" treatment, for payments made to the beneficiary, is different from the "regular annuity rules" treatment that applied to payments made to the deceased annuitant.

The amount received by the beneficiary is considered paid in full discharge of the obligation under the contract in the nature of a refund of consideration and therefore comes under the cost recovery rule regardless of when the contract was entered into or when investments were made in the contract. This rule applies whether the refund is received in one sum or in installments made under the same payout arrangement under which the deceased annuitant had been receiving payments.

If the refund or commuted value of remaining installments certain is applied anew under a different annuity option for the beneficiary, the payments will be taxed under the regular annuity rules. A new exclusion ratio will be determined for the beneficiary.

If the refund beneficiary of an annuitant whose annuity starting date is after July 1, 1986 does not recover the balance of the investment in the contract that was not recovered by the annuitant, the beneficiary may take a deduction for the unrecovered balance.

Any payment made on or after the death of an annuity holder is not subject to the 10 percent premature distribution tax.

6. Is the purchaser of a deferred variable annuity taxed on the annual growth of a deferred annuity during the accumulation period?

An annuity owner who is a "natural person" will pay no income tax until he or she receives distributions from the contract. If the contract is annuitized, taxation of payments will be calculated based on the rules that apply given the annuity starting date when payments begin. Distribution amounts received "not as an annuity" — i.e., partial withdrawals or full surrenders without annuitization — prior to the annuity starting date are subject to the rules discussed here and here.

The tax deferral enjoyed by a deferred annuity owned by a natural person is not derived from any specific IRC section granting such deferral. Rather, this tax treatment is granted by implication. All distributions from an annuity are either "amounts received as an annuity" or "amounts not received as an annuity." As the annual growth of the annuity account balance, except to the extent of dividends, is not stated in the IRC to be either, it is not a "distribution," and therefore is not subject to tax as earned.

A variable annuity contract will not be treated as an annuity and taxed as explained in this and the following questions unless the underlying investments of the segregated asset account are "adequately diversified," according to IRS regulations.

If the owner of the contract is a person other than a natural person (for example, a corporation or certain trusts), growth in the value of the annuity might not be tax deferred.

7. How are payments under a variable immediate annuity taxed?

Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser's investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an "exclusion ratio" as it is for a fixed dollar annuity. Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid. In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.

If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table VI, whichever is applicable (depending on when the investment in the contract is made). IRS regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death. The life expectancy multiple need not be adjusted if payments are monthly. If they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted.

A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy). However, if payments received are from an annuity with a starting date that was before January 1st, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.

Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year's exclusion.

If an annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period.

8. When is a policy owner deemed to have exchanged one annuity contract for another?

Under IRC Section 1035, policy owners may exchange one annuity contract for another on a tax-deferred basis.

However, the distinction between an "exchange" and a surrender-and-purchase is not always clear. Where the contract is assignable, the IRS has required a direct transfer of funds between insurance companies. In addition, the "exchange" of an annuity contract received as part of a distribution from a terminated profit-sharing plan for another annuity with similar restrictions as to transferability, spousal consent, minimum distribution, and the incidental benefit rule was granted IRC Section 1035 treatment. In addition, the IRS has ruled privately that the surrender of a non-assignable annuity contract distributed by a pension trust and immediate endorsement of the check by the annuitant to the new insurer in a single integrated transaction under a binding exchange agreement with the new insurer qualified as an exchange.

On the other hand, while the Tax Court did once allow an exchange where the taxpayer surrendered an annuity contract for cash and then purchased another annuity contract, the IRS acquiesced only in the result of that case. And the IRS has ruled that a taxpayer's receipt of a check issued by an insurance company will be treated as a distribution (and, thus, not an exchange), even if the check is endorsed to a second insurance company for the purchase of a second annuity.

The IRS also has ruled privately that a valid exchange did not occur where the taxpayer surrendered one life insurance policy and then placed the funds in a second policy purchased one month earlier. In another instance, the IRS viewed several transactions as "steps" in one integrated exchange. The taxpayer purchased an annuity contract then later withdrew an amount equal to the taxpayer's basis from the contract, placing the funds in a single premium life insurance policy. Next, the taxpayer exchanged the annuity for another annuity, treating this part of the transaction as a tax-free exchange under IRC Section 1035. The IRS disagreed, characterizing the events as a single exchange, with the value of the life insurance policy received as taxable boot.

The Tax Court, in Conway v. Commissioner, held that a 1035 exchange occurred when the taxpayer transferred a portion (but not all) of the funds from one annuity to a second newly-issued annuity. The IRS later ruled that the proper way to allocate investment in the contract when one annuity is "split up" into two annuities is on a pro rata basis based on the cash surrender value of the annuity before and after the partial exchange. For example, if 60 percent of an annuity's cash surrender value is transferred to a new annuity, the investment in the contract of the "new" annuity will be 60 percent of the investment in the contract of the "old" annuity, and the investment in the contract of the "old" annuity will be 40 percent of what it was before the partial exchange.

In 2008, the IRS released a revenue procedure concerning certain tax-free partial exchanges of annuity contracts (under Sections 1035 and 72(q)). The revenue procedure applies to the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract, regardless of whether the two annuity contracts are issued by the same or different companies.

A transfer will be treated as a partial tax-free exchange under Section 1035 under current final rules issued in 2008, as updated by Revenue Procedure 2011-38, as long as the taxpayer does not take any withdrawals from either contract (the old or the new one) within 180 days of the partial exchange. When a partial 1035 exchange is completed, the basis is divided pro rata between the old contract and the new one based on the relative value of the contracts when the split occurred.

If the direct transfer of a portion of an annuity contract for a second annuity contract does not qualify as a tax–free exchange, it will generally be treated as a taxable distribution followed by a payment for the second contract, although the Service reserves the right to conclude differently after applying general tax principles to determine the substance and appropriate treatment of the transfer.

The IRS will not require aggregation of two annuity contracts that are the subject of a tax-free exchange (under Section 1035 and this guidance) even if both contracts were issued by the same insurance company.

Planning Point: Although the rules under IRC Section 1035 cover a broader array of annuity exchanges, funds in nonqualified annuities are not freely movable. For example, the IRS does not provide guidance on the transfer of a portion of the funds in one annuity to a second existing annuity. It is not certain that such a transaction is covered under Section 1035 and therefore this type of transaction may not receive tax-free treatment. — Fred Burkey, CLU, APA, The Union Central Life Insurance Company.

9. When is the exchange of one annuity contract for another a nontaxable exchange?

The IRC provides that the following exchanges are nontaxable:

the exchange of a life insurance policy for another life insurance policy, for an endowment or annuity contract, or for a qualified long-term care insurance contract;
the exchange of an endowment contract for an annuity contract, for an endowment contract under which payments will begin no later than payments would have begun under the contract exchanged, or for a qualified long-term care insurance contract;
the exchange of an annuity contract for another annuity contract; and
the exchange of a long-term care insurance contract for another qualified long-term care insurance contract.

These rules do not apply to any exchange having the effect of transferring property to any non-United States person.

As a result of the Pension Protection Act of 2006, for exchanges after 2009, life, annuity, endowment, and qualified long-term care insurance contracts may now be exchanged for (another) qualified long-term care insurance contract. In addition, the presence of a qualified long-term care insurance contract as a rider on an annuity or life insurance policy does not cause it to fail to qualify for the purposes of such exchanges; in other words, a taxpayer can exchange an annuity without a long-term care insurance contract rider for an annuity with such a rider, and still qualify for nonrecognition treatment.

If an annuity is exchanged for another annuity, the contracts must be payable to the same person or persons. Otherwise, the exchange does not qualify as a tax-free exchange under IRC Section 1035(a). The IRC defines an annuity for this purpose as a contract with an insurance company that may be payable during the life of the annuitant only in installments. Despite the singular reference in IRC Section 1035(a)(3) to "an annuity contract for an annuity contract," the IRS concluded that one annuity could properly be exchanged under IRC Section 1035 for two annuities, issued by either the same or a different insurance company.

Further, the exchange of two life insurance policies for a single annuity contract also has been considered a proper IRC Section 1035 exchange. The exchange of one annuity for a second annuity with a term life insurance rider attached was afforded income tax-free treatment under IRC Section 1035. A proper IRC Section 1035 exchange also occurred where an annuity holder directly transferred a portion of the funds in one annuity to a second newly-issued annuity. An assignment of an annuity contract for consolidation with a pre-existing annuity contract is a tax-free exchange under Section 1035, even though the two annuities were issued by different insurance companies.

The exchange of a life insurance policy, endowment contract, or fixed annuity contract for a variable annuity contract with the same company or a different company qualifies as a tax-free exchange under IRC Section 1035(a). (Although the exchange of a variable annuity for a fixed annuity is not specifically addressed in this ruling, there does not appear to be any evidence that would prohibit such an exchange from qualifying for IRC Section 1035 treatment, and in practice insurance companies routinely allow this treatment). Additionally, the exchange of an annuity contract issued by a domestic insurer for an annuity contract issued by a foreign insurer was considered a permissible IRC Section 1035 exchange.

10. What distributions are required when the owner of an annuity contract dies before the entire interest in the contract has been distributed?

A deferred annuity contract issued after January 18, 1985, will not be treated as an "annuity contract" and taxed under the favorable provisions of IRC Section 72 unless it provides that if any owner dies –

on or after the annuity starting date (in other words, when the annuity was in "payout status") and before the entire interest in the contract has been distributed, the remaining portion will be distributed at least "as rapidly as under the method of distribution being used as of the date of the owner's death," and
before the annuity starting date, the entire interest in the contract will be distributed within five years after the owner's death, unless either of two exceptions applies.

In the case of joint owners of a contract issued after April 22, 1987, these distribution requirements are applied at the first death.

Exceptions to the Five Year Rule

Installment payments made to a designated beneficiary. If any portion of the owner's interest is to be distributed to a designated beneficiary(see definition later in this section) over the life of such beneficiary (or over a period not extending beyond the life expectancy of the beneficiary) and such distribution begins within one year after the owner's death, that portion will be treated as distributed on the day such distribution begins (and, therefore, will meet the five year rule).

Where the beneficiary is the surviving spouse of the annuity owner. If a designated beneficiary is the surviving spouse of the "holder of the contract" (the owner), that person may treat the annuity as his or her own (that is, as if he or she had owned it from inception) and continue the contract. This "spousal continuation" option must be allowed in the annuity contract to be exercised. Some contracts require that the surviving spouse be the sole beneficiary to elect this "spousal continuation" option.

Amounts distributed under these requirements are taxed under the general rules applicable to amounts distributed under annuity contracts. These rules are intended to prevent protracted deferral of tax on the gain in the contract through successive ownership of the contract.

Where the owner of a contract issued after April 22, 1987 is a corporation or other non-natural person, the primary annuitant, as designated in the contract, will be treated as the owner of the contract for purposes of the distribution requirements of Section 72(s), and a change in the primary annuitant of such a contract will be treated as the death of the owner. Where the owner is a corporation or other non-natural person, see here.

These requirements do not apply to annuities purchased to fund periodic payment of damages on account of personal injuries or sickness. Although these requirements do not apply with respect to qualified pension, profit sharing and stock bonus plans, IRC Section 403(b) tax sheltered annuities, and individual retirement annuities, similar distribution requirements do apply.

Where the beneficiary is not a natural person

The term designated beneficiary means an individual – a human being. Where the beneficiary is not a human being, the Section 72(s)(2) and (s)(3) exceptions to the five year payout rule probably are not available. If a trust, for example, is named as beneficiary of a deferred annuity, and the annuity owner (or primary annuitant, as deemed owner, if the trust owns the annuity) dies, the trust probably will be unable to take distributions other than in a lump sum or within five years. This is because most insurers take the position that a trust, as a non-natural person, is not an individual, cannot be a designated beneficiary, and, therefore, is ineligible for the life expectancy exception of Section 72(s)(2) (and for the spousal continuation exception of Section 72(s)(3), because trusts, not being human beings, cannot marry).

Some insurers will permit a trustee of a trust named as beneficiary to elect the life expectancy option of Section 72(s)(2) over a period not extending beyond the lifetime of the oldest trust beneficiary. This is probably because they take the position that Congress intended, in enacting Section 72(s), to provide parity between the rules governing death distributions from IRAs and qualified plans and the rules governing death distributions from nonqualified annuities. Although the legislative history of Section 72(s) offers much support for this view, it should be noted that there is no specific authority for it in the IRC or regulations for annuities, as there is under IRC Section 401(a)(9) and the associated Section 1.401(a)(9) regulations with respect to see-through trust treatment for beneficiaries of retirement accounts.

Planning Point: Avoid naming a client's revocable living trust (or any trust, as a general rule) as the beneficiary of a nonqualified annuity if any stretch out of taxation of the gain is desired. A surviving spouse of the holder can annuitize over his or her lifetime or treat the annuity as his or her own; if that same spouse is the trustee of the decedent's trust, both opportunities probably are unavailable. — John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

Effect of exchange on pre-January 19, 1985 contracts

According to the report of the conference committee (TRA '84), an annuity contract issued after January 18, 1985 in exchange for one issued earlier will be considered a new contract and will be subject to the distribution requirements.

11. How are damage payments taxed if an annuity is used to fund a judgment or settle a claim for damages on account of personal injuries or sickness?

Other than punitive damages, any damages received on account of personal physical injuries or physical sicknesses are not includable in gross income. This is true whether the damages are received by suit or agreement or as a lump sum or periodic payments. For this purpose, emotional distress is not treated as a physical injury or physical sickness.

The phrase "other than punitive damages" does not apply to punitive damages awarded in a wrongful death action with respect to which applicable state law, as in effect on September 13, 1995, provides that only punitive damages may be awarded in such an action.

The rule regarding emotional distress does not apply to any damages that do not exceed the amount paid for medical care, as described generally in IRC Section 213, attributable to emotional distress.

If a lump sum payment representing the present value of future damages is invested for the benefit of a claimant who has actual or constructive receipt or the economic benefit of the lump sum, only the amount of the lump sum payment is treated as received as damages and excludable. None of the income from investment of the payment is excludable.

Where damages are to be paid periodically and the person injured has no right to the discounted present value of the payments or any control over investment of the present value, the entire amount of each periodic payment is excludable, including earnings on the fund.

Thus, where a single premium annuity is purchased by a person obligated to make the damage payments to provide that person with a source of funds, and the person receiving payments has no interest in the contract and can rely only on the general credit of the payor, the entire amount of each periodic payment is excludable.

Under proposed regulations issued in 2009, damages for physical injuries may qualify for the Section 104(a)(2) exclusion even though the injury giving rise to the damages is not defined as a tort under state or common law. In addition, the exclusion does not depend on the scope of remedies available under state or common law. In effect, the regulations reverse the result in United States v. Burke by allowing the exclusion for damages awarded under no-fault statutes.

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