Disposition of an Annuity Contract

<div class="Section1">A waiver of the right to receive a qualified joint and survivor annuity or a qualified pre-retirement survivor annuity ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3881">3881</a>) by a nonparticipant spouse is not treated as a taxable transfer by the nonparticipant spouse if the waiver is made before the death of the participant spouse.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 2503(f).<br /> <br /> </div></div><br />

<div class="Section1">Yes, if the purchaser of the contract does not reserve the right to change the beneficiary of the survivor payments.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> In the case of a joint and survivor annuity between spouses, the unlimited marital deduction makes this a moot point (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="584">584</a>); in the case of a non-spouse joint annuitant, though, gift tax consequences may be incurred.<br /> <br /> <hr><br /> <br /> On how to value the gift, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="585">585</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 2523(f)(6).<br /> <br /> </div></div><br />

<div class="Section1">The term <em>designated beneficiary</em> means an individual &ndash; a human being. Where the beneficiary is not a human being, the Section&nbsp;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&nbsp;years (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="594">594</a>). 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&nbsp;72(s)(2) (and for the spousal continuation exception of Section&nbsp;72(s)(3), because trusts, not being human beings, cannot marry).<div class="Section1"><br /> <br /> Some insurers will permit a trustee of a trust named as beneficiary to elect the life expectancy option of Section&nbsp;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&nbsp;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&nbsp;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&nbsp;401(a)(9) and the associated Section&nbsp;1.401(a)(9) regulations with respect to see-through trust treatment for beneficiaries of retirement accounts.<br /> <br /> </div></div><br />

<div class="Section1">If the purchaser receives lifetime proceeds under the contract, the purchaser is taxed in the same way as an original owner would be taxed, but with the following difference: the purchaser&rsquo;s cost basis is the consideration the purchaser paid for the contract, plus any premiums the purchaser paid after the purchase and less any excludable dividends and unrepaid excludable loans received by the purchaser after the purchase.<div class="Section1"><br /> <br /> If the contract is purchased after payments commence under a life income or installment option, a new exclusion ratio must be determined, based on the purchaser&rsquo;s cost and expected return computed as of the purchaser&rsquo;s annuity starting date. The purchaser&rsquo;s annuity starting date is the beginning of the first period for which the purchaser receives an annuity payment under the contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="534">534</a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If the purchaser of an annuity is a corporation, or other non-natural person, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="513">513</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.72-4(b)(2), 1.72-10(a).<br /> <br /> </div></div><br />

<div class="Section1">In general, the original owner of a nonqualified annuity product is able to exchange one annuity for another in an IRC Section 1035 exchange without treating the transaction as a sale—no gain is recognized when the first annuity contract is disposed of, and there is no intervening tax liability. Despite this, Section 1035 requires that, for the annuity exchange to be tax-free, the newly acquired annuity must be payable to the same individual that was entitled to annuity payouts under the original annuity.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> The IRS has ruled privately that the beneficiary who inherits rights to payouts under an annuity also inherits an ownership interest in the annuity that is sufficient to allow tax-free exchange treatment under IRC Section 1035.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In the IRS ruling, the beneficiary inherited multiple annuity products and elected to receive distributions over her life expectancy after the original account owner’s death. Later, she found an annuity product that offered more attractive investment features and sought to exchange the original contracts for an annuity that would increase her annuity payout, but would continue to distribute those payouts over her life expectancy.<br /> <br /> By allowing this exchange, the IRS permitted the beneficiary to exchange the entire pre-tax value of the inherited annuity, rather than requiring that she take a lump sum distribution of the inherited annuity interest, pay taxes on this distribution and then purchase the replacement annuity contract with the after-tax value.<br /> <br /> However, the IRS was careful to note that the rules applicable to post-death distributions still apply, meaning that the newly acquired annuity must require distribution of the entire interest in the inherited annuity within five years or over the beneficiary’s life expectancy.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 1035.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Let. Rul. 201330016.<br /> <br /> </div>

<div class="Section1">An irrevocable beneficiary designation would appear to be a gift falling under the broad sweep of IRC Section&nbsp;2511, applying the gift tax &ldquo;whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> The IRS has ruled, for example, that a retiring federal employee who receives a reduced annuity to provide a survivor annuity for the beneficiary makes a gift subject to gift tax of the value of the survivor annuity by the mere act of retiring.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> If the beneficiary designation does trigger a gift, it will clearly be one of a future interest, which means it will not qualify for the gift tax annual exclusion.<a href="#_ftn3" name="_ftnref3">³</a> If the beneficiary of the survivor annuity is the employee&rsquo;s spouse, however, the gift generally will qualify for the marital deduction ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="619">619</a>).<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 2511(a); Treas. Reg. &sect; 25.2511-1(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Ruls. 8715010, 8715035, 8811017.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 25.2503-3(c) (Ex. 2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 2523(f)(6).<br /> <br /> </div></div><br />

<div class="Section1">Yes.<div class="Section1"><br /> <br /> These contributions generally qualify for the marital deduction, however, and do not require the filing of a gift tax return. There should be no question that an individual&rsquo;s contributions to a spousal IRA would qualify for the marital deduction, so long as the donee spouse is the one who names a beneficiary to receive account proceeds remaining at that spouse&rsquo;s death.<br /> <br /> If the donor spouse (i.e., the contributing individual) designates a beneficiary, the donee spouse&rsquo;s interest in the IRA would be a nondeductible terminable interest and the marital deduction would not be allowed, except in the case of certain joint and survivor annuities ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="619">619</a>).<br /> <br /> </div></div><br />

<div class="Section1">If no cash or other non-like kind property is received in connection with an exchange, any gain from the contract surrendered will not be recognized in the transfer to the new contract. Accordingly, the cost basis of the new policy will be the same as the cost basis of the old policy (plus any premiums paid and less any excludable dividends received after the exchange).</div><br /> <div class="Section1"><br /> <br /> If cash or other non-like kind property is received in connection with any of the above exchanges, gain will be recognized to the extent of the cash or other property received as so-called “boot” property.<a href="#_ftn1" name="_ftnref1">¹</a> The amount of any policy loan that the other party to the exchange takes property subject to or assumes (reduced by any loan taken subject to or assumed by the first party) is treated as money received on the exchange.<a href="#_ftn2" name="_ftnref2">²</a> If the owner has exchanged an annuity at a loss, and the requirements of Section 1035 were satisfied, the receipt of boot does not cause the loss to be recognized.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> It should be noted that application of Section 1035 is not an election; its nonrecognition treatment is mandatory when the provisions of that section are met.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.1031(b)-1(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.1031(b)-1(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC §§ 1035(d)(1), 1031(c).<br /> <br /> </div>

<div class="Section1">Yes.<div class="Section1"><br /> <br /> The payee, however, generally may elect not to have anything withheld, which is commonly chosen. In addition, only the amount that is reasonable to believe is includable in income is subject to withholding, not any return of principal payments.<br /> <br /> If withholding occurs from periodic payments (i.e., an annuitized contract), the amounts are to be withheld at the same rate as wages. Payments are periodic, even if they are variable, if they are payable over a period of more than one year.<br /> <br /> If payments are not periodic, 10&nbsp;percent of the includable amount is withheld. Payments made to the beneficiary of a deceased payee are subject to withholding under the same rules.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> An election out of withholding generally will be ineffective if a payee does not furnish his or her taxpayer identification number (&ldquo;TIN,&rdquo; usually the payee&rsquo;s Social Security number) to the payor or furnishes an incorrect TIN to the payor and the payor is so notified by the IRS.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Payments under qualified pension, profit sharing, and stock bonus plans are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3972">3972</a>; payments under IRC Section&nbsp;403(b) tax sheltered annuities are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4083">4083</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4085">4085</a>; and private annuities are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="603">603</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 3405(a), 3405(b); Temp. Treas. Reg. &sect; 35.3405-1T (A-9, A-10, A-12, A-17, F-19 through 24).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 3405(e)(12).<br /> <br /> </div></div><br />

<div class="Section1">Under the Pension Protection Act of 2006, an annuity issued after December 31, 2009 may include a qualified long-term care insurance rider. Under these rules, inclusion of the rider will not trigger taxable distributions as premiums are deducted from cash value for long-term care premiums, although such charges will reduce investment in the contract.<a href="#_ftn1" name="_ftnref1">¹</a> In addition, all long-term care benefits paid under the rider (whether attributable to gains or cost basis) will be tax-free and are excludable from the recipient’s gross income (and not reduce investment in the contract).</div><br /> <div class="Section1"><br /> <br /> In order to qualify for favorable treatment, the long-term care insurance policy must conform to the “qualified” long-term care insurance requirements of IRC Section 7702B. In a private letter ruling, the IRS analyzed the federal income tax treatment of a particular company’s long-term care insurance rider to be offered with certain annuity contracts by an insurance company with respect to taxable years beginning after December 31, 2009, and ruled that the rider will constitute a qualified long-term care insurance contract.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(e)(11); Notice 2011-68, 2011-36 IRB 205.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC §§ 72, 104, 7702B.<br /> <br /> </div>