On June 28, 2011, the Internal Revenue Service (IRS) issued Rev. Proc. 2011-38, which sets forth modified guidance with respect to the federal income tax treatment of “partial exchanges” of annuity contracts under sections 72 and 1035 of the Internal Revenue Code. In brief, Rev. Proc. 2011-38 provides that a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract will be treated as a tax-free exchange under section 1035 if no amount, other than an amount received as an annuity for a period of 10 years or more or during one or more lives, is received under either the existing annuity contract or the second annuity contract during the 180 days beginning on the date of the transfer (in the case of a new contract, the date the contract is placed in-force).
Under prior guidance – Rev. Proc. 2008-24, 2008-1 C.B. 684 – a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract was treated as a tax-free exchange under section 1035 if no amount was withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date of the transfer, or if the taxpayer demonstrated that one of the conditions described by section 72(q)(2)(A), (B), (C), (E), (F), (G), (H), or (J) or any similar life event “occurred between” the date of the transfer and the date of the withdrawal or surrender. A transfer within the scope of Rev. Proc. 2008-24 that was not treated as a tax-free exchange under section 1035 instead was treated as a taxable distribution under section 72(e), followed by a payment for the second annuity contract.
Rev. Proc. 2008-24 was issued in the wake of Conway v. Commissioner, 111 T.C. 350 (1998), acq., 1999-2 C.B. xvi, which concluded that partial exchanges of annuity contracts can qualify for nonrecognition treatment under section 1035. The rules in Rev. Proc. 2008-24 were designed, in part, to limit taxpayers’ ability to effect partial annuitizations, which, prior to this year, the IRS held did not qualify for exclusion ratio treatment under section 72(a), by effecting a tax-free partial exchange and then annuitizing either the existing annuity contract or the new annuity contract. Rev. Proc. 2008-24 also was intended to prevent taxpayers from effecting a partial exchange and then surrendering one of the annuity contracts soon thereafter, which could allow recovery of more investment in the contract on a tax-free basis than would be possible if the amount received on surrender had been withdrawn from the original annuity contract.
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