A checking-account transfer between annuities was taxable

Plain-English summary

A taxpayer inherited part of an annuity and mistakenly signed a lump-sum payment form, believing it was a section 1035 exchange form. The insurer deposited the proceeds into the taxpayer's checking account, and the taxpayer later used some of that money to buy a second annuity. Section 1035 protects an exchange of one annuity contract for another, but it does not provide rollover treatment when the policyholder first receives the money. Because the proceeds passed through the taxpayer's account rather than moving in a qualifying contract exchange, the IRS ruled that the distribution was taxable under section 72(e) to the extent allocable to income on the first annuity. The transaction was not a tax-deferred section 1035 exchange.

Ruling snapshot

• Question: Did the mistaken lump-sum distribution followed by the purchase of another annuity qualify as a tax-deferred exchange?
• Outcome: Denied, the distribution was taxable under section 72(e)
• Key authorities: IRC §§ 72(e) and 1035(a)(3); Rev. Ruls. 72-358, 2002-75, and 2007-24

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

Number: 201625001                                               Third Party Communication: None
Release Date: 6/17/2016                                         Date of Communication: Not Applicable
Index Number: 72.00-00
                                                                Person To Contact:
--------------------------                                      --------------------, ID No. ------------------
-----------------------------                                   Telephone Number:
------------------------------------                            ----------------------
                                                                Refer Reply To:
                                                                CC:FIP:B04
                                                                PLR-131113-15
                                                                Date:
                                                                March 16, 2016


Legend

Date 1                                 =   -------------------

Date 2                                 =   ----------------------------

Date 3                                 =   ----------------------

Date 4                                 =   ------------------------

Date 5                                 =   ------------------

Date 6                                 =   ---------------------------

Taxpayer                               =   --------------------------

Father                                 =   ---------------------------------------

Son 1                                  =   ----------------------------------

X                                      =   ----

Annuity 1                              =   -----------------------------------------

Annuity 2                              =   ----------------------------------------

Company 1                              =   ----------------------------------------------

Company 2                              =   --------------------------------------------------------------

Year 1                                 =   -------
PLR-131113-15                                2



Dear ------------------:

       This letter responds to your request for a ruling concerning the federal income
tax consequences of a transaction.

        Facts

       Taxpayer's father died on Date 1 and left his entire estate to his two children, Son
1 and Taxpayer, in equal shares. One of the assets that Taxpayer inherited from his
father was x% interest in Annuity 1, held by Company 1. On Date 2, Taxpayer, thinking
that the form was an exchange form pursuant to § 1035 of the Internal Revenue Code
(“Code”), mistakenly signed a “Lump Sum Payment” form for Annuity 1. On Date 3, the
lump sum payment was deposited into Taxpayer’s checking account.

       On Date 4, Taxpayer signed an application for Annuity 2, sold by Company 2.
Taxpayer used, in part, the funds that he received in a lump sum payment from Annuity
1 to pay for Annuity 2.

       On Date 5, while preparing Taxpayer’s federal income tax return for year ending
Date 6 (Year 1), Taxpayer’s accountant discovered a Form 1099R that Taxpayer had
received from Company 1, that reflected the lump sum payment that Taxpayer had
received on Date 3. Taxpayer requested an extension of time to file Taxpayer’s Year 1
federal income tax return and submitted this request prior to filing the return.

        Rulings Requested

       1.     That the erroneous distribution from Annuity 1 and the subsequent
contribution of those distributed funds to Annuity 2 will be treated as a tax deferred
exchange under § 1035(a)(3) of the Code and will not result in the imposition of income
tax under § 72(e) of the Code; and

      2.     That no further corrective transactions are required as between Annuity 1
and Annuity 2 in that, although the distribution was made erroneously, both Annuity 1
and Annuity 2, as of Date 6, are exactly as they would have been had the error not
occurred.

        Law and Analysis

       Section 72(a) provides that, except as otherwise provided in Chapter 1 of the
Internal Revenue Code, gross income includes any amount received as an annuity
under an annuity contract. Under § 72(e), amounts received under an annuity contract,
but not as an annuity, generally are included in gross income to the extent allocable to
PLR-131113-15                                3

income on the contract. That is, they are taxed on an income-first basis. Section
72(e)(5)(E) provides that this rule applies to any amounts received on the complete
surrender, redemption, or maturity of an annuity contract.

       Section 1035(a)(3) provides that no gain or loss is recognized on the exchange
of an annuity contract for another annuity contract. The legislative history of § 1035
explains that § 1035 provides non-recognition treatment for taxpayers who have “merely
exchanged an [annuity contract] for another better suited to their needs and who have
not actually realized gain.” H. Rep. 1337, 83d Cong., 2d Sess. 81 (1954). Under
§ 1.1035-1, the contracts exchanged must relate to the same insured, and the obligee
or obligees under the contract received in the exchange must be the same as those
under the original contract.

        In Rev. Rul. 72-358, 1972-2 C.B. 473, a taxpayer who owned a life insurance
contract issued by one insurance company assigned the contract, prior to its maturity, to
a second insurance company in exchange for a variable annuity contract issued by the
second company. The ruling concludes that, pursuant to § 1035, no gain or loss is
recognized on the exchange. Similarly, Rev. Rul. 2002-75, 2002-2 C.B. 812, concludes
that an individual’s assignment of an annuity contract issued by one insurance company
to a second insurance company, which then deposits the cash surrender value of the
assigned contract into a pre-existing annuity contract owned by the same taxpayer,
qualifies as a tax-free exchange under § 1035.

        In Rev. Rul. 2007-24, 2007-1 C.B. 1282, insurance company one disbursed a
check representing a surrender of old non-qualified annuity policy to taxpayer who, in
turn, endorsed the check to a second insurance company as consideration for a new
non-qualified insurance contract. Noting that neither § 1035 nor the regulations make
any special provision for the purchase of an annuity contract with amounts distributed to
the policyholder under another contract and because the annuity contract was a non-
qualified contract, no rollover provision, such as § 403(a)(4), applied to the amount
received. The amount that taxpayer received from insurance company one under the
first annuity contract is taxable in the year received to the extent set forth in § 72(e).

        Similarly, in the present case, the proceeds from Taxpayer’s request for lump
sum payment of Annuity 1 were deposited into Taxpayer’s checking account. Taxpayer
then used those funds to purchase Annuity 2. Accordingly, the amount that Taxpayer
received from Company 1 under Annuity 1 is taxable in the year received to the extent
set forth in § 72(e).

      Conclusion

        The amount that Taxpayer received from Company 1 under Annuity 1 is taxable
in the year received to the extent set forth in § 72(e). Accordingly, the erroneous
distribution from Annuity 1 and the subsequent contribution of those distributed funds to
PLR-131113-15                                  4

Annuity 2 will not be treated as a tax deferred exchange under § 1035(a)(3) of the
Code.

      The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. This office has not verified any of the
material submitted in support of the request for rulings, and it is subject to verification on
examination.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. In addition, no opinion is expressed regarding whether
Taxpayer timely elected to receive annuity payments.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent. A copy of this letter
must be attached to any income tax return to which it is relevant.



                                           Sincerely,



                                           Alexis A. MacIvor
                                           Branch Chief, Branch 4
                                           Office of Associate Chief Counsel
                                           (Financial Institutions & Products-)