Broker dealer and agent use only
When last we visited partial 1035 exchanges, the IRS had acquiesced in the Conway case, which
said nothing in Code section 1035 prevents someone from doing a tax-free exchange of only part of
their annuity. However, the acquiescence left an ominous warning by the IRS not to abuse partial
Now the IRS has issued 2 pieces of guidance, which clarify the treatment of partial 1035 exchanges.
- A new Revenue Ruling says that when a person makes a partial 1035 exchange, the basis is
divided pro-rata, not income-out-first. For example, suppose a client has a $1,000 cash surrender
value annuity with and $800 basis, and he sends $500 of it to another company in a partial 1035
exchange. Since he exchanged half the value of the contract, the new contract takes half the
basis. He ends up with 2 contracts with $500 CV and $400 basis. We’re not sure how to pro-rate
basis if there are surrender charges.
- A new IRS Notice warns that the IRS is not going to let people abuse partial 1035s to withdraw
tax-free return of principal from their annuities quicker. The Notice proposes how the IRS might
treat an abusive withdrawal after a partial 1035 exchange, and asks the industry to comment.
Here is an example of the abuse they are trying to stop: Client originally has one $50,000 cash value
annuity with a $30,000 basis. Since income comes out first, Client knows he has to withdraw all
$20,000 of taxable earnings to get to tax-free return of principal. But sneaky Client gets the idea to do
a partial 1035 of half the annuity, resulting in 2 annuities with $25,000 CV and $15,000 basis. Then
he thinks he can withdraw just $10,000 taxable earnings from one of the annuities to get to tax-free
return of principal.
But the IRS wasn’t born yesterday. They see the potential to abuse partial 1035s in this way. They
are working on regulations to define this abuse and how they’re going to make it unprofitable. The
IRS proposes that they will presume you are abusing the partial 1035 exchange if you withdraw within
2 years. In that case, they may require the client to aggregate the contracts. Using the example
above, that would mean that even if Client takes money from just one of his 2 contracts, he’d have to
remove the full $20,000 earnings (the aggregated income on both contracts) in order to get tax-free
return of principal. Stymied!
Under the IRS proposal, you can rebut the presumption by showing that you didn’t plot all this? That
you didn’t contemplate the withdrawal at the time of the partial 1035 exchange. Safe harbor rebuttals
reaching age 59 ½
substantially equal payments
loss of employment
If you can rebut the presumption that you contemplated withdrawing from the annuity within 2 years
after the exchange, then you wouldn’t have to aggregate the old and new contracts. You’d only have
to drill through the earnings of the one contract that you took the withdrawal from.
This is the taxing scheme that the IRS is toying with right now. They want to know what practitioners
think of this, and have asked for comments before they officially publish them as regulations. They
said until them, they will look at the “facts and circumstances” of withdrawals from partial 1035s to
see if they are abusive.
This material reflects Integrity Life Insurance Company’s understanding of current federal tax laws and contains information of a general
nature. The information provided is not intended to be legal or tax advice. Integrity suggests you or your clients consult a tax advisor or
attorney as to the applicability of this material or a specific situation.
Last Updated: 7/25/2003 2:19:00 AM