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Update to Partial 1035 Exchanges
When last we visited partial 1035 exchanges, the IRS had acquiesced in the Conway case, which said nothing in Code section 1035 preventing 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 1035 exchanges. Now the IRS has issued 2 pieces of guidance, which clarify the treatment of partial 1035 exchanges:

1) 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 an $800 cost 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 cost basis. He ends up with 2 contracts with $500 cash value and $400 cost basis. We're not sure how to pro-rate cost basis if there are surrender charges.

2) A new IRS Notice warns that the IRS is not going to let people abuse partial 1035's 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 cost 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 creative Client gets the idea to do a partial 1035 exchange of half the annuity, resulting in 2 annuities with $25,000 cash value and $15,000 cost 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 1035's 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 might include: 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 then, they will look at the "facts and circumstances" of withdrawals from partial 1035 exchanges to see if they are abusive.

Last Updated: 9/23/2012 10:05:00 PM