Incorrect procedure in §1035 exchange of annuity results in unexpected taxation

 

Incorrect procedure in §1035 exchange of annuity results in unexpected taxation.

By Kyle Mostransky, LUTCF®, CLTC
Posted on April 2, 2017

In a private letter ruling,1 the Internal Revenue Service (IRS) determined that a taxpayer’s receipt of cash from the surrender of an inherited annuity accompanied by the prompt deposit of such cash into another annuity failed to qualify as a tax-free exchange under Internal Revenue Code (IRC) Section 1035

Background

IRC §1035 permits the tax-free exchange of a life insurance contract for another life insurance contract, endowment contract, annuity, or qualified long-term care contract.

It also permits the tax-free exchange of an endowment contract for another endowment contract, annuity, or qualified long-term care contract, or an annuity contract for another annuity contract or qualified long-term care contract, as well as the exchange of one qualified long-term care contract for another.

However, to achieve the desired tax- free result, certain requirements need to be met: (1) the contracts exchanged must relate to the same insured; (2) the obligee must be the same under both the contract exchanged and the contract received in the exchange; and (3) the transferred funds must flow directly from the ceding insurance carrier to the receiving insurance carrier and may not be paid to the contract owner.2

Facts

Taxpayer (“T”) inherited a percentage of an annuity from T’s father. T attempted to exchange his share of the inherited annuity for another annuity issued by a different insurance company. However, T mistakenly executed a “lump sum payment” form instead of an “exchange” form. The insurance company issued T a check for the lump sum amount, which T deposited into his checking account. A short time later, T used the funds to purchase a new annuity from another insurance company. T’s accountant discovered the error and helped T to request a private letter ruling seeking to have the transaction characterized as a tax-free exchange under §1035.

Rulings requested

T requested that (1) the erroneous distribution from Annuity 1 and the contributions of those funds to Annuity 2 should be treated as a deferred exchange under §1035; and (2) no further corrective actions need be taken because the end result with respect to Annuity 1 and Annuity 2 was exactly the same as it would have been had the error not occurred.

Ruling

The IRS ruled that because the funds from Annuity 1 were paid directly to T, any gain from the amount T received was taxable under §72(e) in the year received and that the erroneous distribution from Annuity 1 and the subsequent contribution of those funds to Annuity 2 would not be treated as a tax deferred exchange under §1035(a) (3).

Comments

This private letter ruling emphasizes the importance of following tax-free exchange procedures precisely and is a reminder that errors in tax matters are not always easily correctable, even when the taxpayer has good intentions.

There are often hidden tax traps when engaging in financial transactions. In most instances, a taxpayer would be well advised to consult his or her tax, legal, financial, or insurance professional before taking action.

About Kyle

Kyle Mostransky is the founder of Mostransky & Associates with more than a decade of experience providing retirement planning and insurance services. He specializes in helping successful business owners, families, and individuals grow, protect, and distribute their financial resources in a manner that’s in alignment with their objectives and values. Passionate about education and understanding the life insurance industry, he is a Life Underwriter Training Council Fellow (LUTCF®) and holds the Certified Long-Term Care designation (CLTC®). Based in Huntington, New York, Kyle serves clients throughout the greater New York City metropolitan area and across the country. To learn more, connect with Kyle on LinkedIn or visit www.mostranskyfinancial.com.

Kyle Mostransky, CLTC, LUTCF®, California Insurance License #0H17709, is a Registered Representative offering securities through NYLIFE Securities LLC, Member FINRA/SIPC, A Licensed Insurance Agency, 15 Green Street, Huntington, NY 11743, (646) 227-8384. Member Agent, The Nautilus Group®, a service of New York Life Insurance Company. New York Life, its agents or employees may not give legal, tax or accounting advice; everyone should seek and rely upon the counsel of his or her own professional advisors. Mostransky & Associates LLC is not owned or operated by New York Life or its affiliates. SMRU 1731794 10.6.2018

This material was produced by The Nautilus Group. It is being provided by Kyle Mostransky as a courtesy.

1PLR 201625001 (6/17/2016). A PLR applies tax laws to specific facts only, is solely for the taxpayer who requested it and should not be re- lied upon as authority by other taxpayers. PLRs may later be revoked by the IRS. PLRs do not carry the stamp of law, but do give an indication of the IRS’s current thinking towards a specific type of transaction. All reference to PLRs in this article are for informational purposes only.

2 Reg. §1.1035-1; Rev. Rul. 72-358, 1972-2 C.B. 473; Rev. Rul. 2002-75, 2002-2 C.B. 812; and Rev. Rul. 2007-24, 2007-1 C.B. 1282.