Annuity owners sometimes wish to make a change to a portion of their annuity holdings without facing adverse tax consequences - and under current law, this can be accomplished by exchanging part of the existing annuity for a new contract on a tax-free basis.
However, the recent private letter ruling 201038012 from the IRS may have unintentionally expanded the flexibility of partial annuity exchanges to the point that they might not just be used, but could be abused as well.
Partial 1035 Exchanges From Annuities Followed By A Partial Withdrawal
The private letter ruling at issue is the recent PLR 201038012, which explored the tax consequences of an individual who completed a partial 1035 tax-free exchange and then took a withdrawal shortly thereafter from the annuity, when he was also over the age of 59 1/2. Under the existing guidance of Revenue Procedure 2008-24, if an individual takes a withdrawal from a partial exchange annuity within a year of the exchange, the amount of the exchange is treated as though it was a taxable distribution, and this is exactly what the annuity company reported. However, the taxpayer believed that the partial exchange should hold (even though the distribution occurred within 1 year of the exchange) because Revenue Procedure 2008-24 allows subsequent withdrawals from a partial exchange when the individual meets certain requirements, and the taxpayer believed he satisfied the requirement because he was over age 59 1/2. After reviewing the facts of the situation, the IRS agreed with the taxpayer, effectively opening the door to allow anyone to take withdrawals immediately after a partial exchange (i.e., without waiting the 1-year period), as long as they are over the age of 59 1/2.
What's interesting about this ruling is not the straightforward result that occurred for this particular taxpayer - it's the potential tax abusive situation that, ironically, the IRS has been fighting to shut down for over 10 years and may have unwittingly just reopened again. To understand how partial exchanges can be abusive, let's look at an example:
John Smith holds a $100,000 annuity with a $60,000 cost basis. He wishes to withdraw $40,000 from the annuity (which would normally be fully taxable as a gains-first withdrawal). Instead, he completes a $40,000 partial exchange to a new annuity #2, which will carry with it a pro-rata portion of cost basis; thus, the new annuity will be worth $40,000, with a cost basis of $24,000 and an embedded gain of $16,000. At this point, John liquidates the new annuity #2 he just exchanged towards, resulting in a reported gain of $16,000 on proceeds of $40,000, instead of the full $40,000 gain he would have had if he withdrew that amount from the original annuity. Thus, John can extract a portion of his cost basis and defer some of his gains, instead of the normal gains-first tax treatment on withdrawals, as long as he completes a partial exchange followed by a withdrawal, in lieu of taking a withdrawal from the original contract.
Shutting Down The Partial-Exchange-And-Withdraw Loophole?
The IRS has been attempting to "shut down" this tax strategy - which they consider an abusive use of the tax rules - for over a decade. In the first legal case on the issue - Conway v. Commissioner (1998) - the IRS tried to prevent partial 1035 exchanges at all, but the court ruled against them. Subsequently, the IRS issued IRS Notice 2003-51, allowing for partial 1035 exchanges, but providing for less favorable tax consequences if a withdrawal occurred from the new annuity within 24 months of the exchange. Under the subsequent Revenue Procedure 2008-24, the proscribed time period was reduced to 12 months, and certain exceptions were made available, but the basic framework remained in place - again, for the purpose of preventing taxpayers from overtly dodging part of their gains by completing a partial exchange followed immediately by a withdrawal.
Up to this point, the IRS' new rules had generally worked. Taxpayers actually still could complete a partial exchange followed by a withdrawal to take advantage of the strategy shown in the earlier example, but would have to wait at least 12 months for the withdrawal, which in practice dramatically reduces the frequency of the abuse. The problem, though, is that with PLR 201038012, the IRS has essentially shown that as long as a taxpayer is over age 59 1/2, the 12 month holding period requirement isn't necessary... which means a taxpayer really can complete a partial exchange and take a withdrawal immediately thereafter and still dodge part of the taxable gain on an annuity.
Admittedly, the IRS probably didn't intend for this result, and a private letter ruling cannot be used as a legal defense. If a taxpayer tries a partial exchange followed by a withdrawal because they are over age 59 1/2, the IRS can still claim that Revenue Procedure 2008-24 will apply to the transaction, even though the Service just allowed a similar exchange in the PLR (i.e., the IRS is still allowed to change its mind). Nonetheless, it appears that the door is back open for the possibility of partial exchanges followed by withdrawals, as long as the client is over age 59 1/2!
For a more detailed discussion of this issue, see the full commentary recently published for Leimberg Information Services that I co-authored with John Olsen (who was also my co-author for "The Annuity Advisor"). For those of you who enjoy this kind of in-depth commentary on recent IRS guidance and court cases, you might wish to consider a full subscription to Steve Leimberg's great service!