Annuity contract received in Sec. 1035 exchange did not retain original contract's grandfather status.

• Author: Taylor, David E.

IRS Letter Ruling (TAM) 9346002 concluded that an annuity contract received in a Sec. 1035 exchange did not retain the original contract's grandfather status. Therefore, taxpayers contemplating an exchange of an older insurance or annuity contract should consider the possible loss of grandfathered benefits before such an exchange.

A taxpayer acquired a deferred variable annuity contract in 1974. In 1989, she exchanged the contract for another deferred variable annuity contract without recognizing gain or loss (pursuant to Sec. 1035). Before the new contract's starting date, the taxpayer died and the contract's benefits were distributed to her two sons in two equal lump sums.

Under Sec. 1014(b)(9)(A), annuities described in Sec. 72 acquired from a decedent do not qualify for a basis step-up under Sec. 1014(a). However, at the time the taxpayer acquired the original contract, Rev. Rul. 70-143 held that the right to the accumulated value under an annuity contract was not a Sec. 72 annuity because it would not be received on or after the annuity starting date. Therefore, a deferred annuity contract was entitled to a basis step-up under Sec. 1014(a) if the contract's owner died before the annuity starting date.

However, Rev. Rul. 79-335 revoked Rev. Rul. 70-143 and held that a variable annuity contract acquired from a decedent was a Sec. 72 annuity even if annuity payments have not yet begun. Thus, a basis step-up was precluded by Sec. 1014(b)(9)(A). Yet, this revocation was prospective since, under the authority of Sec. 7805(b), Rev. Rul. 79-335 contained the following grandfather provision:

. . . the conclusion in this revenue ruling will not be applied to deferred variable annuity contracts purchased prior to October 21, 1979, including any contributions applied to such contracts pursuant to a binding commitment entered into before that date. This revenue ruling will apply to all other amounts contributed to deferred variable annuity contracts on or after October 21, 1979. (Emphasis added.)

In TAM 9346002, the taxpayer argued that the annuity contract received in the Sec. 1035 exchange should qualify for a stepped-up basis - since it was a continuation of the original contract, carrying with it the same basis and other tax attributes, including Rev. Rul. 79-335's grandfather status. The taxpayer cited Regs. Sec. 1. 1002-1, which states that the "underlying assumption of [the tax-free exchange provisions] is that the new property is...