Partial exchange of annuity contract is nontaxable.

• Author: Schneider, Arthur C.

In Conway 111 TC No. 20 (1998), the Tax Court held that a partial exchange of an existing annuity contract for a new annuity contract is a nontaxable exchange under Sec. 1035. This decision rejects the IRS's long-standing position that partial exchanges of an annuity contract are not contemplated under Sec. 1035(a)(3).

In Conway, the taxpayer purchased a deferred annuity contract from Fortis Benefits Life Insurance Company in 1992 for $195,643. In 1994, the taxpayer instructed Fortis to withdraw $119,000 of her investment and transfer the funds to Equitable Life Insurance Company for the purchase of a new annuity contract. Fortis reduced the taxpayer's annuity account value by $119,000, withheld $10,000 as a surrender charge and remitted $109,000 directly to Equitable Life. The terms and provisions of the Fortis and the Equitable annuity contracts were substantially equivalent. The taxpayer's express intention in purchasing the new contract was to qualify the transfer of the funds between the two contracts (from the Fortis contract to the Equitable contract) as tax-free under Sec. 1035.

For 1994, the taxpayer treated the exchange as nontaxable under Sec. 1035, despite receiving a Form 1099-R, Distributions From Pensions,Annuities, Retirement or Profit-sharing Plans, IRA's, Insurance Contracts, etc., from Fortis reporting $30,535 of taxable income. (This amount represented the accumulated income on the Fortis annuity contract which, under the "income first" rule of Sec. 72(e)(2)(B), is included in gross income when there is a withdrawal or partial surrender under a deferred annuity contract.) On audit, the Service asserted that the exchange was a taxable event, because the entire Fortis annuity contract was not replaced by the Equitable annuity contract. Accordingly, the IRS made a $30,535 adjustment to the taxpayer's income and further asserted that she was subject to the 10% excise tax on premature dispositions imposed by Sec. 72(q).

While the Service has long maintained that Sec. 1035 "contemplates the contemporaneous exchange of the entire old contract and simultaneous funding of a single, new contract" (see, e.g., Letter Ruling 8741052), the Tax Court concluded that:

Neither Sec. 1035 nor the regulations condition nonrecognition treatment upon the exchange of an entire annuity contract. Respondent cites no authority to support respondent's position that nonrecognition treatment under Sec. 1035 is limited to exchanges involving...