IRS EXPLAINS THE INCOME TAX CONSEQUENCES OF A CASH WITHDRAWAL FROM AN ANNUITY CONTRACT SUBSEQUENT TO A TAX-FREE EXCHANGE OF CONTRACTS

Rev. Rul. 85-159

ISSUE

What are the Federal income tax consequences of a withdrawal from an annuity contract after there has been an exchange of annuity contracts qualifying for nonrecognition under section 1035 of the Internal Revenue Code, as described below?

FACTS

The taxpayer, an individual, purchased an annuity contract on March 1, 1973, for 100x dollars, with an annuity starting date of June 24, 1993. On September 1, 1982, the taxpayer exchanged the annuity contract for an annuity contract with a different company, with the same annuity starting date. The exchange qualified as a tax-free exchange under section 1035(a) of the Code.

In December 1982, the taxpayer paid an additional premium of 50x dollars under the annuity contract. On March 1, 1983, when the contract was not subject to surrender charges, the taxpayer, age 45, made a partial surrender of the annuity and received 160x dollars. The cash value of the annuity was 200x dollars as a result of: (1) 100x dollars in premiums paid prior to August 14, 1982; (2) 50x dollars in premiums paid after August 13, 1982; (3) 49x dollars in accumulations attributable to investments made prior to August 14, 1982; and (4) 1x dollars in accumulations attributable to investments made after August 13, 1982.

LAW AND ANALYSIS

Section 72(e)(2)(B)(i) of the Code requires that amounts received as partial surrenders or cash withdrawals from an annuity contract prior to the annuity starting date be included in gross income to the extent allocable to income on the contract.

Section 72(e)(3)(A) of the Code provides that the amount by which the cash value of the contract (determined without regard to any surrender charge) exceeds the contract owner's investment in the contract immediately prior to receipt is the amount allocable to income on the contract. Distributions of less than the amount by which the cash surrender value exceeds the investment are includible in full in income. Section 72(e)(3)(B) provides that to the extent amounts are not allocable to income under the preceding rule, such amounts shall be allocated to the investment in the contract and, therefore, are not included in gross income. In short, withdrawals are allocated first to income and then to the investment in the contract.

Sections 72(e)(5)(A) and (B) of the Code provide that for contracts entered into before August 14, 1982, the rule contained in section 72(e)(2)(B) treating withdrawals as taxable to the extent allocable to income on the contract does not apply. Instead, amounts received under these contracts before the annuity starting dates are includible in gross income only to the extent they exceed the investment in the contract. Therefore, withdrawals are includible in income only after they exceed the investment in the contract.

Subject to certain exceptions and limitations, section 72(q) of the Code imposes a penalty on premature distributions from annuity contracts. The penalty is 5 percent of the amount includible in the contract owner's gross income. The penalty does not apply to a distribution that is allocable to an investment in the contract made before August 14, 1982.

H.R. Rep. No. 97-760, 97th Cong., 2d Sess. 647 (1982), 1982-2 C.B. 600, 686 states, referring to the preceding sections: "(A) replacement contract obtained in a tax-free exchange of contracts succeeds to the status of the surrendered contract for purposes of the new provisions."

Thus, pursuant to section 72(e)(5)(B) of the Code, the cash withdrawal rules do not apply to amounts invested in an annuity contract prior to August 14, 1982, nor to income accumulated on such amounts, notwithstanding that the annuity contract was exchanged after August 13, 1982, for another annuity contract in a tax-free exchange under section 1035. Accordingly, under section 72(e)(5)(B) as described above, withdrawals are allocable first to investments prior to August 14, 1982, then to income accumulations with respect to such investments, then, pursuant to section 72(e)(3)(B), to income accumulated with respect to investments after August 13, 1982, and finally to investments after August 13, 1982.

HOLDING

Because the taxpayer received the present annuity in a tax-free exchange, that annuity will retain the attributes of the surrendered annuity for purposes of determining when amounts are to be considered invested and for computing the taxability of any withdrawals.

In the example above, the taxpayer is considered to have withdrawn amounts allocable to the taxpayer's pre-August 14, 1982, investment first. Accordingly, the first 100x dollars of the 160x dollars withdrawn is treated as a return of capital. The next 49x dollars withdrawn is ordinary income since it is allocable to income accumulations on pre-August 14, 1982, investments. The next 1x dollars withdrawn is ordinary income allocable to income accumulations on post-August 13, 1982, investments. The remainder of the withdrawal, 10x dollars, is attributable to the 50x dollars invested after August 13, 1982, and is treated as a return of capital.

The 5 percent penalty only applies to distributions made after December 31, 1982, of income accumulations that are allocable to an investment made after August 13, 1982. Therefore, the penalty tax is 5 percent of 1x dollars.