SWAPPED ANNUITY CONTRACT WAS SUBJECT TO PREMATURE WITHDRAWAL PENALTY.

Rev. Rul. 92-95

ISSUE

If an annuity contract is acquired in exchange for another annuity contract in a transaction described in section 1035 of the Internal Revenue Code, what is "the date of the purchase of the annuity" for purposes of section 72(u)(4) (which defines the term "immediate annuity") and section 72(q)(2)(1) (which exempts distributions under an immediate annuity from the premature withdrawal penalty of section 72(q)(1))?

FACTS

On January 15, 1987, A, an individual, then age 40, purchased an annuity contract from IC-1, an insurance company. On September 1, 1991, A exchanged the IC-1 annuity contract for an annuity contract issued by IC-2, which also is an insurance company. A began receiving a series of substantially equal monthly distributions from the IC-2 annuity contract on October 15, 1991, and will continue to receive monthly distributions until September 15, 1998. If the IC-2 annuity contract is not an immediate annuity under section 72(u)(4) of the Code, the portion of each monthly distribution includible in gross income is subject to the premature withdrawal penalty of section 72(q)(1).

LAW

Section 72(q)(1) of the Code imposes a penalty on premature distributions from annuity contracts. This penalty is an additional tax and is equal to 10 percent of the portion of the distribution that is includible in gross income. Certain distributions, as delineated in section 72(q)(2), are not subject to the penalty. Specifically, under section 72(q)(2)(I), distributions under an immediate annuity contract (within the meaning of section 72(u)(4)) are excepted from the penalty.

Section 72(u)(4) of the Code defines an immediate annuity as an annuity:

(A) which is purchased with a single premium or annuity consideration,

(B) the annuity starting date (as defined in section 72(c)(4)) of which commences no later than 1 year from the date of the purchase of the annuity, and

(C) which provides for a series of substantially equal periodic payments (to be made not less frequently than annually) during the annuity period.

The exchange of the IC-1 annuity contract for the IC-2 annuity contract is described in section 1035 of the Code. Thus, there is no recognition of gain or loss on the exchange.

For purposes of Subtitle A of the Code (sections 1 - 1564), section 1223(1) provides that, in determining the period for which a taxpayer has held property received in an exchange, there is included the period for which the taxpayer held the property exchanged, if the property received in the exchange has the same basis in whole or in part in the taxpayer's hands as the property exchanged and the property exchanged at the time of the exchange was a capital asset (as defined in section 1221).

Section 1035(c)(2) of the Code refers to section 1031(d) for rules to determine the basis of property acquired in a section 1035 exchange. Section 1031(d) provides that property acquired in a section 1035 exchange has the same basis as that of the property exchanged, decreased by the amount of any money received by the taxpayer and increased by any gain (or decreased by any loss) recognized by the taxpayer on the exchange.

ANALYSIS

When amounts are prematurely distributed from an annuity contract, section 72(q)(1) of the Code generally imposes a 10 percent premature withdrawal penalty in addition to the income tax on the distribution. From the inception of section 72(q), there have been certain distributions that are not subject to the penalty. See, e.g., section 72(q)(2)(F) (penalty not applicable to distributions allocable to pre-August 14, 1982 investment in the contract). In applying this exception, the legislative history states that "a replacement contract received in a tax free exchange of contracts succeeds to the status of the surrendered contract . . ." H.R. Conf. Rep. No. 760, 97th Cong., 2d Sess. 647 (1982), 1982-2 C.B. 600, 686. Thus, a replacement contract received in a tax free exchange of annuity contracts is not treated as an investment in a new contract. Instead, the replacement contract retains the attributes of the exchanged contract for purposes of determining when amounts are considered to have been invested in the replacement contract. See Rev. Rul. 85-159, 1985-2 C.B. 29.

The Tax Reform Act of 1986, section 1123(b)(4), 1986-3 (Vol. 1) C.B. 391, amended section 72(q)(2) of the Code so that distributions under an immediate annuity contact (as defined in section 72(u)(4)) are also excepted from the penalty.

An important feature of an immediate annuity is the relative absence of opportunity for tax benefit attributable to deferral of income on the contract. The definition of "immediate annuity" in section 72(u)(4) of the Code identifies a class of contracts that creates little opportunity for deferral and is not subject to section 72(u). See section 72(u)(3)(E).

In general, the premature withdrawal penalty of section 72(q)(1) of the Code is designed to recapture a portion of the benefit derived from the deferral of income on the annuity contract. Thus, the basis for exempting immediate annuities from the penalty is the relative absence of opportunity for tax benefit attributable to deferral of income on the contract.

In the present situation, A was allowed the benefit of tax deferral on the income on the IC-1 annuity contract. As the IC-2 annuity contract was obtained in a section 1035 exchange for the IC-1 contract, the IC-2 annuity contract contains the tax-deferred income earned on the IC-1 contract. The tax-deferred income on the IC-1 annuity contract is contained in the excess of the value of the IC-2 annuity contract over A's basis in the IC-2 annuity contract. See sections 1035(c)(2) and 1031(d) of the Code (original contract basis carries over to contract received on a section 1035 exchange).

Since the IC-2 annuity contract contains the tax-deferred income earned on the IC-1 annuity contract, it retains certain attributes of the IC-1 annuity contract, such as, the date when amounts are considered to have been invested in the IC-2 annuity contract. Cf. H.R. Conf. Rep. No. 760 at 647; Rev. Rul. 85-159. See also, section 1223(1) of the Code (holding period for carryover basis property received in an exchange includes the period that the exchanged property was held). A similar attribute which is retained is the date of purchase. Accordingly, the date of the purchase of the IC-2 annuity contract for purposes of sections 72(u)(4) and 72(q)(2)(I) is the earliest date of any predecessor annuity contract that was exchanged for the IC-2 annuity contract in a transaction described in section 1035.

The IC-2 annuity contract is not an immediate annuity contract within the meaning of section 72(u)(4) and section 72(q)(2)(I) of the Code because the distributions commenced later than one year from the date of the purchase of the IC-1 annuity contract.

HOLDING

If an annuity contract is acquired in exchange for another annuity contract in a transaction described in section 1035 of the Code, "the date of the purchase of the annuity" for purposes of section 72(u)(4) (which defines the term "immediate annuity") and section 72(q)(2)(I) (which exempts distributions under an immediate annuity from the 10 percent penalty of section 72(q)(1)) is the date of purchase of the annuity contract exchanged for the new annuity contract.

DRAFTING INFORMATION

The principal author of this revenue ruling is Laurie D. Lewis of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Ms. Lewis on (202) 622-3970 (not a toll-free call).