Exchange Of Annuity Contracts Has No Adverse Tax Consequences

2. Is the nontransferability restriction of section 401(g) violated if the owner of an annuity contract that was distributed upon plan termination exchanges such contract for another similar annuity contract from a different insurer?

3. What are the income tax consequences to an individual who exchanges an annuity contract distributed from a qualified plan upon termination for another similar contract from a different insurer?

4. What are the income tax consequences to an individual who exchanges an annuity contract distributed from a qualified plan upon termination for a contract materially different from the one he received from the qualified plan?

2. The nontransferability restriction of section 401(g) is not violated if the owner of an annuity contract that was distributed upon termination of a 401 plan exchanges such contract for another similar annuity contract from a different insurer.

3. There are no income tax consequences to an individual who exchanges an annuity contract distributed from a qualified plan upon termination for another similar contract from a different insurer if the transaction is carried out in a certain manner.

4. An individual who exchanges an annuity contract distributed from a qualified plan upon termination for a contract materially different from the one he received from the qualified plan must include the fair market value of the new contract in his income in the year of receipt.

In * * * was sold and the Plan was terminated.

Upon termination, the account balances of all participants became fully vested and all participants were given the option of taking their distributions partly in kind, including the * * * individual annuities. At the time of this termination, the surrender charge then applicable under the individual annuities was in excess of 10%. Due to this high surrender charge, the taxpayer accepted distribution, partly in kind, and thus the individual deferred annuity was endorsed by * * * to the taxpayer. In compliance with the requirements of sections 401(g), 401(a)(11) and 417 of the Code, the annuity contract was both nontransferable and subject to the spousal consent requirements of the Retirement Equity Act of 1984.

Because of the substantial amount of other funds invested by the taxpayer with * * * and given recent financial failings of certain insurance companies, the taxpayer desires to transfer the annuity to another insurer. The reason for the transfer is to reduce the potential risk of loss to the taxpayer in the event of the financial failure of * * *.

In order to achieve this objective, the taxpayer proposes to exchange the current fixed deferred annuity contract for a fixed deferred annuity contract to be issued through a new insurer.

The contract to be issued by the new insurer will also be nontransferable in accordance with section 401(g) of the Code. In addition, the contract will provide the spousal consent requirements in accordance with sections 401(a)(11) and 417 of the Code. Further, the annuity starting date will remain the same under the annuity contract proposed to be issued as under the existing contract.

It is proposed that this exchange be accomplished through the direct transfer of the policy proceeds from * * * to the new insurer. Thus, no proceeds will be received by the taxpayer.

You have asked us to consider the four issues listed above.

The first issue presented is whether or not the non- transferability requirement applies to contracts distributed to participants upon plan termination. Our conclusion is that it does.

The basis for this conclusion is Example (4) of Treas. Reg. section 1.401-9(c). That example states:

The second issue you have presented is whether the nontransferability restriction of section 401(g) is violated if the owner of an annuity contract that was distributed upon plan termination exchanges such contract for another similar contract from a different insurer.

It is not clear from the legislative history of section 401(g) that a transfer between insurers was to be prohibited. Apparently, the nontransferability restriction was first placed into the legislation to prevent a participant in a Keogh plan from disposing of face-amount certificates ¹ once he had deducted the cost of purchasing such an investment. To prevent discrimination against face-amount certificates, the same nontransferability restriction was imposed upon annuity contracts. See Self-Employed Individuals' Retirement Act, Hearings on H.R. 10 Before the Senate Finance Committee, 87th Cong., 1st Sess. 168-173 (1961). Thus, nontransferability arguably was aimed at liquidation rather than exchange.

Historically the Service has viewed such a transaction as a transfer and thus a violation of section 401(g). See * * * GCM 36039, I-214-74 at 7 (October 7, 1974) (attached proposed revenue ruling at 5), revoked on other grounds by * * * GCM 39065, EE-170-81 (November 25, 1985); and Priv. Ltr. Rul. 8344029 (July 29, 1983).

This historical position is also set forth in Rev. Rul. 73-124, 1973-1 C.B. 200. In this revenue ruling, an employer described in section 501(c)(3) entered into an agreement with one of its employees. The agreement provided that the employer was to purchase a noncontributory individual annuity contract that met the requirements of section 403(b) of the Code. The contract was nontransferable within the meaning of section 401(g) of the Code.

The following transaction took place in a subsequent year:

The revenue ruling concludes that the amount received by the employee upon the surrender of the annuity contract is not includible in his gross income under section 72(e) at the time of surrender.

The revenue ruling states that the employee could not have exchanged the first contract with the second insurance company and received the second contract because of the nontransferability restriction of section 401(g). The revenue ruling states:

In order to make those transactions legally acceptable, there had to be an agreement between the obligee of the first annuity contract and the second insurance company that the obligee would purchase a similar contract from the second insurance company. See Rev. Rul. 69-254, 1969-1 C.B. 129, and Brief for the Internal Revenue Service at 4, 8, 13-14, Greene v. Commissioner, 85 T.C. 1024 (1985), acq. in result only, 1986-2 C.B. 1.

"Surrender and purchase" was the sole method of acquiring a new annuity contract in exchange for an old annuity contract without violating the nontransferability restriction of section 401(g) until the publication of Rev. Rul. 90-24, 1990-1 C.B. 97.

The issue presented in Rev. Rul. 90-24 is whether a transfer of all or part of the holder's interest in a section 403(b)(1) annuity contract or a section 403(b)(7) custodial account ("section 403(b) investments") to another section 403(b)(1) annuity contract or section 403(b)(7) custodial account constitutes an actual distribution to the holder within the meaning of section 403(b)(1).

The revenue ruling holds that the transfer of all or part of a holder's interest in a section 403(b)(1) contract or a section 403(b)(7) custodial account to another section 403(b)(1) or 403(b)(7) investment did not constitute an actual distribution under section 403(b)(1) as long as the transferee accounts/contracts had the same or more stringent distribution restrictions as the transferor accounts/contracts. Thus, the transfers are not taxable transfers. The revenue ruling also holds that it is irrelevant whether a complete or partial interest is transferred, and whether the transferring individual is a current employee, a former employee or a beneficiary of a former employee.

The revenue ruling explains that because the annuity interest is retained throughout this transaction, the direct transfer between section 403(b) investments is a mere change in issuers that does not violate the nontransferability requirement of section 401(g). C.f. section 1.401-9(b)(3) of the Income Tax Regulations. Thus, Rev. Rul. 90-24 eliminated the need for a "surrender and purchase" transaction in order to avoid violating the section 401(g) nontransferability restriction. A section 403(b) annuity contract with one insurer can mow be exchanged for a section 403(b) annuity contract with another insurer, provided the distribution restrictions of the first contract remain in the second contract. ²

Because Rev. Rul. 90-24 revokes Rev. Rul. 73-124, the underlying premise in Rev. Rul. 73-124 that section 401(g) precludes such transfers in the case of an annuity distributed from a section 401 plan is called into question. In our opinion, the conclusions of Rev. Rul. 90-24 are equally applicable to annuity contracts in and distributed from section 401 plans. The nontransferability restriction applicable to 403(b) annuity contracts is contained in section 401(g), and we believe should be applied in the same manner to annuity contracts used to fund 401 plans. See section 401(g).

Thus, our holding for issue two is that the nontransferability restriction of section 401(g) is not violated if the owner of an annuity contract that was distributed upon termination of a 401 plan exchanges such contract for another similar contract from a different insurer.

The third issue presented is what are the income tax consequences to an individual who exchanges an annuity contract distributed from a qualified plan upon termination for another similar contract from a different insurer. Our conclusion is that if the transaction is carried out in accordance with Rev. Rul. 90-24, there will be no income tax consequences to the individual. In order for the exchange to be like the exchanges in Rev. Rul. 90-24, the contract received by the individual must be materially similar to the one he exchanged, i.e., it must meet the applicable section 401 requirements, including the minimum distribution rules, the incidental death benefit rules, and the qualified joint and survivor annuity rules.

Rev. Rul. 90-24 revoked Rev. Rul. 73-124, but permitted the "surrender and purchase" method of Rev. Rul. 73-124 to be used until December 31, 1991. Thus, because we believe the rationale in Rev. Rul. 90-24 is equally applicable to 401 plans, the "surrender and purchase" method cannot be used after December 31, 1991.

The last issue presented is what are the income tax consequences to an individual who exchanges an annuity contract distributed from a qualified plan upon termination for a contract materially different (a contract which does not meet the applicable section 401 requirements) from the one he received from the qualified plan. Our conclusion is that such individual must include the fair market value of the new contract in his income in the year of receipt.

Although section 1035 provides that no gain or loss shall be recognized on the exchange of an annuity contract for another annuity contract, we do not believe that the exchange of a qualified plan contract for a materially different contract comes within the ambit of this section. See * * * GCM 39184, I-142-83 (June 24, 1983), and * * *, OM 19728, EE-99-83 (June 16, 1983). ³

Our reasons for this conclusion are as follows. An annuity contract that is nontaxable when distributed from a qualified plan contains certain provisions in order to comply with section 401 and to protect participants and beneficiaries. Many of these provisions must remain in effect until the last payment is received under the annuity contract. If a "401 annuity contract" is exchanged for a materially different contract, the requirements and protections of section 401 would undoubtedly be lost.

When an individual exchanges a "401 contract" for a materially different contract, we believe he is in the same position as an individual who receives a non-401 contract from a qualified plan. Such an individual must include the fair market value of the non-401 contract in income in the year of receipt. See section 402(a) and Treas. Reg. section 1.402(a)-1(a)(2); see also Rev. Rul. 66-322, 1966-2 C.B. 123, for an illustration of the immediate inclusion in income of a contract which does not meet the requirements of Treas. Reg. section 1.402(a)-1(a)(2).

We are not concluding in this analysis of the issue that the taxpayer recognizes a gain on receiving a materially different contract when exchanging a qualified plan contract. Rather, our conclusion is that the taxpayer must include in income the fair market value of the contract received in the exchange because he has lost the protection of Treas. Reg. section 1.402(a)-1(a)(2).

Another approach to this issue is to treat the exchange of the 401 contract for a non-401 contract as the exchange of an annuity contract that doesn't fall within the specifically enumerated tax- free exchanges or as an exchange that fails to qualify for nonrecognition. Such an exchange would be treated under the rules applicable to sales and exchanges generally. Thus, the exchange is taxable under section 1001 of the Code to the extent of any excess of the value of the new contract plus any cash received over the adjusted basis of the old contract. This amount is taxed as ordinary income and not as capital gain. Barrett v. Commissioner, 42 T.C. 993 (1964), aff'd., 348 F.2d 916 (let Cir. 1965). For purposes of this rule, the value of the new contract is its replacement cost, i.e., the cost of a similar policy to a person of the same age, condition of health, etc., with the same company on the date of exchange, rather than its cash surrender value. Rev. Rul. 54-264, 1954-2 C.B. 57.

Thus, our conclusion for the last issue is that an individual who exchanges an annuity contract distributed from a qualified plan upon termination for a contract materially different from the one he received from the qualified plan must include the fair market value of the new contract in his income in the year of receipt.

² The revenue ruling does not address the consequences of a transfer that violates the early distribution restrictions of section 403(b)(7)(A)(ii) or section 403(b)(11).

³ The need for a "surrender and purchase" arrangement in GCM 39184 and OM 19728 is negated by Rev. Rul. 90-24.