Section 1035 Exchange Tax Trap

In a recent ruling, it was decided that monies received from a terminated annuity contract were taxable to the annuitant since the annuitant received the cash and then immediately paid the cash over to a new annuity company as opposed to having the old annuity company transfer the cash directly to the new annuity company in a 1035 exchange.

Although this was a mistake made by the tax payor and caught by his accountant who then requested a private letter ruling from the IRS which came back negatively.  The IRS ruled that the distribution was a taxable event in the year it was received.  The result of this ruling should not come as a surprise.  The ability to utilize Code Section 1035 (a) which allows for the exchange of a life insurance/annuity contract for another will occur without requiring recognition of gain if done properly.  The failure to follow the technical requirements of Code Section 1035 will lead, as it did here, to an unanticipated adverse tax result.

In order to qualify under Section 1035, there are strict requirements that must be met.  One of them being the exchange must be of policies, not an exchange of cash from an old policy for a new policy.  It has been a long standing rule of the IRS, that when exchanging policies, the policy owner does not receive any cash proceeds from the old policy even if only temporarily.  The deferral of income under Section 1035 does not apply to the exchange by reference to Section 1031 (b) and (c).

In order to make sure that tax deferral is accomplished under Section 1035, it is best that the exchange is handled by the insurance carriers without any issuance of cash proceeds to the policy owner.

This unfortunate result could have been avoided had the owner consulted with his tax advisors prior to surrendering his annuity.