rr-03-76.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 1035.--Certain Exchanges of Insurance Policies

26 CFR 1.1035-1: Certain exchanges of insurance policies.
(Also Part I, '' 72, 1031)

Rev. Rul. 2003-76

ISSUES

Under the facts stated below, is a direct transfer of a portion of the cash
surrender value of an existing annuity contract for a new annuity contract issued by a
second insurance company a tax-free exchange under ' 1035 of the Internal Revenue
Code? What is the basis under ' 1035 and the investment in the existing contract
under ' 72 after the transfer? What is the basis under ' 1035 and the investment in the
new annuity contract under ' 72?

FACTS

A owns Contract B, an annuity contract issued by Company B. A is the obligee
under Contract B. A contracts with Insurance Company C to issue Contract C, a new
annuity contract. A assigns 60 percent of the cash surrender value of Contract B to
Company C to be used to purchase Contract C. At no time during the transaction does
A have access to the cash surrender value of Contract B that is transferred by Company
B to Company C and used to purchase Contract C. No consideration other than the
cash surrender value of Contract B that is transferred from Company B to Company C
will be paid in this transaction. The terms of Contract B are unchanged by this
transaction, and Contract B is not treated as newly issued.

LAW AND ANALYSIS

Section 1035(a)(3) provides that no gain or loss shall be recognized on the
exchange of an annuity contract for an annuity contract. Section 1.1035-1 of the
Income Tax Regulations provides that the exchange, without recognition of gain or loss,
of an annuity contract for another annuity contract under ' 1035(a)(3) is limited to cases
in which the same person or persons are the obligee or obligees under the contract
received in the exchange as under the original contract.

The legislative history of ' 1035 states that exchange treatment is appropriate for
"individuals who have merely exchanged one insurance policy for another better suited
to their needs and who have not actually realized gain." H.R. Rep. No. 1337, 83d

- 2 -
Cong., 2d Sess. 81 (1954). In Conway v. Commissioner, 111 T.C. 350 (1998), acq.,
1999-2 C.B. xvi, the Tax Court held that the direct exchange by an insurance company
of a portion of an existing annuity contract to an unrelated insurance company for a new
annuity contract was a tax-free exchange under ' 1035. In that case, the transfer was
made directly from the first insurance company to the unrelated insurance company,
and none of the assets transferred in the transaction were received by the taxpayer.

Section 1035(d)(2) references ' 1031 for the rules to determine the basis of
property acquired in a ' 1035 exchange. Section 1031(d) provides that property
acquired in a ' 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.

Section 1.1031(d)-1 provides, in part, that in a ' 1035 exchange the basis of the
property acquired is the same as the basis of the property transferred by the taxpayer
with proper adjustments to the date of the exchange. Section 1.1031(j)-1(c) provides
that, in the case of a multiple exchange of properties, the basis of properties received is
the Aaggregate adjusted basis of the properties transferred,@ which is then Aallocated
proportionately to each property received in the transaction.@ Cf
. Section 1.1031(j)-1(d)
ex. 5 (the basis of a single property transferred in a non-recognition transaction is
allocated on a pro rata basis to the two properties received in the transaction). Section
1.61-6(a) echoes the allocation rule of ' 1.1031(d)-1, providing that when a part of a
larger property is sold, the basis of the entire property is equitably apportioned among
the parts, and the gain realized or loss sustained on the part sold is the difference
between the selling price and the basis allocated to such part.

Section 72 governs the federal tax treatment of distributions from an annuity
contract. When amounts received are not annuity payments, ' 72(e)(6) defines the
investment in the contract. (For purposes of ' 72(b), which applies to annuity
payments, ' 72(c)(1) defines the investment in the contract in a similar, but not identical,
manner). Section 72(e) sets forth rules regarding the tax treatment of distributions from
annuity contracts. Under ' 72(e)(2), distributions that are not amounts received as an
annuity, including withdrawals and partial surrenders, result in income to the contract
holder to the extent of the earnings in the contract and then in a recovery of the contract
holder=s investment in the contract.

After completion of the transaction, A still owns original Contract B, reduced in
value to reflect the cash surrender value transferred to Company C for Contract C. A
also owns new Contract C. Because the funds were transferred by Company B directly
to Company C, A had no access to the funds during the transaction other than in the
form of annuity contracts. Therefore, the transfer of a portion of Contract B to Company
C for new Contract C is a tax-free exchange under ' 1035. The continued existence of
Contract B with its reduced cash value does not affect the tax-free character of the
exchange.

- 3 -

Under ' 1035(d), A=s basis in Contract B immediately before the exchange is
allocated ratably between Contract B and Contract C based on the percentage of the
cash value retained in Contract B and the percentage of the cash value transferred to
purchase Contract C. A=s investment in Contract B immediately before the exchange is
allocated ratably between Contract B and Contract C based on the percentage of the
cash value retained in Contract B and the percentage of the cash value transferred to
purchase Contract C.

HOLDINGS

(1) The direct transfer by A of a portion of the cash surrender value of Contract B
to Company C for Contract C is a tax-free exchange under ' 1035.

(2) After the transaction, pursuant to ' 1035, A=s basis in Contract C equals 60
percent of A=s basis in Contract B immediately before the exchange. After the
transaction, A=s basis in Contract B equals 40 percent of A=s basis in Contract B
immediately before the exchange.

(3) After the transaction, pursuant to ' 72, A=s investment in Contract C equals 60
percent of A=s investment in Contract B immediately before the exchange. After the
transaction, A=s investment in Contract B equals 40 percent of A=s investment in
Contract B immediately before the exchange.

TREATMENT OF CERTAIN PARTIAL EXCHANGES

Treasury and the Internal Revenue Service (the Service) are concerned that
some taxpayers may enter into a partial exchange of a portion of one annuity contract
for a new annuity contract as a means of reducing or avoiding tax that would otherwise
be imposed under ' 72(e). On August 18, 2003,Treasury and the Service published
Notice 2003-51, 2003-33 I.R.B. __, which announced that Treasury and the Service are
considering whether to exercise the authority granted under ' 72(e)(11) to promulgate
regulations that would prescribe the tax treatment of these transactions. Notice 2003-
51 provides interim guidance regarding the tax treatment of these transactions. Finally,
Notice 2003-51 requests comments regarding the appropriate application of ' 72(e)(11)
to these transactions. Taxpayers should review Notice 2003-51 prior to entering into a
partial exchange to determine whether their transaction is subject to the interim
guidance provided by the notice.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ann H. Logan of the Office of
Associate Chief Counsel (Financial Institutions and Products). For further information
regarding this revenue ruling contact her at (202) 622-3970 (not a toll-free call).