By Robert S. Keebler, CPA, MST, AEP (Distinguished) & Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL
IRC § 1035 generally allows taxpayers to make a tax-free exchange of one annuity for another better suited to the taxpayer’s needs. Until recently, however, this benefit was not available to taxpayers who inherited non-qualified annuities. Such taxpayers were stuck with the annuity selected by the decedent no matter how unfavorable it may have been for them.
Recently issued PLR 201330016 now gives a green light to tax-free exchanges of such annuities, however, provided that certain requirements are satisfied. This creates an important new opportunity for tax and financial advisors to help clients.
Background—Requirements for a Tax-Free Exchange
The following three requirements must be met to have a tax-free exchange of an inherited, non-qualified annuity:
(1) both the original contract and the new contract must qualify as annuities under the requirements of IRC § 72(s);
(2) the exchange must meet the technical requirements of IRC § 1035; and
(3) it must be possible to extract the full value of the old contract so it can be transferred.
IRC § 72(s)
For purposes of IRC § 1035 exchanges, the key IRC § 72(s) issue is the distribution schedule for the new annuity. IRC § 72(s)(1)(B)) provides that if the holder of a contract dies before the annuity starting date, the entire interest in the contract must be distributed within five years after the death of such holder. Under an exception in IRC § 72(s)(2), however, the interest can be paid over the life of the designated beneficiary.
IRC § 1035
IRC § 1035 introduces two more potential obstacles to a tax-free exchange. First, Reg. § 1.1035-1 provides that tax-free treatment is available only if the owner under the new contract is the same as the owner under the original contract. Second, Revenue Ruling 2007-24 holds that there must be a direct transfer of funds between the issuer of the original annuity and the issuer of the new annuity.
Extracting the Value of the Old Contract
Note that an exchange of an inherited annuity can be made only if the full value of the original contract can be removed and transferred directly to the new issuer. If an inherited annuity contract has been annuitized, there is no cash value to exchange. A tax-free exchange may also be impossible if the inherited annuity limits payouts. For example, some contracts requirethat the beneficiary take money out over a minimum of 5 years and not as a liquid lump sum. A restricted beneficiary designation form that allows beneficiaries to access only set annual amounts would also appear to prevent a postmortem IRC §1035 exchange by the beneficiary.
The taxpayer in PLR 201330016 was able to meet all three requirements. Thus, the ruling can be used as a roadmap for taxpayers who wish to make a tax-free exchange of an inherited, non-qualified annuity.
Facts of the Ruling
The taxpayer’s mother owned fixed and variable annuities naming the taxpayer as beneficiary. The annuities all provided that if the mother died before reaching her required beginning date, the death benefit would be paid to the taxpayer. When the mother did die before reaching her annuity starting date, the taxpayer elected to receive the death benefits provided by the annuities over her life expectancy, as permitted under IRC § 72(s)(2)(B).
The taxpayer later determined that she might be able to increase the amount of her payouts if she could replace them with payouts from another company. To take advantage of this opportunity, she acquired new annuities, remitting the amounts payable under the original annuities directly to the new issuer, which credited these amounts to the new contract. In acquiring the new contract, the taxpayer elected to receive payments over her life expectancy and agreed (1) not to transfer ownership of the new contract and (2) not to make any additional contributions to the new contract.
The IRS ruled that the exchanges were tax-free under IRC § 1035. The original contract was an annuity because it provided for distribution of the mother’s entire interest over her life expectancy as required by IRC § 72(s). The new contract was also an annuity contract. The combination of (1) the election by the taxpayer to receive distributions over her life expectancy, (2) the agreement not to transfer the annuity and (3) the agreement not to make any additional contributions to the new contract obligated the new issuer to pay the taxpayer the entire interest her mother had in the original contracts over the taxpayer’s life expectancy as required under IRC § 72(s). In addition, the value of the original contract was transferred directly to the new issuer, the owner of the new contract was the same as the owner of the original contract, no additions could be made to the new contract and there were no restrictions on extracting the value of the original contract. Thus, all requirements were met.
PLR 201330016 opens up important new planning opportunities for taxpayers who inherit non-qualified annuities. They may now be able to make a tax-free exchange of the annuity to: (1) take advantage of higher payouts, (2) switch from a fixed annuity to a variable annuity, (3) switch to investments better suited to their investment objectives, (4) switch to a stronger annuity issuer, (5) lower annuity expenses or (6) simply update the annuity. For example, a fixed annuity invested to produce income might have been a good choice for an elderly annuity owner, but is not suitable for a young beneficiary of the annuity who wants a variable annuity that can be invested for growth.
Several cautions are in order.
Effect of a PLR. APLR can be relied upon only by the taxpayer to whom it was issued and applies only to the specific facts presented. On the other hand, PLRs reflect the current IRS position on an issue and the position is unlikely to change unless the PLR is abused. Thus, other taxpayers with similar facts can draw considerable comfort from the ruling.
Will Insurance Companies Allow the Exchanges? Historically, annuity companies have not permitted beneficiaries to make IRC § 1035 exchanges of non-qualified inherited annuities. PLR 201330016 is a favorable development for the insurance industry, however, and it seems likely that many companies will decide to allow exchanges in the future. To make sure that the technical requirements of PLR 201330016 are satisfied, they should develop standard forms similar to those used in the ruling. These forms should include contractual provisions stating that: (1) annuity ownership could not be transferred, (2) new contributions could not be made to the annuity and (3) distributions had to be made as least as rapidly as required under IRC § 72(s) for the original annuity contract.
Due Diligence. Investors and their advisors should carefully analyze the exchange decision. This may include an in-depth comparison of the payouts, potential investments, expenses, and issuer strength for the original annuity with those for potential replacement annuities. Given that withdrawals willbe required in the first year from the new contract to comply with IRC § 72(s), it is also important to verify that those withdrawals will not run afoul of any new surrender charges of the new contract or result in the immediate forfeiture of any gains.
PLR 201330016 creates an important new planning opportunity for taxpayers who inherited a non-qualified deferred annuity. Tax and financial advisors should send out client letters on the PLR to identify clients who could benefit from the ruling.
RELATED EDUCATIONAL TELECONFERENCE
Check out the remarkable, dramatic planning options presented by this new PLR, by joining us, along with Michael Kitces, who applied for and received the PLR and nationally renowned CPA and tax authority, Robert S. Keebler, CPA, MST, AEP, on Wednesday, September 11, 2013 at 9am Pacific (12pm Eastern), for a teleconference entitled “Post-Mortem Planning For Deferred Annuities”. >For more information and to register…
ABOUT THE AUTHORS
Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters. He can be reached at (920)593-1701 or at [email protected].
Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, is a partner and the Director of Research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland that oversees approximately $1 billion of client assets. In addition, he is the practitioner editor of the Journal of Financial Planning, and the publisher of the e-newsletter The Kitces Report and the popular financial planning industry blog Nerd’s Eye View through his website www.Kitces.com, dedicated to advancing knowledge in financial planning.