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Partial 1035 Exchange Issue Is Raised

CHICAGO - The annuity industry is expecting to receive a formal statement soon from the Internal Revenue Service as to whether partial 1035 exchanges are allowable.

The traditional stance of the IRS has been that a 1035 exchange - with its favorable tax treatment - can only be done if a person is switching a whole annuity to another annuity, industry lawyers said. But, a tax court decision in December 1998 allowed a partial 1035. In the case, Dona Elizabeth Conway vs. Commissioner of Internal Revenue, filed Dec. 30, 1998, the court found that because the transaction was from one annuity to another and the two contracts were written for the same person, the transfer was non-taxable under Rule 1035.

The IRS is expected to make a public statement about its opinion of the Conway case soon, said Joseph McKeever, an attorney with Davis & Harman of Washington, D.C. at the National Association for Variable Annuities' annual meeting here last month.

Conway bought an annuity from Fortis Benefits Insurance of Woodbury, Minn. for $195,643 in 1992, according to the tax court case file.

In 1994, Conway asked Fortis to withdraw $119,000 from the annuity and issue a check to transfer funds to Equitable Life Insurance of Iowa. Fortis debited Conway's annuity for $119,000, took out $10,000 as a surrender charge, issued a check for $109,000 made out to Equitable and mailed the check to Equitable, the file said. Equitable then opened an annuity contract for Conway for the $109,000, the file said.

Conway said she wanted the withdrawal of funds from the Fortis annuity and transfer of funds to Equitable to purchase another annuity to be treated as a section 1035 non-taxable exchange, the file said.

In 1994, Fortis mailed Conway a tax Form 1099-R indicating that the transaction was taxable and that $30,535 of the $119,000 withdrawn represented taxable income, the file said. But in 1997, Fortis reversed its position and sent Conway a letter saying that the transaction should have been processed by Fortis as a non-taxable 1035 exchange, the file said.

After an audit, the IRS determined that Conway's exchange was taxable under section 1035 and that she had therefore received $30,535 of unreported taxable income. The IRS also determined that Conway was liable for a 10 percent penalty of the withdrawal from the annuity contract, the file said.

The case went to trial and the tax court ruled in favor of Conway, the file said. The court said Conway's situation seemed to fit the fact that Rule 1035 "...required only that the contract be of the same type, e.g., an annuity for an annuity and that the obligee under the two contracts be the same person. No other requirements are set forth in the applicable regulations."

Fortis does not normally allow partial 1035s and has not completed one since the Conway case, said Michael O'Connor, assistant general counsel for pension and tax for the firm. Conway pursued the partial transfer on her own, with help from tax advisors, which is why Fortis decided to process it as a 1035 exchange, O'Connor said.

"Our policy has been not to do partial 1035s because they're in a gray area where the IRS is likely to challenge them," O'Connor said. "This person had her own tax advisors so she proceeded on the advice of her own tax advisors."

In fact, O'Connor confirmed that Fortis originally considered the transfer taxable.

"We did issue a 1099 indicating it was a taxable distribution," he said. "After we did that, her advisors contacted us and said that they were advising her and they wished to claim it as a partial exchange qualifying under Section 1035 of the code. Because she had professional advisors, we acquiesced with that and complied with their request to reclassify it as a 1035."

The tax court decision in favor of Conway "was something of a surprise, but not a complete surprise because we do recognize play in the language of Section 1035 of the code," he said.

In the future, Fortis "will continue to treat partial 1035s as taxable distributions," O'Connor said. "And we will advise our clients accordingly until we hear differently from the IRS because we understand that it remains the IRS' position. However, if professional advisors intervene on behalf of their client, we would be prepared to make another exception."

In general, the insurance industry is taking the same stance - that it will continue to discourage partial 1035s until the IRS clearly states that they are allowed, said John Adney, an attorney with Davis & Harman of Washington, D.C.

Annuity providers would like partial 1035s to be allowable, and would also like to see partial annuitizations in the future, Adney said. A partial annuitization - in which only part of an annuity contract is annuitized - might best be completed by considering the annuitized portion as a separate contract, he said.

None of the half dozen major companies contacted by Annuity Market News, besides Fortis, said they had ever completed partial 1035s. None reported having done partial annuitizations either.

There have been a number of other partial 1035 exchanges over the years, but they have been relatively rare, said Norse Blazzard, principal of Blazzard, Grodd and Hasenauer of Westport, Conn.

"It's more likely done based on what the customer wants, not something presented by the insurance company as a thing that should be done," he said.