FORM MATTERS

Section 1035 of the Internal Revenue Code allows a taxpayer to swap an annuity contract for another annuity contract without incurring income or gain. The contracts exchanged must relate to the same insured and the obligee(s) under both contracts must remain the same.

The statute works fine when the taxpayer directly swaps one contract for another, even though the cash value of one contract is applied to the new annuity. Such swap will often be accomplished by an assignment of the old annuity contract to the company issuing the new annuity. Alternatively, the cash value of the old contract may be directly transferred by its issuing company to the issuer of the new annuity.

In Rev.Rul. 2007-24, the owner of an annuity requested that the issuer of his annuity send funds directly to the issuer of a new annuity from his old annuity contract. The first issuing company refused, and instead mailed the owner a check for the value of his annuity contract. The owner, seeking to come within Section 1035, did not deposit the check into his own account. Instead, he endorsed it over to the new issuing company.

The IRS ruled that this indirect swap was ineffective for purposes of Section 1035. Instead, since the owner received a check for the value of his old contract, this will be taxable to him as an annuity distribution under Code Section 72(e).

You never know when the IRS will be lenient when a taxpayer follows the substance of an exemption or reduction provision, but doesn't quite exactly follow the form. Nonetheless, it is generally true that for exemptions from gain or loss on exchanges of items to apply, the IRS usually does not like to see cash pass through the hands of the exchanging party, and thus will hold the taxpayer to the exact form of their transaction instead of applying a more liberal "substance over form" argument.