IRS Revenue Procedure – Tax Treatment of Certain Tax-Free Exchanges of Annuity Contracts
In March, the IRS updated Notice 2003-51 by issuing a revenue procedure, Rev. Proc. 2008-24. These clarifications are generally quite favorable and although both Notice 2003-51 and Rev. Proc. 2008-24 deal with annuity contracts, they may have important implications for partial exchanges of life insurance policies.
Notice 2003-51 provided interim guidance on partial exchanges and was issued in the wake of the Tax Court ruling against the IRS in Conway v.
Commissioner (1999). The court ruled that the partial exchange of one annuity contract for another qualifies as tax-free under IRC Section 1035 (subject to certain conditions).
Although the IRS acquiesced to the Tax Court’s decision, it was conditioned upon two requirements:
1) All funds in the original contract, less any surrender fee, must remain in the annuity contracts after the transaction;
2) The transaction must also meet the requirements of Section 1035.
Notice 2003-51, among other things, stated that withdrawals or surrenders from either surviving annuity contract within 24 months from the date the partial exchange was consummated would be treated as a single, integrated contract in determining the applicable tax under Section 72(e) (resulting in a greater amount of cash surrendered or withdrawn being considered gain as opposed to cost basis, resulting in higher income taxes and potentially a greater amount of excise tax). Exceptions to the imposition of penalty tax were granted if the taxpayer could prove that a distribution was contemplated at the time of exchange and demonstrate that one of the conditions of Section 72(q)(2) occurred between the time of exchange and distribution (or other life event, e.g., divorce).
With Rev Proc. 2008-24, the Service has shortened the 24 month requirement stated in 2003-51 to 12 months. Importantly, the Service also dropped the requirement for distributions to have not been contemplated at the time of exchange (the taxpayer must still demonstrate that one of the conditions described in Section 72(q)(2)(A), (B), (C), (E), (F), (G), (H) or (J) or similar life event occurred between the date of exchange and the date of distribution to avoid taxation as a single, integrated contract, i.e., if the distributions takes place within 12 months of the exchange).
The Service will not treat qualifying partial exchanges as aggregated under Section 72(e)(12), even if both contracts were issued by the same insurance company.
2008-24 also clarifies that when a partial transfer does not meet the requirements of Section 1035, it will be treated as a taxable distribution followed by a payment for the new contract. It also makes clear that the Section 72(q)(2) exceptions noted above cannot be satisfied based on payments under 72(q)(2)(D) (distributions under immediate annuities) pending the IRS’ resolution of partial annuitization related issues, which are still under review.
IRS Private Letter Ruling – 1035 Exchanges of COLI/BOLI
This is the most recent in a series of relatively positive and affirming private letter rulings issued by the Service in connection with 1035 exchanges of COLI/BOLI plans (it is worthwhile noting that until a few years ago there were no PLRs issued in connection with COLI/BOLI plans, just individually owned policies).
The taxpayer in PLR 200801001 was seeking confirmation that the proposed exchange would be tax free under Section 1035 and that the cost basis under the original policies would be carried over to the replacement successor policies. Individual general account policies and group general account policies were to be exchanged for group variable or separate account policies. Some polices would be subject to an internal exchange (i.e., the carrier would remain the same) while others would move to a new carrier.
The Service affirmed the sought after tax treatment and cost basis treatment. As part of its rationale for affirming the first issue, the service noted that certificates issued under a group contract on an individual are treated as separate contracts under state insurance laws and as separate contracts for purposes under the IRC (i.e., Sec 7702A).
PLR 200801001 does not specifically address whether Sections 101(j) and 6039I (COLI Best Practices Act) will be triggered by the exchange. However, last year, in PLR 200715006 the Service stated that 101(j) and 6039I did not apply to a similar exchange (one in which the face amounts of the policies would not increase as a result of the exchange except to the extent necessary to continue to comply with Section 7702(a)).
IRS Revenue Ruling – Performance Based Compensation
In late February the IRS issued RR 2008-13 in response to the backlash from public companies to PLR 200804004 (issued in September 2007), which reversed two earlier PLRs addressing the scope of “performance based compensation” under IRC 162(m) (performance-based compensation exception to the $1 million deduction limitation). While essentially reinforcing its position under PLR 200804004, RR 2008-13 does not apply retroactively and applies to periods beginning after January 1, 2009. This Groom Law Group memorandum provides additional details.
Safeguarding Personal Information
In the aftermath of well publicized breaches in data security, the SEC is proposing amendments to Regulation S-P, which implemented certain provisions of Gramm-Leach-Bliley Act and the Fair Credit Reporting Act. The proposed amendments would entail more specific requirements for safeguarding information and responding to information security breaches and expand the scope of information covered by Regulation S-P. They also broaden the scope of application of the disposal provisions to include natural persons associated with brokers, dealers, investment advisors and transfer agents.
Comments on the proposed rules must be received by May 12, 2008. The proposed new rules are fairly voluminous (over 100 pages) and we are reviewing them for possible implications to COLI/BOLI owners, carriers, service providers and vendors.
Israeli Discount Bank vs MetLife and Blackrock
In late January Israeli Discount Bank (IDB) filed suit in New York against Met Life and Blackrock claiming it lost $2 million on assets invested in its COLI investment fund managed by Blackrock and alleging that Met Life claimed liquidity issues affecting other investors precluded prompt movement of assets when IDB demanded a reallocation from the Blackrock managed fund. In a somewhat unusual move, IDB followed up the suit in February with a prominent advertisement in the Wall Street Journal inviting other policyowners to contact IDB’s counsel regarding joining the suit.
HB 3361 – Pension Protection Technical Corrections Act of 2007
On March 13 House Bill 3361 was introduced. This is the Pension Protection Technical Corrections Act of 2007 (SB 1974 is the Senate companion bill). Of note is the absence of any technical corrections to the COLI Best Practices portions of the PPA. The IRS Priority Guidance Plan indicated that further clarification and guidance regarding implementation of COLI BPA will be forthcoming in 2008.