CITES:  PLR 201625001 (June 17 2016); Greene v. Commissioner, 85 T.C. 1024 (1985); Rev. Proc. 92-44; Rev. Proc. 2011-38.

SUMMARY:   The taxpayer inherited a non-qualified annuity from his father and wished to exchange the annuity for a new annuity issued by another insurance company. He assumed the exchange would be tax-deferred under Code Section 1035, but he failed to exchange annuity contracts as required by Section 1035. Instead, he cashed in the inherited annuity contract, taking a lump sum from the original insurance company, and deposited the proceeds
into his checking account. He then used the proceeds to purchase a new annuity. Informed of his mistake by his accountant, the taxpayer requested a private letter ruling from the IRS requesting favorable (no taxable event) treatment on the transaction. The IRS ruled the distribution was taxable in the year it was received to the extent
determined under Code Section 72(e).

RELEVANCE:   The result in this ruling should not be a surprise to life insurance professionals.  Code Section 1035(a) allows the exchange of a life insurance contract for another—or a deferred annuity for another—generally without requiring recognition of gain upon the exchange.  However, failure to understand and follow the technical requirements of Code Section 1035 can lead, as it did here, to an unanticipated adverse result. While lenient rulings involving partial exchanges of annuities have been accorded Section 1035 exchange treatment (See Rev. Proc. 2008-24 as amended by Rev. Proc. 2011-38), the Service has for the most part required certain formalities to be strictly followed to accomplish the appropriate tax deferral.

MARKET TREND:  Divorce rates have been on the rise nationally over the past several years.  Accordingly, it should play a larger role in legacy management.

SYNOPSIS:  Divorce related legacy planning is critical. Spousal inheritance rights continue to exist until the divorce is final. Merely filing a divorce petition may not terminate provisions for a spouse under existing legacy planning documents or sever survivorship interests in marital or joint tenancy assets.  To ensure a client’s assets pass to intended beneficiaries, it is critical that the client amend his legacy plan (or create one) to adapt to the changed circumstances. Although clients have the most leeway to change their plans before proceedings are initiated, there are still actions the client can and should take after proceedings commence.

TAKE AWAYS:  Before a divorce petition is filed, clients can execute new wills, amend, revoke, or create and fund revocable and irrevocable trusts, execute new powers of attorney and beneficiary designations, and make other legacy planning changes in anticipation of the divorce. After divorce proceedings begin, clients can still freely execute new wills and powers of attorney, but may need to notify the spouse, obtain the spouse’s consent, or secure a court order before implementing more extensive changes. State laws differ as to what a client is authorized to change and transfers that can be made during a divorce. Clients and their advisors must work closely with divorce counsel to determine the exact planning actions that can and can’t be taken once a petition for divorce is filed.