52 Bull. Sec. Tax'n 895 (1998-1999)
Taxpayer Was Entitled to Nonrecognition of Gain under Section 1035 on the Partial Exchange of an Annuity: Conway v. Commissioner

handle is hein.journals/txlr52 and id is 905 raw text is: NOTE
In Conway v. Commissioner,' the Tax Court held that the transfer of a portion
of an annuity contract into another annuity contract, with the original annuity
surviving, qualifies under section 1035 as a nontaxable annuity-for-annuity ex-
change.2 The court reasoned that the transfer of funds from the old annuity
account to the new account was direct and thereby qualified for nonrecognition
of gain under section 1035.1 The decision allows a taxpayer to continue to
accrue interest on the original annuity account while also having the benefit of a
cash distribution which, when directly invested in a new annuity, becomes a tax-
free exchange under section 1035.
Part I of this Note discusses section 1035, section 72 and the facts of Conway.
Part II discusses the arguments presented by each of the parties and the Tax
Court's decision. Part I1 analyzes the decision and concludes that the court
erred in focusing on the direct nature of the transfer rather than on the fact that
the transfer was only a partial surrender of the original policy. Part IV highlights
the practical consequences of the court's decision.
A. Section 1035
Section 1035(a)(3) provides nonrecognition treatment on the exchange of an
annuity contract for another annuity contract. An annuity is defined in section
1035(b)(2) as a contract with an insurance company which depends in part on
the life expectancy of the insured, but which may be payable during the life of
the annuitant only in installments.
If the annuity contract exchange is not a section 1035 exchange, it is gov-
erned by section 72(e)(2)(B)(i). Section 72(e)(2)(B)(i) requires a taxpayer to
include in gross income any distribution of an annuity contract prior to the
annuity starting date to the extent allocable to income on the contract, but not to
the extent allocable to the investment in the contract, which includes amounts
received in partial surrenders.' In addition, if the transaction does not qualify as
a nontaxable exchange, but is instead governed by section 72(e)(2)(B)(i), then
section 72(q) imposes a penalty of ten percent of the premature distribution
I111 T.C. 350 (1998).
'See id. at 356.
3See id. Section 1035 provides that no gain or loss shall be recognized on the exchange of an
annuity contract for an annuity contract. I.R.C.  1035(a)(3).
4Under section 72, investment appreciation is first included in gross income, and the excess of any
distribution over the amount of investment appreciation is allocated to basis.
5See I.R.C.  72(q)(1). Petitioner is not liable for any penalty amount if the transaction is a
nontaxable exchange, because under section 1035 there would be no gain recognized and therefore
no amount includable in gross income against which to assess the penalty.

Tax Lawyer, Vol. 52, No. 4

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