Sapers & Wallack
Bulletins: AALU Washington Reports
Bulletin No. 10-06Deductibility of Variable Annuity Losses In Connection With Section 1035 Exchanges
MDRT: 7400.00
SEE THE CIRCULAR 230 DISCLAIMERS APPENDED TO THE CONCLUSION OF THIS WASHINGTON REPORT.
This bulletin reports on the state of the law regarding the deductibility by individuals of losses on the sale or surrender of variable annuity contracts. It has been suggested that exchanging a variable life insurance contract with respect to which the owner has suffered nondeductible losses for a variable annuity contract may, at some future time, enable the owner to realize and deduct those losses for tax purposes.
In these challenging economic times, the owners of variable life insurance contracts may have seen the value of those contract decline. If a life insurance policy is surrendered (or sold) for its cash value, and the cash value is less than the premiums paid, the owner will realize a loss. This loss is generally – in the view of the Internal Revenue Service – nondeductible, by individuals (as contrasted to institutional — e.g., corporate — owners), however, because it is deemed to be a personal (as opposed to a business, or investment) loss.
The life insurance contract may, however, be exchanged tax free (i.e., no gain recognition) for a variable annuity contract under section 1035 of the Revenue Code. The basis of the life insurance contract (which for purposes of this discussion is assumed to be higher than its fair market value – a loss generating circumstance) thereupon carries over to the annuity contract. Thereafter, assuming that losses on the surrender or sale of a variable annuity contract are deductible, and further assuming that the Revenue Service does not collapse the transaction based on “step transaction” or “form over substance” theories (i.e., it does not attempt to compress together the exchange of the life insurance contract and the sale of the annuity, thus, by such joinder, characterizing the transaction as a non loss recognition sale of the life insurance contract through the intermediary use of the annuity), the annuity contract may be surrendered or sold to produce a loss that is recognized for tax purposes.
The assumption of the loss being deductible on the sale of the variable annuity contract is based on arguments made by some life insurance practitioners and tax experts. These are the issues and conclusions advanced in those arguments:
1. Profit Motive. First of all, the annuity contract must be held either as a business asset or with the intention of making a profit. Most individual annuity holders do not hold an annuity as a business asset, but they do, in most cases, expect a profit from the annuity.
2. Miscellaneous Itemized Deduction vs. Above the Line Deduction. The second issue involves whether, if the losses are deductible, they are deductible as “miscellaneous itemized deductions,” subject to the “2% floor,” or as “above the line” deductions, that may be taken in full.
We understand from the writings of John Huggard, who publishes often on life insurance and tax subjects, that the IRS has taken the position, in informal advice rendered in 2001, that a loss incurred on the surrender of a variable annuity contract may be deducted as a miscellaneous itemized deduction, subject to the 2% floor. This means that, pursuant to Code section 67(b), the loss would be reportable on line 22 of Schedule A, and would be deductible only to the extent that it, in aggregate with other encompassed expenditures, exceeds 2% of the taxpayer’s adjusted gross income (AGI). For example, if a taxpayer incurred a loss on an annuity contract in the amount of $30,000, and had adjusted gross income of $100,000, the loss would be deductible to the extent of $28,000 (assuming no other section 67 deduction limiting expenditures to complicate the computation), or the amount by which $30,000 exceeds $2,000, which is 2% of taxpayer’s $100,000 AGI.
There is, however, support for the proposition that variable annuity losses are ordinary losses that may be deducted “above the line,” – i.e., they would not be subject to itemization and would be taken on Form 1040 itself. Rev. Rul. 61-201 permitted the deduction of a loss on the surrender of a single premium annuity contract with a refund feature, without mentioning any requirement to meet an AGI threshold. (We note, however, that section 67(b) was added to the Internal Revenue Code over 20 years later in 1986.) The revenue ruling did, however, caution, that “[n]othing in this ruling should be construed as permitting a loss deduction on the surrender of any contract other than a refund annuity.”
Support for the “above the line” theory can also be derived from the fact that, although variable annuity losses are not included on the section 67 list of itemized deductions not subject to the 2% floor, it is clear from a number of authorities that this list is not exclusive. Gambling losses, for example, are not subject to the 2% floor, but also are not specifically excluded from the application of section 67(b).
3. Other Important Considerations: Other important considerations suggested by Mr. Huggard (see paragraph 2 above) in Chapter 28 of Investing With Variable Annuities (12th Ed. 2008) include:
If the variable annuity generates an unusually large miscellaneous itemized deduction, taking such a deduction may trigger an IRS audit;
- If the proceeds from the sale of the variable annuity will be used to purchase the same annuity after realizing a loss from such a sale, the repurchase may constitute a wash sale that could negate the loss deduction;
- The sale of the variable annuity may result in the imposition of surrender charges that may make such a sale less beneficial; and
- The sale of a variable annuity resulting in a large miscellaneous itemized deduction may trigger the alternative minimum tax (AMT).
- Large miscellaneous itemized deductions may be partially phased-out depending on the taxpayer’s income level.
AALU is here neither endorsing any particular tax position on this issue, nor offering tax advice. Its purpose is to bring the subject to the attention of AALU members who, in consultation with their clients’ tax advisors, may find it helpful from a planning perspective.
In order to comply with requirements imposed by the IRS which may apply to the Washington Report as distributed or as re-circulated by our members, please be advised of the following:
THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, BY YOU FOR THE PURPOSES OF AVOIDING ANY PENALTY THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.
In the event that this Washington Report is also considered to be a “marketed opinion” within the meaning of the IRS guidance, then, as required by the IRS, please be further advised of the following:
THE ABOVE ADVICE WAS NOT WRITTEN TO SUPPORT THE PROMOTIONS OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE, AND, BASED ON THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK ADVICE FROM AN INDEPENDENT TAX ADVISOR.