Part III. Administrative, Procedural, and Miscellaneous

Section 1035.—Certain Exchanges of Insurance Policies

Notice 2003–51

SECTION 1—PURPOSE

This notice addresses the taxation of certain tax-free exchanges of annuity contracts under § 72(e) and § 1035 of the Internal Revenue Code. This notice announces that Treasury and the Service are considering whether to exercise the authority granted under § 72(e)(11) to promulgate regulations that would prescribe the tax treatment of these transactions. This notice provides interim guidance regarding the tax treatment of these transactions. Finally, this notice requests comments regarding the appropriate application of § 72(e)(11) to these transactions.

SECTION 2—BACKGROUND

Section 1035(a)(3) provides that no gain or loss shall be recognized on the exchange of an annuity contract for another annuity contract. Section 1.1035–1 of the Income Tax Regulations provides that “the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under § 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract.”

The legislative history of § 1035 states that exchange treatment is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain.” H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954). In Conway v. Commissioner, 111 T.C. 350 (1998), acq ., 1999–2 C.B. xvi, the Tax Court held that the direct exchange by an insurance company of a portion of an existing annuity contract to an unrelated insurance company for a new annuity contract was a tax-free exchange under § 1035. In that case, the transfer was made directly from the first insurance company to the unrelated insurance company, and none of the assets transferred in the transaction were received by the taxpayer.

Section 1035(d)(2) cross-references § 1031 for the rules to determine the basis of property acquired in a § 1035 exchange. Section 1031(d) provides that property acquired in a § 1035 exchange has the same basis as that of the property exchanged, decreased by the amount of any money received by the taxpayer and increased by any gain (or decreased by any loss) recognized by the taxpayer on the exchange. Revenue Ruling 2003–76, 2003–33 I.R.B. 355, addresses a transaction in which a taxpayer transfers a portion of the cash value of an existing contract to a new insurance company in exchange for a new annuity contract (commonly referred to as “partial exchanges”). Rev. Rul. 2003–76 holds that the basis under § 1031 and investment in the contract under § 72 of the surviving contract immediately before the exchange is allocated ratably between the surviving contract and the newly issued contract.

Section 72(e) governs the federal tax treatment of distributions from an annuity contract. Section 72(e)(11) provides anti-abuse rules applicable to transactions governed by § 72(e). Section 72(e)(11)(B) grants the Secretary broad authority to publish regulations as necessary “to prevent avoidance of the purposes of

[§ 72(e)].”

Section 72(q)(1) imposes a 10 percent penalty on withdrawals from, or surrenders of, annuity contracts. Section 72(q)(2) provides that distributions from an annuity contract will not be subject to the 10 percent penalty if the distribution is made after the taxpayer attains age 59-1/2, if the distribution is made on or after the death of the annuity holder, if the distribution is attributable to the taxpayer’s becoming disabled, or if other conditions not relevant here are satisfied.

SECTION 3—TREATMENT OF CERTAIN PARTIAL EXCHANGES

Treasury and the IRS are concerned that some taxpayers may enter into a transaction similar to the transaction at issue in Conway (commonly referred to as a “partial exchange”) to reduce or avoid the tax that would otherwise be imposed by § 72(e)(2). For example, if a taxpayer withdraws $100 from an annuity contract

with a cash surrender value of $200 and investment in the contract of $80, the entire $100 of the withdrawal would be included in income pursuant to § 72(e)(2). However, if that same taxpayer assigned 50 percent of the cash surrender value of the annuity contract in a partial exchange, such that the cash surrender value of each contract after the exchange was $100 and the investment in each contract after the exchange was $40, and then surrendered either the existing annuity contract or the new annuity contract, under § 72(e)(2) only $60 would be included in income and $40 would be excluded as a return of investment in the contract.

Treasury and the Service are considering whether to exercise the regulatory authority of § 72(e)(11) to address the transaction described above to assure that such transactions do not become a vehicle for avoiding the rules of § 72(e). In particular, Treasury and the Service are considering whether such regulations should provide rules for determining when a partial exchange of an annuity contract followed by the surrender of, or distributions from, either the surviving annuity contract or the new annuity contract should be presumed to have been entered into for tax avoidance purposes. Specifically, Treasury and the Service are considering whether to treat surrenders or distributions that occur within 24 months of the date on which the partial exchange was completed as presumptively entered into for tax avoidance purposes. However, Treasury and the Service believe that taxpayers should be provided the opportunity to rebut any presumption by demonstrating that the surrender or withdrawal was not contemplated at the time the partial exchange was completed. Treasury and the Service are considering whether to treat any surrender or distribution that is not subject to the 10 percent penalty tax imposed by § 72(q)(1) because it is described in § 72(q)(2) as successfully rebutting any presumption. In addition, Treasury and the Service are considering whether other events, such as the safe harbors set forth in § 1.121–3T(e), for divorce, loss of employment and other similar events, should be treated as successfully rebutting any presumption.

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institution has collected its own historical basis and earnings information for the CESAs it holds, the financial institution may not have the basis and earnings information for amounts that were transferred to the financial institution from CESAs managed by other financial institutions. Commentators also asked whether gross distributions required to be reported on Form 1099–Q include trustee-to-trustee transfers. Commentators indicated that the records of a financial institution that acts as trustee or custodian of CESAs may not establish whether a CESA distribution was sent to a CESA or QTP at another financial institution or directly to the beneficiary. Commentators requested additional time to allow financial institutions to implement appropriate recordkeeping and reporting procedures.

Modifications to reporting for 2003

The IRS is modifying the reporting requirements relating to CESAs. If a trustee or custodian is unable to calculate the earnings and basis portions of a gross distribution from a CESA made in 2003, the trustee or custodian will satisfy the reporting requirements of section 530(h) if the trustee or custodian provides in a timely manner a Form 1099–Q that includes:

amount of any excess contributions and earnings thereon distributed to a participant during the calendar year, in box 1;

for earnings and basis information in boxes 2 and 3, which should be left blank unless the gross distribution includes a distribution of earnings on excess contributions;

cess contributions in box 2, computed using the method for calculating the net income attributable to IRA contributions that are distributed as a returned contribution pursuant to section 408(d)(4) of the Code under Notice 2000–39, 2000–2 C.B. 132, and Proposed section 1.408–11, Income Tax Regulations;

reported in box 2, an indication in the

SECTION 4—INTERIM GUIDANCE

Pending the publication of final regulations, the Service, using general principles of tax law, will consider all the facts and circumstances to determine whether a partial exchange and a subsequent withdrawal from, or surrender of, either the surviving annuity contract or the new annuity contract within 24 months of the date on which the partial exchange was completed should be treated as an integrated transaction, and thus whether the two contracts should be viewed as a single contract to determine the tax treatment of a surrender or withdrawal under § 72(e). See Helvering v. LeGeirse, 312 U.S. 531 (1941) (concluding that, in substance, annuity contracts and the life insurance contracts purchased by the taxpayer were integrated contracts). However, if a taxpayer demonstrates that one of the conditions of § 72(q)(2), or any other similar life event, such as a divorce or the loss of employment, occurred between the partial exchange and the surrender or distribution, and that the surrender or distribution was not contemplated at the time of the partial exchange, the taxpayer will not be treated as having entered into the partial exchange and the surrender or distribution for tax avoidance purposes.

SECTION 5—REQUEST FOR COMMENTS

Treasury and the Service request comments regarding the need for regulations under § 72(e)(11) to prevent the use of partial exchange transactions as a means of avoiding the tax imposed by § 72(e). In addition, Treasury and the Service request comments regarding whether the principles outlined in Section 3 appropriately address Treasury’s and the Service’s concern without significantly limiting the ability of taxpayers to use partial exchanges to acquire annuity contracts that “are better suited to their needs” as contemplated by Congress. Treasury and the Service also request comments regarding any other similar transactions that any regulations under § 72(e)(11) should address.

DRAFTING INFORMATION

The principal author of this notice is Ann H. Logan of the Office of Associate Chief Counsel (Financial Institutions and

Products). For further information regarding this notice, contact her at (202) 622–3970 (not a toll-free call).

Coverdell Education Savings Accounts

Notice 2003–53

This notice provides guidance regarding certain reporting requirements and transition rules applicable to Coverdell Education Savings Accounts (“CESAs”) described in section 530 of the Internal Revenue Code.

Section 530(h) provides that the trustee or custodian of a CESA shall make reports to the Secretary and to the beneficiary of the CESA with respect to contributions, distributions, and such other matters as the Secretary may require in the time and manner required by the Secretary.

For calendar years before 2003, CESA trustees and custodians were required to report on Form 1099–R ( Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. ) gross distributions from CESAs during the calendar year, together with other information including the name, address and TIN of the beneficiary. For calendar years after 2002, CESA trustees and custodians are required to report on Form 1099–Q ( Payments From Qualified Education Programs (Under Sections 529 and 530) ) not only gross distributions from CESAs during the calendar year (as they did on Form 1099–R), but also the earnings and basis portions of the distributions, and certain other information. Gross distributions reportable on Form 1099–Q include transfers from the CESA trustee to a section 529 qualified tuition program (QTP) or to another CESA (trustee-to-trustee transfers).

The Internal Revenue Service (IRS) has received comments concerning changes to the reporting requirements for distributions from CESAs. Commentators have stated that a financial institution that acts as trustee or custodian of CESAs may not have collected historical account information that would enable the financial institution to determine the basis and earnings portions of gross distributions for a taxable year. Further, even if a financial

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empty box below boxes 5 and 6 that the amount in box 2 includes earnings on excess contributions;

(appropriately labeled) as of December 31, 2003, in the empty box below boxes 5 and 6; and

below boxes 5 and 6 to Publication 970 ( Tax Benefits for Education ), as provided in the instructions to Form 1099–Q, so that recipients will know how to calculate the earnings portion of the gross distribution. If the trustee or custodian does not have records indicating whether a gross distribution from a CESA made in 2003 was a trustee-to-trustee transfer, the trustee or custodian may leave box 4 of Form 1099–Q blank. These modifications allow additional time for CESA trustees or custodians to implement recordkeeping procedures to enable them to report basis and earnings information, and to identify trustee-to-trustee transfers. The IRS expects to publish further guidance about required reporting for CESA distributions made in 2004 and future years. These modifications remain in effect until further guidance is issued. These modifications do not apply to QTPs, which are required to report distributions, including trustee-to-trustee transfers, in accordance with Notice 2001–81, 2001–2 C.B. 617.

Request for Comments

The IRS recognizes that to report basis and earnings information for 2004 and future years, trustees and custodians that have not previously collected this information with respect to existing CESAs will need to use information from various sources to establish basis and earnings. The IRS invites comments on sources of information that should be considered satisfactory for this purpose, including Forms 5498 ( IRA and Coverdell ESA Contribu- tion Information ) filed by other trustees or custodians, account statements from financial institutions, and other forms of documentation. The IRS invites comments on an appropriate rule for determining basis and earnings if documentation is not available. The IRS also invites comments

on other CESA reporting matters that may be appropriate for additional guidance.

Comments should reference Notice 2003–53. Please send written comments by October 17, 2003, to: CC:PA:RU (Notice 2003–53), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:RU (Notice 2003–53), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington DC. Comments may also be sent via e-mail to notice.comments@irscounsel.treas.gov . Comments will be available for public inspection.

DRAFTING INFORMATION

The principal author of this notice is Monice Rosenbaum of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this notice, contact Ms. Rosenbaum at (202) 622–6070 (not a toll-free number).

Common Trust Fund Straddle Tax Shelter

Notice 2003–54

The Internal Revenue Service and the Treasury Department have become aware of a type of transaction, described below, that is being used by taxpayers for the purpose of generating deductions. This notice alerts taxpayers and their representatives that the claimed tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes. This notice also alerts parties involved with these transactions of certain responsibilities that may arise from their involvement with these transactions.

FACTS

The transaction involves the use of a common trust fund (CTF) that invests in economically offsetting gain and loss positions in foreign currencies and allocates the gains to one or more tax indifferent parties and the losses to another taxpayer. For example, in the transaction, a bank

(Bank) forms a CTF. The CTF's plan provides for monthly valuation dates and for the computation of income and loss on a monthly basis. Two tax indifferent investors, through grantor trusts (Investors' Trusts), each invest money in the CTF. The CTF then invests the money in economically offsetting positions in foreign currencies, which become offsetting gain and loss positions as a result of market price movements. The CTF sells the gain position and allocates the gain proportionately to the Investors' Trusts.

The next month, an investor (Taxpayer) who desires a tax loss uses a grantor trust (Taxpayer's Trust) to invest in the CTF. Taxpayer's Trust makes a large investment for an 80 percent share of the CTF. Consequently, the shares of the CTF's portfolio owned by the Investors' Trusts are diminished to 10 percent each. The CTF then sells the loss position. For tax purposes, the loss is allocated proportionately among Taxpayer's Trust and Investors' Trusts. Taxpayer's Trust is allocated 80 percent of the tax loss and Investors' Trusts are each allocated 10 percent of the tax loss under the accounting rules provided in § 1.584–2(c)(2) of the Income Tax Regulations.

ANALYSIS

The transaction described in this notice has been designed to use economically offsetting positions, one or more tax indifferent parties, and the CTF accounting rules of § 584 of the Internal Revenue Code to allow Taxpayer to claim a noneconomic loss. The Service intends to challenge the purported tax benefits from this transaction on a number of grounds.

The offsetting positions entered into by the CTF did not have any effect on the CTF's net economic position or non-tax objectives and did not serve any non-tax objectives of the CTF or afford it a reasonable prospect for profit. Therefore, the losses purportedly resulting from this transaction are not allowable. See ACM Partnership v. Commissioner, 157 F.3d 231, 260 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). In addition, the Service may disallow the loss of an individual under § 165(c)(2) by asserting that the loss was not incurred in a transaction undertaken for profit. See Smith v. Com- missioner, 78 T.C. 350 (1982) and Fox v.

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Commissioner, 82 T.C. 1001 (1984) (disallowing losses from straddle transactions). Further, the Service may, under appropriate circumstances, assert that the CTF does not meet the requirements of § 584, including the requirement that it be operated in conformity with the rules and regulations of the Comptroller of the Currency, as set forth in 12 CFR § 9.18 (2003). In that event, the Service will recharacterize such a CTF as a partnership and reallocate the gains and losses in accordance with the economics of the transaction and the interests of the participants. See § 704(b). In addition, the Service may challenge the allowance of the loss deduction based on other statutory provisions, including § 988, and judicial doctrines.

Transactions that are the same as, or substantially similar to, the transaction described in this notice are identified as “listed transactions” for purposes of § 1.6011–4(b)(2) of the Income Tax Regulations and §§ 301.6111–2(b)(2) and 301.6112–1(b)(2) of the Procedure and Administration Regulations. The transaction described in this notice and the transactions described in Notice 2002–50, 2002–28 I.R.B. 98 (Partnership Straddle Tax Shelter), and Notice 2002–65, 2002–41 I.R.B. 690 (Passthrough Entity Straddle Tax Shelter), are substantially similar transactions. For purposes of §§ 1.6011–4(b)(2), 301.6111–2(b)(2), and 301.6112–1(b)(2), a transaction will be considered the same as, or substantially similar to, the transaction described in this notice even if the gain and loss legs of the economically offsetting positions are triggered in separate taxable years, or a trust other than a grantor trust is used. Further, it should be noted that, independent of their classification as “listed transactions” for purposes of §§ 1.6011–4(b)(2), 301.6111–2(b)(2), and 301.6112–1(b)(2), transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the disclosure requirements of § 6011, the tax shelter registration requirements of § 6111, or the list maintenance requirements of § 6112 (§§ 1.6011–4, 301.6111–1T, 301.6111–2 and 301.6112–1).

Persons who are required to satisfy the registration requirement of § 6111 with respect to the transaction described in this

notice or substantially similar transactions and who fail to do so may be subject to the penalty under § 6707(a). Persons who are required to satisfy the list-keeping requirement of § 6112 with respect to the transaction or substantially similar transactions and who fail to do so may be subject to the penalty under § 6708(a). In addition, the Service may impose penalties on participants in this transaction or substantially similar transactions or, as applicable, on persons who participate in the reporting of this transaction or substantially similar transactions, including the accuracy-related penalty under § 6662 and the return preparer penalty under § 6694.

The principal author of this notice is Tara P. Volungis of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice, contact Ms. Volungis at (202) 622–3080 (not a toll-free call).

26 CFR 601.201: Rulings and determination letters. (Also Part I, § 856, 1.856–4.)

Rev. Proc. 2003–66