SECTION 2. BACKGROUND

.01 Section 72 sets forth rules for the income taxation of amounts received under an annuity, endowment, or life insurance contract.

.02 Section 72(a) provides that gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract. Section 72(b), however, excludes from gross income that part of an amount received as an annuity that bears the same ratio to that amount as the investment in the contract bears to the expected return under the contract (determined as of the annuity starting date). For this purpose, investment in the contract is defined in § 72(c)(1) to equal the aggregate amount of premiums or other consideration paid for the contract as of the annuity starting date, minus the aggregate amount received under the contract before that date, to the extent that amount was excludable from gross income.

.03 Section 72(e) governs the treatment of amounts received under an annuity contract that are not received as an annuity.

Section 72(e)(2) provides in general that such amounts received on or after the annuity starting date are included in gross income, and that amounts received before the annuity starting date are included in gross income to the extent allocable to income on the contract, i.e. on an incomefirst basis. For purposes of determining the amount taxable under this subsection, § 72(e)(6) defines investment in the contract as the aggregate amount of premiums or other consideration paid for the contract, minus the aggregate amount previously received under the contract, to the extent that amount was excludable from gross income.

.04 Section 1035(a) provides that no gain or loss shall be recognized on certain exchanges of insurance policies. The legislative history of § 1035 states that tax-free exchange treatment is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs.” H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954). 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.”

.05 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. Such a transaction is sometimes referred to as a “partial exchange.” See also Rev. Rul. 2003–76, 2003–2 C.B. 355 (direct transfer of a portion of an annuity contract for a new annuity contract treated as a tax-free exchange under § 1035); Rev. Rul. 2002–75, 2002–2 C.B. 812 (assignment of an entire annuity contract for deposit into a preexisting annuity contract treated as a tax-free exchange under § 1035).

.06 Section 7702B(b) defines a qualified long-term care insurance contract as an insurance contract that (a) provides protection only for coverage of qualified long

term care services; (b) does not pay or reimburse expenses incurred for certain services or items reimbursable under Title XVIII of the Social Security Act; (c) is guaranteed renewable; (d) does not provide for a cash surrender value; (e) permits premium refunds or policyholder dividends to be applied only as a reduction in future premiums or an increase in future benefits; and (f) meets the consumer protection requirements of § 7702B(g).

.07 Under § 7702B(a), a qualified long-term care insurance contract is treated as an accident and health insurance contract. Premiums paid under a qualified long-term care insurance contract are generally treated as payments for insurance for purposes of the deduction under § 213 for expenses paid for medical care, and amounts received as benefits under such a contract generally are treated as amounts received for personal injuries and sickness and as reimbursement for expenses actually incurred for medical care. An employer plan providing coverage under such a contract treats the contract as an accident and health plan with respect to that coverage. The issuer of a qualified long-term care insurance contract treats the contract as a guaranteed renewable contract subject to the rules of § 816(e).