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Taxation of losses on nonqualified variable annuity contracts


Guest Richard Plant

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Guest Richard Plant

Carol V. Calhoun wrote a fantastic article entitled "The Tax Law and the Nonqualified Variable Annuity" on her website at http://benefitsattorney.com/annuity.html. After reading this article I am very interested to hear opinions regarding the following situation.

Say an individual purchases a nonqualified variable annuity (as the owner and annuitant) with $100k for purposes of making a profit. The following day the market crashes, the value of the variable annuity drops to $75k and the individual surrenders the entire variable annuity for cash. Please note that this contract was not annuitized (e.g. Life & cash refund, Life & 20 year term certain, Life annuity) - it was simply liquidated for cash. Would you view this transaction as a:

1) Capital loss

2) Ordinary Loss

3) A loss deducted as a miscellaneous itemized deduction subject to the 2% AGI limit (Schedule A, Form 1040)

4) No loss at all (for tax purposes)

According to Tax Facts, under IRC Sec. 165, an "ordinary loss" could be claimed if a taxpayer sustains a loss upon the surrender of a "refund annuity" contract. Then Revenue Ruling 61-201 is cited. What if the surrender of the contract was not distributed as "refund annuity" over a predetermined number of years - but as a lump sum surrender where no prior distributions were made? I believe the definition of a "refund annuity" was defined in Reg. 1-72-7.

Others have argued that the tax treatment of variable annuities and nondeductible traditional IRAs are similar IN THAT, as discussed in Publication 590 under paragraph titled: "Recognizing Losses on IRA Investments", "If you have a loss on your traditional IRA investment, you can recognize the loss on your income tax return, but only when all the amounts in all your traditional IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your traditional IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2% limit, on Schedule A, Form 1040." It is widely believed that this philosophy could be applied separately to the aggregate of an individual's Roth IRAs, Education IRAs, or 529 College Savings plans too.

Yet, others argue that a nonqualified annuity is like holding a bond IN THAT the earnings (interest) generate ordinary income (when distributed); however, the sale of the underlying instrument is a capital transaction (just like the sale of the bond itself) and gives rise to either a capital gain or loss.

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This is a little off-topic, inasmuch as this board is supposed to deal with 403(B) annuities rather than nonqualified annuities. However, given that there isn't another board dedicated to nonqualified annuities, I'll try to answer here.

Although I have not researched this issue recently, my initial reaction is that an ordinary loss deduction would likely be available. The courts have recognized that the purchase of an annuity may be an investment decision, and thus that a loss on such investment can be deductible. See, e.g., McIngvale v. Commisssioner, 936 F.2d 833 (5th Cir. 1991); Cohan v. Commissioner, 11 B.T.A. 743 (1928).

Presumably, the reason for treating a loss on an IRA as subject to the 2% floor would be that it was a loss incurred as an employee, not a loss incurred as an investor. I'm not sure that I would agree with this view, but in any event, it should not apply to an annuity purchased outside of an employment context, purely for investment.

The situation you describe appears to me comparable to that of a refund annuity. Before a change in the law, an annuity owner was taxable on a portion of each annuity payment representing the portion of the payment estimated (at the beginning of the annuity payments) not to come from basis. If the individual actually lived long enough to recover more than his or her entire basis, a portion of each payment was still excluded from income. Thus, in the interest of symmetry, a loss could not be taken if the individual received payments equal to less than basis. However, the IRS ruled that this reasoning would not apply to a refund annuity; a fortiori, it should not apply to a single sum received in lieu of an annuity (whether directly from the insurance company, or by sale of the annuity to a third party).

However, again, this is just an initial impression. Has anyone else dealt with this issue?

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Guest olsenfin

I believe that the difference between the surrender value and taxpayer's basis is an Ordinary Loss and that Ms. Calhoun is correct that the loss should not be subject to the 2% floor (for precisely the reason she cites).

One problem, as I see it, is that the facts situation in Rev. Rul 61-201 is of an annuity which had been "annuitized" - that is, the contractholder had already begun to receive income payments that were treated "as an annuity", such that a portion of each payment was excludible from taxpayer's income under the "regular annuity rules" of Sect. 72.

The relevance of the "refund element" is, as I understand it, that under the rules at the time of the Ruling, a portion of each payment would be excludible from taxpayer's income EVEN IF TAXPAYER LIVED TO RECEIVE ENOUGH PAYMENTS TO RECOVER HIS ENTIRE BASIS. Payments after that point would still contain an exlcludible element.

This is no longer the case. In both fixed annuities and variable annuities, taxpayer loses the excludible portion at some point (though the calculation of that point is different for the two annutiy types).

What if the contract in question had NOT been a "refund annuity"? Well, the excludible portion of each annuity payment would not have been reduced by the "value of the refund element". But I would argue that the taxpayer, in such a circumstance, ought still to be able to deduct his unrecovered basis. That basis would have been calculated differently, but the issue of deductibility should not be different.

In a LUMP SUM surrender of an annuity which has NOT been annuitized, the same principles ought to apply.

Alas, this is a debatable issue because the Service has not issued much guidance about annuity taxation. The options available to a non-spouse beneficiary are, in my opinion, not clear at ALL. IRC 72(h) gives that beneficiary sixty days from the time funds become available to her to elect annuitization of proceeds. IRC 72(s)(1) appears [to some; not to me] to allow deferral of recognition of tax on such proceeds for five years; 72(s)(2) seems to allow "regular annuity rule" taxation, if such payments begin no later than ONE YEAR from holder's death [this section is silent as to when the ELECTION to annuitize must be made].

Does 72(s) "trump" 72(h)? I don't believe so, despite indications in the legislative history that Congress intended 72(s) to bring "parity" to the rules governing non-qualified annuity distributions and those governing distributions from qualified plans. Sect. 72(h) is still on the books.

We've almost NO guidance in this area. NO final regs. And no Case Law that I can discover.

- John L. Olsen, CLU, ChFC

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