Taxpayer Finds Annuity Distribution Taxable Even Though He Claimed He Had Never Made Money On It

The tax law doesn’t often work the way we like it to, and in the case of Tobias v. Commissioner, TC Memo 2015-164 the taxpayer’s argument that, when viewed as a whole he hadn’t really seen income from a series of transactions was not availing.

The taxpayer in this case was an attorney who held an inactive CPA license.  In 2003 the taxpayers had purchased an annuity for $228,800.  In order to buy the annuity the taxpayer had sold securities at a loss of $158,000.  The taxpayers continued to make contributions to the annuity through 2006 of $346,154. 

In 2007 the taxpayer entered into a §1035 exchange an acquired a different annuity in a tax free transaction.  The annuity (which the taxpayer held at the date in issue in this case) had an annuity starting date of February 3, 2047.

In 2010 the taxpayers withdrew $525,000 from the annuity to purchase their current residence.  At the time of the distribution the cash value of the annuity was $761,256 and the accrued earnings were $186,302.  The issuer of the annuity sent the taxpayers a Form 1099R indicating a taxable distribution of $186,302 (the accrued earnings) and indicated there was no known exception to the early distribution penalty.

The taxpayers did not report this amount as income, rather attaching an explanation to their return that stated:

The [ING annuity] account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately ($148,000). Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by ING is incorrect and is contested.

The taxpayers also did not report and pay the penalty for premature distributions with their tax return.

Generally taxpayers do not recognize income earned inside an annuity until the taxpayer takes a distribution from the account.  If the taxpayer does not take distributions until the annuity starting date, under Reg. §1.72-4(b) the taxpayer recovers his/her basis in the contract ratably as each payment is received.  However, if a taxpayer takes a distribution before the annuity starting date, under IRC §72(e) the payments are included in income to the extent they are allocation to income on the contract.

The income in the contract is computed by subtracting the cash value of the contract immediately before the distribution from the taxpayer’s basis in the contract.  Thus, the taxpayer is to be taxed on the lesser of:

  • The total distribution received or
  • The income in the contract as computed above.

The taxpayer argued that much of the “income in the contract” arose from capital gains incurred in the annuity and that they should be able to offset at least their capital loss carryover against that amount.  As well, they argued they hadn’t really made any money off the contract.

The Tax Court rejected this view.  First, the Court points out:

Petitioners’ “investment in the contract,” which determines the amount taxable under section 72(e)(2), is “the aggregate amount of premiums or other consideration paid for the contract.” Sec. 72(e)(6)(A). The aggregate amount of premiums petitioners paid for the contract was $574,954. They have suggested no statutory rationale for increasing this figure to $732,954 on account of losses they incurred when generating funds to make the initial premium payment.

As well, the Court notes:

There is likewise no support for petitioners’ contention that their 2010 withdrawal should be characterized as capital gain rather than ordinary income. It is irrelevant to what extent petitioners’ “income on the contract” may have derived from capital gains realized by Allstate or ING. Section 72 mandates the inclusion of annuity payments in petitioners’ hands as ordinary income. Their assertion that section 72 is inapplicable because they intended to use the annuity as an “investment vehicle” rather than as a source of retirement income is without merit. Section 72 explicitly applies to all annuities regardless of the purchasers’ intent.