IRS Cannot Grant Relief Where Taxpayer Erroneously Signed an Annuity Distribution Rather Than Exchange Form

Some tax related mistakes are not able to be corrected by asking for forgiveness, as the taxpayer discovered in Private Letter Ruling 201625001. In this case the issue was a taxpayer who inherited a private annuity and wished to roll the annuity over in a tax free §1035 exchange.

Inherited annuities are eligible to be rolled by the beneficiary under IRC §1035 (see PLR 201330016). And advisers are aware that the IRS has the authority under IRC §408(d)(3)(I) to waive late rollovers for IRAs. So it may not be surprising that when an error occurred in attempting to rollover an annuity under IRC §1035 that the taxpayer asked the IRS for a waiver.

In the case in question the taxpayer had inherited an interest in annuity from his father. The taxpayer wished to transfer this balance to another annuity, but mistakenly signed a form that authorized a lump sum payment from the annuity, believing it was a form to exchange the annuity. The lump sum was deposited in the taxpayer’s checking account and he used those funds, along with some other, to purchase a new annuity.

All was well until the taxpayer’s accountant received the taxpayer’s information to prepare the tax return for the year of the distribution. The accountant noticed that a Form 1099R had been issued showing a fully taxable distribution of the balance of the account to the taxpayer. The taxpayer filed for an extension of time to file the tax return and submitted the letter ruling request.

The taxpayer requested two rulings:

  • That the erroneous distribution from Annuity 1 and the subsequent contribution of those distributed funds to Annuity 2 will be treated as a tax deferred exchange under § 1035(a)(3) of the Code and will not result in the imposition of income tax under § 72(e) of the Code; and
  • That no further corrective transactions are required as between Annuity 1 and Annuity 2 in that, although the dis tribution was made erroneously, both Annuity 1 and Annuity 2, as of Date 6, are exactly as they would have been had the error not occurred.

As a practical matter, the taxpayer was arguing for a “no harm, no foul” ruling, since he had gained no benefit from the fact that the balance had not been directly transferred to purchase the new annuity.

Unfortunately for the taxpayer, the IRS ruled that the agency did not have the authority to allow the taxpayer to treat the transaction as the taxpayer wished.

The IRS noted:

In Rev. Rul. 2007-24, 2007-1 C.B. 1282, insurance company one disbursed a check representing a surrender of old non-qualified annuity policy to taxpayer who, in turn, endorsed the check to a second insurance company as consideration for a new non-qualified insurance contract. Noting that neither § 1035 nor the regulations make any special provision for the purchase of an annuity contract with amounts distributed to the policyholder under another contract and because the annuity contract was a non-qualified contract, no rollover provision, such as § 403(a)(4), applied to the amount received. The amount that taxpayer received from insurance company one under the first annuity contract is taxable in the year received to the extent set forth in § 72(e).

Similarly, in the present case, the proceeds from Taxpayer's request for lump sum payment of Annuity 1 were deposited into Taxpayer's checking account. Taxpayer then used those funds to purchase Annuity 2. Accordingly, the amount that Taxpayer received from Company 1 under Annuity 1 is taxable in the year received to the extent set forth in § 72(e).