Decisions — The income-first rule

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As it applies to the taxation of annuities, the “income-first” rule (internal revenue code section 72(e)) means you include payments received before the annuity starting date in your gross income to the extent allocable to income on the contract. No surprise there, since the code says gross income means all income from whatever source derived.

But what if you have a capital loss caused by selling stock to purchase the annuity? Can you offset the income from the annuity with the capital loss?

When you buy an annuity, you’re purchasing a contract to receive future periodic payments. You pay premiums per the terms of the contract and the annuity provider invests those premiums. The investments generate income to cover the promised payments, which are scheduled to begin on the “annuity starting date” specified in the contract.

Under the current internal revenue code, the money you use to purchase an annuity is considered your basis, or “investment in the contract.” Gains on the investments within the annuity are tax-deferred, meaning they’re not taxed until you receive distributions. At that point, they’re taxed as ordinary income. How you calculate the amount to include in income depends on whether you take distributions before or after the annuity starting date.

For example, to figure the taxable portion of a distribution received prior to the annuity starting date, you subtract your investment in the contract from the cash value of the contract before the distribution. You’re taxed on either the full amount of the distribution or the full amount of the accrued earnings, whichever is less.

In T.C. Memo. 2015-164 (Tobias/Koegler), the taxpayer purchased a variable annuity in 2003. The initial investment was $228,800, and the taxpayer sold securities at a loss of $158,000 to pay for the annuity. The taxpayer used part of the capital loss from the stock sale to offset other income during the years at issue.

From 2003 to 2006, the taxpayer made additional after-tax investments in the annuity of $346,154. In 2010, the taxpayer withdrew $525,000 from the annuity to fund the purchase of a home and improvements to the home. At the time of the withdrawal, the annuity start date was February 3, 2047. The cash value of the annuity was $761,256, which included the taxpayer’s total investment of $574,954 and earnings within the annuity of $186,302.

The insurance company sent the taxpayer Form 1099-R, showing the taxable amount of the withdrawal as $186,302.

The taxpayer did not include the amount from Form 1099-R on his federal income tax return. Instead, he attached a statement to the return explaining that the annuity was funded with after-tax cash and any potential gains should be applied to the capital loss carryforward.

The IRS said the withdrawal of $525,000 was greater than the $186,302 of income on the contract and the $186,302 should have been included on the return in full. (The rest of the distribution was a tax-free recovery of basis.)

The taxpayer argued that the calculation failed to take into account the $158,000 capital loss realized in 2003 when he sold securities to raise funds to acquire the annuity. He said much of the “income on the contract” likely resulted from capital gains realized by the insurance company. He made no money on annuity and he believed the $158,000 capital loss from 2003 should offset the income.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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For the IRS.

The taxpayer’s argument is unpersuasive for at least two reasons. His “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 the taxpayer paid for the contract was $574,954. He has suggested no statutory rationale for increasing this figure to $732,954 because of losses incurred when generating funds to make the initial premium payment.

His argument that the investment in the contract should be increased to account for prior capital losses also contradicts his own return position. On his 2010 Schedule D he reported the $148,396 remnant of the 2003 capital loss as a long-term capital loss carryforward and deducted $3,000 of the loss, the maximum amount allowed, against ordinary income.

There is likewise no support for the taxpayer’s contention that the 2010 withdrawal should be characterized as capital gain rather than ordinary income.

It is irrelevant to what extent the taxpayer’s “income on the contract” may have derived from capital gains realized by the insurance company. Section 72 mandates the inclusion of annuity payments in the taxpayer’s hands as ordinary income. The assertion that section 72 is inapplicable because the taxpayer 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.

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