Tax Question: 20 years in the making...

[MAJ]

I have a client who received a $250, life insurance disbursement 22 years ago. It was put into an annuity where it sat for a number of years.

I have been preparing this clients taxes for about 4-5 years now. I was always led to believe that this was from a 401(k). Turns out - Life Insurance. Just found this out this year. I know - My fault.. But you have to know this women! NASA uses her head as a wind tunnel for testing....

Anyway.. It appears she has been paying 10% penalties and taxes on ALL disbursements since she first started taking money out about 10 years ago. Easy to say. Hard to prove. I've been on the phone with the IRS a number of times and no one can tell me how far back they can access records. It's my desire to provide due dillegence and get copies of as many transcripts as possible to determine how much (if any) has been excluded from taxes and 10% penalty. Just 2008 - 2010 we're talking almost 100k.

She currently owes them a few (5 digit) grand... I honestly do not think she owes anything. Wish we could have captured 2007 as well.

What are your thoughts? I am going to get as many transcripts as possible. Copies of as many returns she has tucked away. And then, Amend 2008-2010 to recover as much as the payments and debt as I can.

Thank again....

[New York Enrolled Agent]

I have a client who received a $250, life insurance disbursement 22 years ago. It was put into an annuity where it sat for a number of years.

Anyway.. It appears she has been paying 10% penalties and taxes on ALL disbursements since she first started taking money out about 10 years ago.

I assume you meant to say she put in $250 THOUSAND (or at least some larger number than 250) in the annuity.

Need more facts - it may be correct that she should be paying the 10% penalty and income taxes on all disbursements. Based on your post, she purchased the annuity somewhere around 1989. Once she put the money into the annuity, it lost its "life insurance" tax treatment.

Any annuity contract entered into after 8/13/1982 follows the "interest first" rule unless the taxpayer enters into a systematic liquidation (i.e. she annuitizes the amount into periodic payments). If she is taking distributions other than these regular annuity payments, the IRC treats the payments as "amounts not received as an annuity" and the taxation of the distribution is not based on the annuity rules but the "interest first" rules.

[RitaB]

Wow, great return, lol

I assume you meant to say she put in $250 THOUSAND (or at least some larger number than 250) in the annuity.

Thank you for picking up on that, I was going, "Whaaa?"

NASA uses her head as a wind tunnel for testing....

And, that you, Matthew for this. I will be using it soon...

[Burke]

Need more facts - it may be correct that she should be paying the 10% penalty and income taxes on all disbursements. Based on your post, she purchased the annuity somewhere around 1989. Once she put the money into the annuity, it lost its "life insurance" tax treatment.

If the annuity were purchased with actual non-taxable life insurance proceeds, then she would only owe taxes on the earnings, as the original $250K would be her non-taxable basis. This would be a non-qualified annuity, and part of the distributions would be tax-free each year. The original amount would not morph into another tax status just because it was put into a tax-deferred vehicle. I think the burden of proof to the IRS would be that it was actually life insurance proceeds to begin with. The annuity contract would offer some clue perhaps, since a copy of the application is usually in there. Sounds to me as if the company has been reporting the distributions each year as a qualifed annuity, fully taxable. If so, they should have some record of a "rollover" or transfer from the original source. Can she prove where the $$$ came from? Perhaps it was an annuity originally, just paid out to her, due to death of spouse or other annuitant on which she was named beneficiary?

[MAJ]

Yup! $250k -- How did I miss that?

Yes, I spoke with the IRS (3 divisions} - it's great how they will only answer the exact questions that pertain to their small piece of the forest... So hard to get someone to look at the whole forest..

But yes, I'm sure she can prove the life insurance disbursement. It's the money that went into the equity that's hard. They only keep records for 5-7 years. They screwed up and this poor woment has been paying the price. Stinks to watch someone cry in front of you! However, the one lady crying was good!! Her refund was $10k and she broke down and cried - That was the first year I did their return and they were able to pay the last semester of their kids college... Tapped and maxed to the hilt!!

Back to the real world.. We're going to get as many transcripts as we can dating back as far as we can. Hopefully this will show some detail or at least a level of due dilegence.

I appreciate all the input.

If the annuity were purchased with actual non-taxable life insurance proceeds, then she would only owe taxes on the earnings, as the original $250K would be her non-taxable basis. This would be a non-qualified annuity, and part of the distributions would be tax-free each year. The original amount would not morph into another tax status just because it was put into a tax-deferred vehicle. I think the burden of proof to the IRS would be that it was actually life insurance proceeds to begin with. The annuity contract would offer some clue perhaps, since a copy of the application is usually in there. Sounds to me as if the company has been reporting the distributions each year as a qualifed annuity, fully taxable. If so, they should have some record of a "rollover" or transfer from the original source. Can she prove where the $$$ came from? Perhaps it was an annuity originally, just paid out to her, due to death of spouse or other annuitant on which she was named beneficiary?

[JoshinNC]

NYEA is right

The fact that the $ to fund the annuity was from a life insurance death benefit (it is a death benefit right, not a 1035 exchange?) is not relevant. Distributions from a NQ (non qualified) annuity are 100% taxable to the extent there are earnings in the contract, "interest first", and would also be subject to 10% penalty if under 59 1/2.

[MAJ]

IRS to the rescue....

This is such a messy topic due to age... But to date .. The IRS is standing by the non-taxable standard. It was a Life Insruance distribution and as such the $250k basis is not taxed. This in part is why we are going for the transcripts. To determine what (if any, I believe no income was ever excluded). The worst part is the lack of information going back so far.

I am always looking for better answers. If one can point me to direct IRC quotes I'll take it from there. In the mean time - preparing for a refile of 2008-2010 - Almost $100k of taxed distributions. Hopefully transcripts will help...

Thanks again..

[JoshinNC]

Matt, your terminology in your questions is confusing me

Is this a DEATH BENEFIT from a life insurance policy or did your client accept the CASH VALUE of a life insurance policy by SURRENDING it?

In your most recent post you said it was not taxed (which leads me to believe it's a DEATH BENEFIT), but you called it a distribution, which usually conotes that it is a SURRENDER.

This will be the defining question in determining how much, if any, of your clients annuity distributions are taxable.

[JG EA]

Were there no 1099 forms all these years?

[Burke]

There should have been. And that is where I have some question on this. The company that holds this annuity should have records showing what was distributed each year, and what the earnings were, and they are apparently reporting the full distribution (whatever that is) as fully taxable. If the annual distribution did not exceed the earnings each year, then the entire yearly distribution was fully taxable when received. Apparently the funds (or some of them) were invested in equities. Since annuity proceeds are ordinary income to the extent it is taxable, the advantage of capital gains treatment is lost in this product. So the bottom line is, has she received payments that exceed the earnings to the point she is is now dipping into her original $250K? If not, then I don't see any recourse here as to amending returns or treating the distributions as partly non-taxable, unless she were to surrender the contract at this time. She should be able to get a complete history of earnings and payments from this company back to the beginning date of the contract. They would also have sent her statements at the end of each year with this information.

[MAJ]

Death Benefit.

Yes. This was a $250k Life Insurance Death Benefit. Husband went out for a job at lunch time while at work - Like he always did with a large group of people. 15,000 employees at Bell Labs - Holmdel NJ - The good ol days.. They leave their badges on a desk when they go - He never came back. That's the only way they knew - because he never retrieved his badge - Imagine that!?

So the money was invested and sat for a number of years. Then she started to withdraw funds. Complete details are unknown. The investment firm says they only keep records for 5-7 years. She was taxed on every penny received (so stated). Now the growth, yes. but the original basis ($250k) - I don't think so.

As for 1099's - Yes. I have some for the last few years. but not from years 1-16. This started in 1989. Wonderful eh?

[JoshinNC]

Matt, there may be nothing you can do

Here's a crude example:

She invests $250k in 1989 and in yr 1 earns a return of 10% (up $25k), but only takes out $10k. All $10k is taxable. Yr 2 is up 5% ($12.5k), so $27.5k in earnings is left, of which she takes another $10k, all taxable. The next yr the market is flat but she takes $10k out, all taxable because there were still leftover earnings.

See how this goes?

[Burke]

Also, you refer to "investment firm." Brokerage? They may keep records only 5-7 years, but any annuity is sold through an insurance company, such as NY Life, Prudential, MetLife, or other entity licensed to sell annuities in your state. And I guarantee you that the insurance company has records back to the beginning. She should also have a policy/contract which would have the company's name on it. Whose name is on the 1099R? Need to dig a bit further.