Annuity issuers have reason to celebrate a recent decision of the Superior Court of California for San Diego County, shutting down a factoring company’s attempt to purchase an individual retirement annuity (IRA or the annuity).1
As competition in the factoring of structured settlements increases and some courts have begun to scrutinize these transactions more carefully, a number of factoring companies are turning their attention to the unregulated market for individual-owned taxable annuities. In the case of IRAs, such transfers may threaten the integrity and long-term viability of annuity issuers’ financial products. These transactions, like all assignments, also pose the prospect of increasing issuers’ costs and exposure to liability as a result of having to deal with ever changing payment directions and tax reporting and withholding obligations, and the threat of becoming embroiled in litigation between disgruntled customers and their assignees.
For these reasons, New York Life Insurance and Annuity Company (NYLIAC) recently resisted an attempt by factoring company DRB Capital, LLC (DRB) to buy an individual owner’s rights to an inherited IRA. DRB then filed a declaratory judgment action, seeking to validate the proposed transfer, notwithstanding that the annuity stated it was “not transferable” and that all of the owner’s interest in the annuity was “nonforfeitable” as required by Section 408 of the Internal Revenue Code (Section 408).
In support of its demurrer to the complaint, NYLIAC pointed out that DRB proposed to charge the individual annuity owner an exorbitant interest rate of 28.96% and that DRB was seeking a declaration that the annuity owner was solely liable for any taxes resulting from the transfer, while DRB would be entitled to any resulting withholding credit. NYLIAC argued that the anti-assignment provisions of the annuity were enforceable under California law and, that if the proposed assignment were permitted, it would not only result in adverse tax consequences to the annuity owner, but would also materially increase NYLIAC’s risks and burdens.
In particular, if the assignment were allowed, the tax qualification of the annuity under Section 408 would cease to exist. As a result, an amount equal to the fair market value of the annuity would be includable in the annuity owner’s gross income for the taxable year in which the assignment occurred. 26 U.S.C. § 408(e); 26 CFR § 1.408-3(c). In addition, since the annuity was purchased with funds transferred from another IRA, the annuity owner would face the possibility that back taxes on the amount transferred from that IRA to the annuity would be owed.
The adverse consequences for NYLIAC, at a minimum, were that the assignment would create additional and different tax reporting and withholding responsibilities for NYLIAC in the year of the assignment. Moreover, if NYLIAC permitted a transfer of the annuity despite the anti-assignment provisions, the Internal Revenue Service might take the position that the contract had not since inception met the requirement that it not be transferable, which could result in further tax reporting and withholding obligations. Worse yet, if the transfer of similar products were routinely allowed, the Internal Revenue Service may conclude that none of the contracts issued by NYLIAC as individual retirement annuities satisfy the non-transferable requirement, thereby potentially disabling this financial product.
NYLIAC further argued that, as with all assignments, the proposed transfer would cause NYLIAC to have to redirect payments; face exposure to double liability if it pays the wrong party; and risk becoming entangled in subsequent litigation between the annuity owner and DRB.
DRB argued that it was not really trying to buy the annuity, just the owner’s payment rights (which was belied by the notice of assignment DRB submitted to NYLIAC); Section 408 requires only that the annuity itself, and not the annuity payment rights, be non-transferable (which is belied by the plain language of Section 408 and CFR §1.408-3); and anti-assignment provisions are not enforceable under California law (which is inaccurate).
The court agreed with NYLIAC’s analysis, and held that the anti-assignment provisions in the annuity are enforceable and that, because the transfer would increase NYLIAC’s risks and burdens, the assignment was also prohibited under Section 317 of the Restatement (Second) of Contracts.2
Annuity issuers would be well-advised to resist factoring companies’ attempts to purchase IRAs in order to preserve the long-term viability of such products. They now have a well-reasoned precedent to assist them in this effort. NYLIAC was represented by Stephen R. Harris, Lisa D. Stern, and Brett N. Taylor of Cozen O’Connor.