Can a Broker Be Liable for Annuity Tax Advice?

When Is a Broker Liable for the Tax Cost of an Annuity Surrender?

A broker is liable when a client proves the elements of a claim such as negligent misrepresentation: a duty of care, false information, justifiable reliance, and a failure to use reasonable care in communicating it. A professional giving advice in the course of business owes that duty; a neighbor offering an opinion does not.

The Minnesota Supreme Court set out the elements in Williams v. Smith, 820 N.W.2d 807 (Minn. 2012): “To prevail on a negligent misrepresentation claim, the plaintiff must establish: (1) a duty of care owed by the defendant to the plaintiff; (2) the defendant supplies false information to the plaintiff; (3) justifiable reliance upon the information by the plaintiff; and (4) failure by the defendant to exercise reasonable care in communicating the information.” The court found no duty in that case because the parties negotiated at arm’s length and had no professional, fiduciary, or other special legal relationship.

An advisory relationship between a financial professional and a client can create the duty. In Florenzano v. Olson, 387 N.W.2d 168 (Minn. 1986), an insurance agent advised a client to withdraw from social security, a financial decision outside the life insurance he sold, and the advice was wrong. The court described him as the client’s “insurance agent and would-be financial adviser” and held that the only basis for liability was negligent misrepresentation. The court explained that “In Minnesota, one making representations is held to this duty of care only when supplying information, either for the guidance of others in the course of a transaction in which one has a pecuniary interest, or in the course of one’s business, profession or employment.” A representative who tells a client what a surrender will cost in tax is supplying exactly that kind of information. For the elements in more detail, see my article on negligent misrepresentation under Minnesota law.

What Tax Harm Does an Annuity Surrender Actually Cause?

A cash surrender of a deferred annuity before payments begin is taxed as ordinary income to the extent of the gain inside the contract, and a 10 percent additional tax can apply on top of it. A client’s claim can rest on either charge, or on a higher bracket caused by taking the whole gain in one year.

Under 26 U.S.C. § 72(e), a partial withdrawal received before the annuity starting date “shall be included in gross income to the extent allocable to income on the contract.” For that withdrawal, the statute measures the income as the excess of “the cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received, over” the investment in the contract. A full surrender follows § 72(e)(5) instead, which applies to “any amount received under a contract on its complete surrender, redemption, or maturity.” For that amount, “the amount shall be included in gross income, but only to the extent it exceeds the investment in the contract.” The client’s cost basis, the “investment in the contract,” therefore decides how much of the check is taxable. Two groups follow other rules: under § 72(e)(5)(A) and (B), paragraph (2)(B), the partial-withdrawal rule quoted above, “shall not apply” to “contracts entered into before August 14, 1982,” and under § 72(e)(8)(B), a withdrawal from an IRA or qualified-plan contract is allocated to the investment in the contract in the ratio “the investment in the contract bears to the account balance.”

Section 72(q) adds a second charge. It reads: “If any taxpayer receives any amount under an annuity contract, the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.” The additional tax does not apply to a distribution “made on or after the date on which the taxpayer attains age 59½,” or to the other exceptions the subsection lists, such as death, disability, and substantially equal periodic payments. The subsection also does not apply to a distribution “from a plan, contract, account, trust, or annuity described in subsection (e)(5)(D),” which includes a distribution “from an individual retirement account or an individual retirement annuity,” or to a distribution “to which subsection (t) applies,” the separate additional tax on early distributions from qualified retirement plans.

The cost basis is where these disputes start. Once, a beneficiary who had inherited an annuity asked me about a claim against the insurance company that issued it. A company representative had stated a cost basis on a call that was far larger than the figure the company later reported on the tax form, and the beneficiary cashed out relying on the larger number. When the beneficiary raised the error, the company asked for the beneficiary’s tax bracket with and without the added income. That request is the comparison a damages figure in these claims rests on.

What Does Minnesota’s Annuity Best-Interest Law Require of a Producer?

An insurance producer recommending an annuity in Minnesota must act in the client’s best interest. That includes making reasonable efforts to learn the client’s tax status before recommending, and having a reasonable basis to believe, at or before the sale, that the client was reasonably informed of the potential tax penalty on a surrender. The statute exempts employer-plan annuities and some other transactions, and the commissioner, not the client, enforces it.

Under Minn. Stat. § 72A.2032, subd. 1a, “An insurance producer, when recommending an annuity, shall act in the best interest of the consumer under the circumstances known at the time the recommendation is made.” The producer must make reasonable efforts to collect “consumer profile information,” which Minn. Stat. § 72A.2031, subd. 3b, defines to include “(14) tax status.” The disclosure duty is in § 72A.2032, subd. 1c(c). That subdivision lists the “potential tax penalty if the consumer sells, exchanges, surrenders, redeems, or annuitizes the annuity” among the features of which the producer must have a reasonable basis to believe the client was reasonably informed. These rules have a scope limit. Under Minn. Stat. § 72A.203, “Unless otherwise specifically included, sections 72A.203 to 72A.2036 do not apply to annuity transactions involving” contracts used to fund group plans. One listed plan is “a plan described by section 401(a), 401(k), 403(b), 408(k), or 408(p) of the Internal Revenue Code of 1986, as amended, if established or maintained by an employer.” Four more parts of the law matter in a tax claim:

1. Replacements get a whole-transaction review. When one annuity replaces another, subd. 1b(j) requires the producer to “consider the whole transaction,” including whether the client “incurs a surrender charge; is subject to the commencement of a new surrender period; loses existing benefits.”
2. Clients 65 and older get an added rule. Subd. 1b(k) bars recommending a replacement or exchange that requires a surrender charge “if the replacement or exchange does not confer a substantial financial benefit over the life of the annuity to the consumer, so that a reasonable person would believe the purchase is unnecessary.”
3. The law reaches recommendations to buy, exchange, or replace. A “recommendation” under § 72A.2031, subd. 8e, is advice “intended to result or does result in a purchase, exchange, or replacement of an annuity.” Advice to cash out an annuity without buying a new one does not match those words.
4. The care requirements create no fiduciary relationship, and the statute gives no private enforcement. Subd. 1b(d) says “The requirements under this subdivision do not create a fiduciary obligation or relationship and only create a statutory obligation under sections 72A.203 to 72A.2036.” Under Minn. Stat. § 72A.2034, subd. 2, “The authority to enforce compliance with sections 72A.203 to 72A.2036 is vested exclusively with the commissioner,” while subd. 1(b) preserves any cause of action “otherwise provided for under applicable federal or state law.”

How Do Titles and Securities Rules Change a Firm’s Duty?

What a firm calls its people can create a fiduciary duty by statute. Minnesota imposes a fiduciary duty on anyone who holds out as a “financial adviser” or similar title and is paid for the services, and a broker-dealer recommending securities must meet Regulation Best Interest, which lists the customer’s tax status.

Minn. Stat. § 45.026, subd. 1, treats a person as a financial planner based on the titles the person uses. The titles count when they appear on cards, letterhead, advertising, or statements. They include “financial planner,” “financial adviser,” “investment adviser,” “financial consultant,” and other similar titles. Under subd. 2, “Persons who represent that they are financial planners have a fiduciary duty to persons for whom services are performed for compensation,” and the client “may recover actual damages resulting from the breach.” I suggest auditing business cards, email signatures, and website bios against that list, because a title chosen for marketing can supply a fiduciary duty that the annuity law’s care requirements, under § 72A.2032, subd. 1b(d), do not create. For the defense side of that claim, see my article on defenses to a fiduciary duty claim.

For broker-dealers, Regulation Best Interest, 17 C.F.R. § 240.15l-1, applies “when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer.” Its care obligation requires the broker to exercise “reasonable diligence, care, and skill” to “Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation.” The rule’s “retail customer investment profile” includes “tax status.” Minnesota coordinates with it: under § 72A.2032, subd. 8, annuity recommendations made in compliance with comparable standards, “including but not limited to regulation best interest,” satisfy the state annuity law. That safe harbor depends on the insurer monitoring the firm’s conduct under subd. 8(b).

The Minnesota Securities Act treats the annuity and any securities bought with its proceeds differently:

• An insurance-company annuity is not a “security” under the Act. Minn. Stat. § 80A.41, para. (30)(B), excludes “an insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed or variable sum of money.”
• A seller of securities answers for misstatements and omissions. Under Minn. Stat. § 80A.76, para. (b), a person who sells a security “by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statement made, in light of the circumstances under which it is made, not misleading” is liable to a purchaser who did not know of the untruth or omission, unless the seller proves “that the seller did not know and, in the exercise of reasonable care, could not have known of the untruth or omission,” and the purchaser’s recovery includes “costs, and reasonable attorneys’ fees determined by the court.”
• The advice remedy requires fraud. Para. (f) of § 80A.76 makes a paid adviser liable for “a device, scheme, or artifice to defraud” or conduct that “operates or would operate as a fraud or deceit,” and para. (f)(2) excludes a broker-dealer whose advice is “solely incidental to transacting business as a broker-dealer and no special compensation is received for the investment advice.”
• Control persons, officers, and aiders can share liability. Para. (g) makes certain persons “liable jointly and severally with and to the same extent as persons liable under subsections (b) through (f).” Para. (g)(1) reaches “a person that directly or indirectly controls a person liable” unless the controlling person proves it did not know and “in the exercise of reasonable care could not have known” of the conduct. Paras. (g)(2) to (g)(4) reach, each with its own lack-of-knowledge defense, “an individual who is a managing partner, executive officer, or director of a person liable,” and an employee, associate, broker-dealer, or agent that “materially aids the conduct giving rise to the liability.”
• The Act adds no other claims. Para. (m) says the chapter “does not create a cause of action not specified in this section or section 80A.66(e).”

How Do a Tax Disclaimer and the Client File Affect a Claim?

A statement that the firm does not give tax advice narrows what the firm undertook, but a representative’s words and the client file decide what the firm actually did. A file that shows the client’s tax status, the tax discussion, and who made the decision is a defense the firm builds before any claim exists.

In Gabrielson v. Warnemunde, 443 N.W.2d 540 (Minn. 1989), the Minnesota Supreme Court said that “Absent an agreement to the contrary, an agent has no duty beyond what he or she has specifically undertaken to perform for the client.” The court held that, “absent special circumstances in the relationship with the insured, an insurance agent is not under such a legal duty,” there a duty to update a homeowner’s policy at renewal. That rule helps a producer who stayed inside the disclaimer. It helps less when a representative ran the numbers on a surrender or told the client the tax would be small, because a court can treat that representative as having undertaken to give tax information.

Chapter 72A supplies the documents that prove what happened:

1. A written record of the recommendation. Under § 72A.2032, subd. 1e, the producer must “make a written record of any recommendation and the basis for the recommendation.”
2. Inaccurate client information. Under subd. 4(2), the best-interest obligation does not apply where “a recommendation was made and was later found to have been prepared based on materially inaccurate information provided by the consumer.” A wrong basis figure from the client fits here.
3. The client’s own decision. Under subd. 4(4), the obligation does not apply where “a consumer decides to enter into an annuity transaction that is not based on a recommendation of the insurance producer,” and subd. 1e requires a signed acknowledgment in that case.

I suggest treating the disclaimer as one piece of a file built transaction by transaction, because a court or arbitrator will weigh it against what the client was actually told.

How Do Comparative Fault and Other Advisers Reduce a Firm’s Share?

Minnesota’s comparative fault statute reduces a client’s recovery by the client’s own share of fault and bars recovery when the client’s fault is greater than the firm’s. When the client’s accountant or another adviser also contributed, each pays by its share of fault, except a party more than 50 percent at fault, parties acting in a common scheme, or one who commits an intentional tort. The Minnesota Supreme Court has said that principles of comparative negligence “would not apply to an intentional tort.”

Minn. Stat. § 604.01, subd. 1, lets a claimant recover for economic loss “if the contributory fault was not greater than the fault of the person against whom recovery is sought, but any damages allowed must be diminished in proportion to the amount of fault attributable to the person recovering.” The court “when requested by any party shall” have the jury find each party’s percentage of fault. Subd. 1a defines “fault” to include “unreasonable failure to avoid an injury or to mitigate damages,” and it adds: “Evidence of unreasonable failure to avoid aggravating an injury or to mitigate damages may be considered only in determining the damages to which the claimant is entitled.”

Florenzano applied these principles to a financial professional. The jury found the client 62.5 percent negligent, and the trial court entered judgment for the agent. The Minnesota Supreme Court reinstated that judgment: “We hold that the principles of comparative responsibility apply to negligent misrepresentation and that the trial court appropriately applied those principles in this case.” Florenzano had set out her complaint in terms of fraudulent misrepresentation, yet the court held “that, on the facts of this case, the only basis for liability was negligent misrepresentation.” The court added: “Without question, principles of comparative negligence would not apply to an intentional tort; we have never so applied them.” Florenzano applied the 1976 version of the statute; the current text quoted above governs a claim today.

The client’s other advisers matter too. Under Minn. Stat. § 604.02, subd. 1, “When two or more persons are severally liable, contributions to awards shall be in proportion to the percentage of fault attributable to each,” except that “(1) a person whose fault is greater than 50 percent,” “(2) two or more persons who act in a common scheme or plan that results in injury,” and “(3) a person who commits an intentional tort” are jointly and severally liable for the whole award. A client who surrendered on a CPA’s sign-off, or who ignored a tax preparer’s warning, has other people whose share of fault belongs in the case.

How Should Damages From a Bad Surrender Be Measured?

I suggest measuring the loss by comparing the client’s actual tax and contract results with the results a careful recommendation would have produced, rather than with paying no tax at all. Income on an annuity contract is taxed when it is received, so the real loss can be the timing, the rate, and the charges that a better path would have avoided.

Section 72(e) taxes the income on the contract when it is withdrawn, whether in one lump sum now or in later withdrawals. A damages model that treats the whole tax bill as the loss assumes the client would never have paid it. I suggest building the comparison around these components, because each one either belongs in the number or does not:

• The additional tax under § 72(q) or § 72(t). The § 72(q) tax is a real added cost for a client under 59½ with no other exception under § 72(q)(2), and it is zero for a client who had reached that age. For an amount received from a qualified retirement plan, which 26 U.S.C. § 4974(c) defines to include “an individual retirement annuity described in section 408(b),” § 72(t)(1) imposes its own tax of “10 percent of the portion of such amount which is includible in gross income.” That tax has its own age exception: under § 72(t)(2), “paragraph (1) shall not apply to any of the following distributions,” including one “made on or after the date on which the employee attains age 59½,” and under § 72(t)(5) the employee includes, “in the case of an individual retirement plan, the individual for whose benefit such plan was established.”
• The bracket effect. Taking the whole gain in one year can push income into a higher bracket than spreading withdrawals or annuitizing would have.
• Surrender charges. These come from the contract, not the tax code, and a different timing might have avoided them.
• The exchange alternative. Under 26 U.S.C. § 1035(a), “No gain or loss shall be recognized on the exchange of” “an annuity contract for an annuity contract.” If the client needed a different product rather than cash, an exchange was a lower-tax path.
• What the client did with the money. I suggest including any investment gains on the surrendered funds, or a debt the client paid off, in the comparison.
• Mitigation. Under § 604.01, subd. 1a, “Evidence of unreasonable failure to avoid aggravating an injury or to mitigate damages may be considered only in determining the damages to which the claimant is entitled.”

A tax preparer or financial expert can run this comparison from the client’s actual returns, and the side-by-side result gives both sides a number to negotiate from.

What Other Claims and Regulators Can Follow an Annuity Complaint?

A tax complaint can also produce a consumer-fraud claim, an added penalty claim when the client is a senior, a regulator’s inquiry, and supervision questions for the firm’s owners. The account or advisory agreement may also move the dispute to arbitration.

1. Consumer fraud. Minn. Stat. § 325F.69, subd. 1, prohibits fraud, misrepresentation, and misleading statements made “with the intent that others rely thereon in connection with the sale of any merchandise.” A private claimant sues under Minn. Stat. § 8.31, subd. 3a. That subdivision lets the claimant “recover damages, together with costs and disbursements, including costs of investigation and reasonable attorney’s fees.” In Hoang Minh Ly v. Nystrom, 615 N.W.2d 302 (Minn. 2000), the Minnesota Supreme Court held “that the Private AG Statute applies only to those claimants who demonstrate that their cause of action benefits the public.” In Ly, a misrepresentation made in a single one-on-one transaction did not meet that test. My article on the Minnesota Consumer Fraud Act covers the statute more fully.
2. Senior clients. Minn. Stat. § 325F.71 adds a civil penalty for consumer-fraud conduct against a “senior citizen,” defined in subd. 1 as “a person who is 62 years of age or older.” Under subd. 2, the penalty applies “if one or more of the factors in paragraph (b) are present.” Subd. 2 names “substantial loss of property set aside for retirement” as a factor, and subd. 4 gives an injured person a private action with attorney’s fees.
3. The commissioner. Under § 72A.2034, subd. 1(a)(2), the commissioner may order “the insurance producer to take reasonably appropriate corrective action for any consumer harmed.” Minn. Stat. § 72A.2036 adds that a violation of the annuity sections “shall be considered a violation of section 72A.20,” the insurance unfair-practices statute.
4. Supervision. For a registered firm, Minn. Stat. § 80A.67, para. (d)(9), makes it a ground for discipline when a person “has failed to reasonably supervise an agent, investment adviser representative, or other individual, if the agent, investment adviser representative, or other individual was subject to the person’s supervision and committed a violation of this chapter or the predecessor act or a rule adopted or order issued under this chapter or the predecessor act within the previous ten years.”
5. Arbitration. Minn. Stat. § 572B.06, para. (a), makes an agreement to arbitrate contained in a record “valid, enforceable, and irrevocable except upon a ground that exists at law or in equity for the revocation of contract,” and the Federal Arbitration Act, 9 U.S.C. § 2, is to the same effect. If the client files in court despite a clause, the firm can move to compel arbitration.
6. Time limits. Each claim carries its own deadline, and the Securities Act sets separate limits in § 80A.76, para. (j). I suggest reading the current text of each statute that applies, because the deadlines differ by claim.

What Should a Firm Do First When a Client Complains About Taxes?

I suggest gathering the file, identifying who else advised the client, reading the agreements, and running the tax comparison before responding on the merits. Those steps show whether the complaint is a misunderstanding, a shared-fault case, or a claim worth resolving early.

1. The full file. I suggest collecting the consumer profile, the recommendation record, the disclosure forms, and any notes of calls, because § 72A.2032, subd. 1e, and Minn. Stat. § 72A.2035, subd. 1, require producers to keep “records of the information collected from the consumer, disclosures made to the consumer, including summaries of oral disclosures,” and those records will be requested.
2. The other advisers. I suggest identifying the client’s accountant, tax preparer, estate attorney, and any other financial professional, because § 604.02, subd. 1, apportions fault among them.
3. The agreements. The account agreement, the advisory contract, and the annuity contract may each contain an arbitration clause, a governing-law clause, and limits on the services the firm agreed to provide.
4. The tax comparison. I suggest asking for the client’s returns for the surrender year and modeling the realistic alternatives, because the tax the client paid and the tax a careful recommendation would have avoided can differ widely.
5. The settlement terms. If the firm resolves the claim, the agreement should state what the payment is for and who bears its tax. My articles on how a settlement payment is allocated and on the tax gross-up clause explain both terms.

Next Steps for a Firm Facing an Annuity Tax Claim

A client’s annuity tax complaint becomes a claim when the firm’s file cannot show what the client was told and why the client chose to surrender. Minnesota law gives a firm real defenses in comparative fault, the client’s own information, and the line between recommending a transaction and following a client’s instruction, but each depends on records made at the time.

If a client has raised a tax complaint about an annuity surrender, email [email protected] with a short description of the transaction and the complaint, and I can tell you which of the claims and defenses above apply to it. I will run a conflict check before you send any client documents. More of my writing on Minnesota business tax practice is collected on the tax page.