IRS Releases Favorable Private Letter Ruling on “Taxable Annuity.”

by Eversheds Sutherland (US) LLP
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On April 10, the Internal Revenue Service (IRS) released PLR 201515001 (Oct. 10, 2014), favorably addressing a “taxable annuity”—essentially, a deferred annuity contract supported, in part, by subaccounts, each of which invested solely in a single publicly available mutual fund. Not surprisingly, the IRS concluded that the publicly available mutual fund shares held in the subaccounts were currently taxable to the contractowner. The groundbreaking aspect of PLR 201515001 was the recognition by the IRS that the contractholder would be taxed as if he owned the underlying publicly available mutual fund shares directly, allowing him to claim capital gains and losses on their investments, not as if he owned a non-diversified variable annuity contract, which would have required him to include annual increases in the cash value of the contract in income currently as ordinary income, with no opportunity for loss deductions.

The Taxable Annuity. The taxable annuity at issue in PLR 201515001 was similar to traditional deferred variable annuity contracts with guaranteed minimum withdrawal benefits. Specifically, the contractowner of the taxable annuity could take scheduled annual withdrawals in specified amounts, and the insurer agreed to provide a life-contingent income stream if the annuity’s account balance was reduced to zero by the scheduled annual withdrawals, poor investment performance, or a combination of the two. In addition, the contractowner could apply the publicly available mutual funds held by the subaccounts to purchase a fixed annuity before the contract’s account balance was reduced to zero. The taxable annuity also included a fixed account, to which a portion of each contribution was required to be allocated. In-kind contributions and distributions of the publicly available mutual fund shares were also permitted under the contract.

The IRS’s Conclusions. Although legal title to the separate account assets belonged to the insurance company, the IRS concluded that the publicly available mutual funds would be treated for tax purposes as owned directly by the contractowner and would be taxed accordingly: the IRS said that the contractowner should “reflect in his gross income any gains, income, or losses with respect to the mutual fund shares, with the amount and tax character of such items being the same as if he held the shares directly.” The IRS also addressed a number of specific consequences flowing directly from this treatment, including the following:

  • In-kind contributions or distributions of the publicly available mutual fund shares would not constitute a taxable sale or exchange because the contractowner was the “tax owner” of the shares both before and after any transfer of legal title from or to the contractowner.
  • Any such transfer of legal title would not constitute a disposition of the shares for federal tax purposes.
  • The publicly available mutual fund shares held in the subaccounts were not only separate investments from one another, but were also separate investments from the fixed portion of the contract involved in PLR 201515001.
  • The fixed portion of the contract constituted an annuity contract for tax purposes.

The result reached in PLR 201515001 was based on, and consistent with, the IRS’s long-standing “investor control” position to the effect that if the contractowner of a variable life insurance or annuity contract has the ability to select specific publicly available investments to support the contract, the contractowner will be treated for tax purposes as the owner of the underlying investment, despite the insurer’s legal title to the assets in the underlying separate account, because the contractowner has retained too much control over the investments. See Rev. Rul. 81-225, 1981-2 C.B. 12; see also Rev. Rul. 77-85, 1977-1 C.B. 12; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 82-54, 1982-1 C.B. 11; Rev. Rul. 2003-91, 2003-2 C.B. 347; Rev. Rul. 2003-92, 2003-2 C.B. 350.

It is important to note that a private letter ruling can be relied on only by the taxpayer to whom it is issued and cannot be used or cited as precedent. See section 6110(k)(3) of the Internal Revenue Code.

The Take-Away. As noted above, the key significance of PLR 201515001 lies in the implicit rejection by the IRS of the view (which some IRS officials had previously voiced) that a taxable annuity like the annuity addressed in PLR 201515001, with subaccounts investing in publicly available mutual funds selected by the contractowner, should be treated as a variable annuity contract supported by one or more segregated asset accounts that fail the diversification requirements of section 817(h) of the Internal Revenue Code and the regulations thereunder. (The diversification failure would occur because the segregated asset accounts supporting the annuity would be treated as holding a single publicly available mutual fund that would be ineligible for look-through treatment under Treas. Reg. § 1.817-5(f)(1).) If this treatment had prevailed, annual increases in the aggregate cash value of the annuity (including the cash value in the fixed account) would be taxed currently as ordinary income, and losses would not be deductible. In short, PLR 201515001 recognizes that the tax treatment implied by the investor control rulings (e.g., potential capital gain and loss treatment; in-kind contributions and distributions are not taxable) trumps the tax treatment imposed on variable contracts that fail to satisfy the diversification requirements of section 817(h) and the regulations thereunder.

A Look Ahead. The “taxable annuity” is among a number of non-traditional annuity products that have emerged in the marketplace in recent years. One such product was the “contingent annuities” previously addressed in a series of private letter rulings. See PLR 201129029 (July 22, 2011); PLR 201128017 (July 15, 2011); PLR 201117013 (April 29, 2011); PLR 201117012 (Apr. 29, 2011); PLR 201105005 (Feb. 4, 2011); PLR 201105004 (Feb. 4, 2011); PLR 201001016 (Jan. 8, 2010); PLR 200949036 (Dec. 4, 2009); and PLR 200949007 (Dec. 4, 2009). From an economic perspective, the taxable annuity described in PLR 201515001 operated in much the same manner as the contingent annuities, which “wrapped” taxable brokerage accounts owned by contractowners, just as the taxable annuity “wrapped” the underlying taxable mutual funds that were held in a separate account of the insurer. The key difference between the taxable annuity and the contingent annuities was that the taxable annuity provided for legal title to the underlying assets to be held by the insurance company. Another private letter ruling favorably addressing a non-traditional annuity product (or at least one that had not been widely available in the marketplace for decades) was PLR 200939018 (Jun. 18, 2009), which involved pure longevity insurance with no cash value or death benefit.

With PLR 201515001, the IRS has ruled on yet another non-traditional variable annuity arrangement which for one reason or other taxpayers may prefer to traditional fixed and variable annuities. It is noteworthy that the annuity product addressed in PLR 201515001 combined the taxable annuity feature with a traditional fixed annuity. Thus, PLR 201515001 suggests that annuity writers could offer a menu of annuity options consisting of several or perhaps even all of the non-traditional forms of annuities, as well as traditional fixed and variable annuities, in the framework of a single product.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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