The Tax Law and the Nonqualified Variable Annuity (Posted on July 1, 1991 by )


Carol V. Calhoun, Counsel
Venable LLP
575 7th Street, NW
Washington, DC 20004
Phone: (202) 344-4715
Fax: (202) 344-8300
Mobile: (202) 441-5592
E-mail: Click here to send e-mail.
Carol V. Calhoun

I. INTRODUCTION

For decades Congress, Treasury, and the Service have struggled overthe proper tax treatment of annuities, 1/ particularly variable annuities. The Tax Reform Act of 1986 (1986 TRA) 2/ and Treasury Regulations interpreting Section 817(h) have affected the tax treatment of variable annuities.

At the same time, there does not appear to have been any effort to document the tax benefits and burdens that now apply to variable annuities, and the purposes achieved by the tax laws relating to variable annuities. Thus,Congressional and regulatory responses to the variable annuity have often been fragmented and internally contradictory.

Considering that the current climate generally disfavors tax preferences,the tax benefits provided to variable annuities are likely to be the subject of continuing and increasing scrutiny. In this analysis, two questions must be answered. First, does the variable annuity foster important social goals to such an extent that it should receive special tax benefits? Second,how can any tax benefits provided to a variable annuity be targeted to maximize the social goals and to minimize the potential for abuse?

This article examines these questions in a historical context. Part II analyzes the history of the variable annuity and its treatment under the tax law. Part III examines the recent legislative and administrative attempts to remedy the perceived abuses of the variable annuity. Finally,Part IV then suggests the direction of future policy initiatives.

II. HISTORY OF THE VARIABLE ANNUITY

Until about 35 years ago, annuities were a fairly standard product under which the prospective annuity owner paid a single amount or series of premiums to an insurance company that agreed to hold the money at a low interest rate, typically around 3% 3/ , until the annuitization date. After the annuitization date, the insurance company paid the annuitant a fixed sum of money each year over the specified period under the contract, generally either over the annuitant’s life or the joint lives of the annuitant and his spouse.The amounts paid by the insurance company were based upon the annuitant’s life expectancy and a 3% interest rate.

These annuity contracts were hardly considered exciting investments.They provided, however, reasonable value to the policyholder and insignificant risk to the insurance company during slow inflationary or deflationary years. The policyholder was guaranteed a return similar to the rate of return on other "safe" investments, a risk-free investment protected by state insurance regulation, tax deferral on the increase in value of the annuity prior to the annuitization period 4/ , and a stream of payments that the annuitant could not outlive. The insurance company obtained the use of the policyholder’s funds at a fairly low interest rate and typically invested the funds money in long-term bonds, which paid the company a higher rate of return.

The variable annuity, one of the first innovations in the annuity field,was instituted after World War II in response to rising inflation, 5/  and attempted to ensure that a policyholder’s return would rise with inflation.Instead of receiving the spread between the investment return and the interest guaranteed to the policyholder, the insurance company received the compensation specified in the contract. The policyholder received the entire return from the investment assets (generally long-term bonds or equity securities)held under the policy (the "segregated asset account"), less the insurance company’s charge. Thus, the policyholder obtained a higher return if the value of the assets held under the contract increased, but the policyholder also assumed the investment risk that the asset values would decline or increase insignificantly compared to the income that the policyholder could have received under a guaranteed annuity policy.

The variable annuity also provided the issuing company with a satisfactory return, regardless of investment performance. The issuing company typically offered a relatively high return to the policyholders without being required to set aside the large reserves that would have been required under state law if the company had guaranteed rates in excess of the maximum rates of interest provided under state law. 6/

The first variable annuities, however, resulted in both securities and tax problems. From a securities perspective, the question was whether a variable annuity constituted an "annuity," which was exempt from registration under the Securities Act of 1933, or whether it was a "security"subject to such registration. A parallel question was whether a company that had as its primary and predominant business activity the writing of such annuities was an "insurance company," which was exempt from the Investment Company Act of 1940. 7/

In SEC v. Variable Annuity Life Insurance Company of America, 8/  the Supreme Court held that variable annuities were securities, and not annuities,for purposes of the federal securities laws. This decision generally was interpreted more broadly than its specific holding and it raised the question as to whether variable annuities constituted annuities for federal tax law purposes.

This issue was important for a number of reasons. At the policyholder level, increases in annuity values were not taxable until annuitization. 9/ If, however, the assets held under the policy were treated as being held in trust for the policyholder, it was arguable that all income and gains under the policy should be taxed immediately to the policyholder. 10/  At the company level, it was unclear whether the issuance of annuity policies qualified the issuer as a life insurance company for federal tax purposes. 11/ Even if the policy qualified as an annuity contract, it was unclear whether the reserves under the contract could be treated as "life insurance reserves." Section 803(b) of the 1954 Code required the calculation of life insurance reserves on the basis of "assumed rates of interest." 12/ There was, however, no need to assume a rate of interest for a variable annuity, which contained a rate of return based upon actual interest rates.Life insurance reserves were, and still are, important in determining the company’s status as a life insurance company for federal tax purposes 13/ and the company’s deductions for its amounts reserved. 14/

Congress resolved these questions by enacting the Life Insurance Company Income Tax Act of 1959 ("LICITA"). 15/  LICITA completely revised the taxation of insurance companies and incidentally recognized the existence of variable annuities for federal tax purposes. In addition, LICITA, as amended in 1962, adapted Code sections dealing with annuity contracts and made these provisions applicable to variable annuities. Under LICITA, an annuitant was not taxed on the growth in value of his annuity prior to annuitization, unless he received distributions from the annuity. 16/  After annuitization, each payment was deemed to consist of a return of capital to the extent that it did not exceed the policyholder’s investment in the contract divided by the expected length of the annuitization period. 17/ In a variable annuity, the investment in the contract was assumed to have been recovered in equal installments over the annuitization period, with any excess of the payments received in a given year over the investment recovered in such year treated as income to the policyholder in that year. 18/ The remainder of each payment 19/ , and all payments made after annuitization other than regular annuity payments, were treated as taxable income. 20/

In spite of what LICITA did to clarify the status of variable annuities,it suffered from the defects that one might anticipate in legislation produced in the immediate aftermath of the Variable Annuity Life case. While LICITA responded to the immediate problem by enacting guidelines that protected the specific litigant in the case, it provided little guidance as to what other arrangements might fall within its ambit. For example, LICITA provided that "an ‘annuity contract’ includes a contract which provides for the payment of a variable annuity computed on the basis of recognized mortality tables and the investment experience of the company issuing the contract." 21/ This definition included contracts issued by the defendant in Variable Annuity Life, which calculated the value of the annuities it issued based on the investment experience of the entire company. 22/  If read literally,however, LICITA could have been interpreted to exclude annuities that based their return on the investment experience of something less than the entire company, for instance, of a particular segregated asset account within the company. Such an interpretation would have made nonsense of LICITA section 801(g)(1)(B), which discusses contracts based on a segregated asset account, and it would also have disqualified the annuities of College Retirement Equities Fund ("CREF"), the first major issuer of variable annuities 23/ ,which maintained one segregated asset account holding bonds and one holding stocks and permitted policy holders to allocate payments between the two funds, both initially and from time to time, during the life of the contract.For these reasons, it seems that the Service has not pursued this narrow interpretation. Nevertheless, the existence of language subject to such an interpretation indicates how narrowly Congress focused on the contracts involved in the case to which it was reacting, without attempting to define other contracts that could be eligible for treatment as variable annuities.

This deficiency became more apparent as variable annuities became more diverse and sophisticated. Since 1959, the following trends have developed in the variable annuity industry.

1. Increased use of funds

In order to hold the assets of segregated asset accounts, companies resorted to greater use of Unit Investment Trusts ("UITs") and open-end regulated investment companies ("mutual funds"). This trend was encouraged by two factors. First, companies already selling fixed annuities entered into the variable annuity market and this made imperative the separate allocation of assets to accounts segregated from assets available for other purposes. Second, once it was clear that registration with the Securities and Exchange Commission was required, companies began qualifying their accounts within categories (UIT or mutual fund) recognized by the Securities and Exchange Commission. 24/  The mutual fund is administered by an investment adviser with investment discretion to purchase and sell assets within certain broad investment guidelines set by the fund. The UIT is more of a passive investment, and is generally used to hold shares in a mutual fund that also sells shares to other variable annuities or to the public, and which is therefore not itself a segregated asset account. 25/

2. Combination of funds

After segregated asset accounts began to operate through mutual funds,either as mutual funds in their own right or as UITs investing in mutual funds, the next logical step was to combine mutual funds used as the basis for variable annuities with other mutual funds. Companies believed that this approach provided two significant advantages. First, the combined fund could utilize the economies of size to secure a better return to its policyholders. Second, larger funds could establish well-known "track records" so that a potential policyholder could have a better basis for determining whether a particular variable annuity was likely to increase in value at an acceptable rate.

3. Specialization of funds

As previously discussed, one of the initial reasons for variable annuities was to enable policyholders to select the higher but riskier yields from equity securities or the safety and lower returns of long-term bonds. From the beginning, companies had separate bond and equity funds and permitted the policyholder to allocate and reallocate funds between them. A natural extension of this trend was to have separate variable annuities or separate sub-accounts within the same annuity based on a wide array of investments.Sub-accounts could be created for bonds, growth stocks, income stocks,"money market" investments, government securities, or savings certificates, with the policyholder permitted to make transfers of funds from one sub-account to another. This trend was exacerbated by the inversion of interest rates in the early 1980s, producing higher returns on many short-term investments than on longer-term securities. Even the typical annuity purchaser, who was concerned about long-range personal planning,would consider it more prudent to purchase an annuity based on a fund making a series of short-term investments than one based on long-term bonds, whose apparent security might be wiped out by inflation.

4. Outside management

The trend toward utilizing outside management was spurred by the entry of traditional insurance companies into the variable annuity business,as well as by the other trends already discussed. In many instances, traditional insurance companies lacked investment expertise when they ventured beyond the blue chip stocks and long-term bonds traditionally held by such companies.They sought assistance in two forms. First, the company might hire an outside consultant with investment expertise to manage its own in-house fund. Second,the company might invest assets of its separate account in a mutual fund managed by another company, frequently a fund open to the general public or to other insurance company separate accounts.

In the 1970s, a totally new type of annuity, the "investment annuity,"emerged. The investment annuity allowed an investor to own and control his investment portfolio and to defer taxation on both income and capital gains. Typically, the policyholder would contribute investments to an insurance company, which set up a variable annuity based on a separate account for that particular policyholder. The policyholder would retain virtually complete investment control over his account, and would direct that the account buy or sell particular assets. The value of the annuity would be equal to the value of the underlying investment portfolio, after deducting the insurance company’s fee for its services. The insurance company’s discretion in dealing with the separate account was extremely limited. For the most part, the insurance company acted merely as a passive trustee-custodian.

III. RECENT LEGISLATIVE AND ADMINISTRATIVE ACTIVITY

The aggressive marketing and growing popularity of the investment annuity focused the Service’s attention on two points: the potential revenue loss associated with the favorable taxation of such investments and the difficulty in distinguishing between investment annuities and other investments. So long as annuities, in traditional form, had provided a fairly low rate of return, their effect on the revenue had been minimal. Investors seeking security were the primary market for such annuities, and in such cases,the Service believed that the legally authorized deferral of individual tax, and the favorable tax treatment to the issuer, resulted in modest revenue losses and encouraged investors to provide security for their declining years. The investment annuity also raised the specter that a large number of investors would use the annuity form primarily as a method to defer tax on investment income. 26/

Beginning in 1977, the Service attempted, first administratively and later legislatively, to curb the perceived abuses in the use of variable annuities by adopting certain restrictions. These restrictions can be classified into three areas: restrictions on investment control, diversification restrictions,and restrictions on access to funds invested in an annuity for nonretirement purposes (such as restrictions on withdrawals and loans).

A. Restrictions on Investment Control

The first attack on perceived abuses in variable annuities focussed on the investment control maintained by the policyholder. After the Service analyzed the investment annuity, and grasped its tax avoidance potential,the Service issued Revenue Ruling 77-85. 27/  In Revenue Ruling 77-85, the Service concluded that an account held under a typical investment annuity was not a segregated asset account under Section 801(g)(1)(B), that the deferral provisions of Section 72 did not apply, and therefore, that the policyholder was taxable on the investment income under Section 61.

Although Revenue Ruling 77-85 is very lengthy and wordy, its conclusion can be summarized as follows:

    The facts of the subject annuity arrangement indicate that the individual policyholder is the owner of the assets in the custodial account for purposes of taxing the income therefrom . . . . In view of the fact that the policyholder possesses such substantial incidents of ownership of the assets in the custodial account, such assets are owned by the policyholder, rather than by the insurance company, for purposes of section 801(g)(1)(B) of the Code.While section 801(g)(1)(B) contemplates that particular classes of policyholders will bear the investment risk with respect to segregated asset accounts of the insurance company, it does not extend to assets in an investment account over which an individual policyholder has direct investment control and can exercise other incidents of ownership that make such person, rather than the insurance company, the owner of such assets. 28/

Revenue Ruling 77-85 was made prospective under section 7805(b). 29/  Thus, an investment annuity would be treated as an annuity if no contributions were made to it after the date of the ruling, and if the segregated asset account held under it was consistently treated as the property of the insurance company for all purposes under Subchapter L of the Code. Furthermore, future employer contributions to qualified retirement plans and to section 403(b)annuities were also permitted, and would not endanger the annuity status of such contracts.

As expected, Revenue Ruling 77-85 was immediately challenged. First Investment Annuity Corporation and its parent, Investment Annuity, Inc.brought suit in the District of Columbia to have Revenue Ruling 77-85 declared invalid. 30/  However, without deciding the merits of the case, the District of Columbia Court of Appeals held that the Anti-Injunction Act 31/  and the tax exception to the Declaratory Judgement Act 32/  barred consideration of the Plaintiff’s challenge to Revenue Ruling 77-85. 33/

B. Diversification Restrictions

Although the Service was ultimately successful in upholding the restrictions on policyholder investment control set forth in Revenue Ruling 77-85, such restrictions could not forever halt the perceived abuses of variable annuities. One difficulty arose from the fact that the exchange of one annuity for another is tax-free under section 1035. Under Revenue Ruling 77-85, theService could prevent an annuity owner from directing his annuity account to buy General Motors stock on day one, and then to sell the General Motors stock and buy American Telephone and Telegraph stock on day two. But, Revenue Ruling 77-85 did not prevent the policyholder from purchasing a variable annuity invested entirely in General Motors stock on day one, and then exchanging that annuity for a different variable annuity invested entirely in AT&T stock on day two.

Ultimately, this perceived abuse was resolved by the enactment of section817(h), which was added by the Tax Reform Act of 1984 (1984 TRA) 34/  and which required that investments held by a variable annuity be adequately diversified. 35/  The Service did not, however, recognize the existence of this problem in the beginning. Indeed, the rulings issued by the Service that restricted undiversified annuities, Revenue Rulings 80-274 36/  and 81-225 37/ ,were nominally issued under the guise of the investment control test set forth in Revenue Ruling 77-85. 38/

Revenue Ruling 80-274 involved "savers’ annuities," under which policyholders transferred existing savings accounts or certificates of deposit to an insurance company that held the deposits in separate accounts for each policyholder. 39/  A deposit could be used only for the benefit of the particular policyholder who had transferred it. On the maturity of a certificate of deposit, the insurance company was required to roll it over into another certificate of the same duration with the same savings institution, or into a certificate of a lesser duration with the same savings institution if necessary to avoid having the term of the certificate expire after the annuitization date. If no such certificate existed, the insurance company was to roll the certificate over into a passbook account. This arrangement was designed to assure each policyholder that his deposit would receive the maximum $100,000 FSLIC insurance coverage. 40/

At any time, upon written request, the policyholder could receive thecash surrender value of the annuity contract. The cash surrender value was the value of the underlying certificate amount deposited plus interest,less any early withdrawal penalty imposed by the savings institution, any applicable state premium taxes and the insurance company’s management fee.The insurance company’s only discretion with regard to the segregated asset account was that it could withdraw deposits from a savings and loan association that was failing or that ceased to participate in the plan. 41/

Citing Revenue Ruling 77-85, the Service ruled in Revenue Ruling 80-274that the holder of a "savers’ annuity" had such incidents of ownership in the underlying savings deposits as to be considered the owner thereof:

    Under the annuity contract, the policyholder’s position is substantially identical to what the policyholder’s position would have been had the investment been directly maintained or established with the savings and loan association.Prior to the annuity starting date, L [the insurance company] is little more than a conduit between the policyholder and the savings and loan association. 42/

Thus, Revenue Ruling 80-274 held that the policyholder would be taxed currently on the interest from the deposits.

Revenue Ruling 80-274, like Revenue Ruling 77-85, was a reversal of several earlier private rulings; indeed, many of the contrary rulings 43/ were issued after the issuance of Revenue Ruling 77-85, which Revenue Ruling 80-274 purported to follow. 44/  Unlike Revenue Ruling 77-85, however, Revenue Ruling 80-274 did not provide for an automatic grandfathering of existing contracts under section 7805(b). Rather, companies that previously had received favorable private rulings on their savers’ annuities were granted section 7805(b) relief on a case-by-case basis. 45/

Although Revenue Ruling 80-274 was nominally based on an "investmentcontrol" theory 46/ , neither the policyholder nor the company maintained much investment control, since the terms of the contract virtually dictated what investments could be purchased, and did not provide either the policyholder or the insurance company with discretion to change investments. Many analysts believed that the key factor in Revenue Ruling 80-274 was each policyholder’s entitlement to $100,000 of FSLIC insurance. The IRS may have believed it inconsistent to assert ownership rights before one government agency while denying ownership responsibilities before another. However, given the different purposes of defining ownership under FSLIC and IRS rules, it is not clear that such insurance should form the basis for treating the contract as not being an annuity for tax purposes.

Revenue Ruling 81-225 47/ , issued one year after Revenue Ruling 80-274, nominally represented a further extension of the investment control theory, but also illustrated the theoretical problems of applying that theory. Revenue Ruling 81-225 encompassed five situations involving variable annuities based upon mutual fund shares. 48/

In Situation one, the segregated asset account was invested solely inthe shares of a mutual fund whose shares were available for investment by the general public, and which was managed by a firm independent of the insurance company issuing the annuity. Situation two was similar, except that the mutual fund was managed by the insurance company or one of its affiliates. Situation three was similar to situation one, except that the segregated asset account consisted of five sub-accounts, and the policyholder had the right to designate the sub-account(s) on which the performanceof the variable annuity would depend and to reallocate amounts during thelife of the contract. Situation four was similar to situation two, except that the shares in the mutual fund were not sold directly to the public, but were available through an annuity purchase or by participation in an investment plan account. Situation five was similar to situation two, except that shares in the mutual fund were available only through the purchase of an annuity contract.

Revenue Ruling 81-225 held that the policyholder would be treated as the owner of the mutual fund shares in situations one through four, but not in situation five, and that the contracts described in the situations one through four were not annuity contracts. 49/  Consequently, the income from the mutual fund shares held in the segregated asset accounts would be taxed to the policyholders in situations one through four. 50/  Revenue Ruling 81-225 and subsequent guidance 51/  accorded limited retroactive relief to contracts that did not comply with the holding the revenue ruling.

Upon analyzing the policyholder’s ownership rights to determine whether they are sufficient to attract taxation of the underlying assets, the distinction in Revenue Ruling 81-225 between situations one through four and situation five is somewhat unclear. In each situation, the policyholder has the basic rights to make additional transfers and withdrawals, surrender the contract, convert the contract into a stream of payments, and vote his representative rights as required by the Securities and Exchange Commission.

In situations one through four, the policyholder could acquire the mutual fund shares through some means other than by buying the policy, while in situation five the policyholder could not do so. But, this distinction is based on a right of access, not an ownership right. Likewise, in situation five the insurance company has greater rights in and a closer relationship to the assets of the mutual fund, since the insurance company or its affiliates manages the fund and the fund is not sold to the general public. It is somewhat difficult, however, to draw any meaningful distinction between the facts in situation five and a case in which the bulk of the mutual fund shares are owned by an insurance company’s segregated asset account and only a few shares are owned by the public. Moreover, the policyholders have the ultimate right to select the mutual fund manager in any event.

The implicit rationale of Revenue Ruling 81-225 is not that the policyholder has substantial ownership rights in underlying assets. Instead, Revenue Ruling 81-225 may be based on the theory that since the policyholder could acquire the mutual fund shares directly and have the responsibility for the tax on income and gain thereon, the indirect acquisition of shares through a variable annuity should not allow the policyholder to escape from taxation on this income and gain.

The Service’s limitations upon the effect of Revenue Ruling 81-225 were initially unclear. In the accompanying press release 52/ , the Service announced that it was proceeding against "wrap-around" annuities–those in which the variable annuity invested solely in the shares of a mutual fund that was available for investment by the public. The Ruling, however,only approved only those annuities (situation five) that not only lacked the "wrap-around" feature, but also were based on a single segregated asset account with no sub-accounts that was invested solely in a mutual fund managed by the insurance company or an affiliate. 53/  The Service did not state whether variable annuities would be generally treated as annuities for tax purposes if they lacked a "wrap-around" feature, or whether other limitations also might be required.

Two rulings in early 1982 helped to clarify the substance, although not the rationale, of Revenue Ruling 81-225. Revenue Ruling 82-54 54/  permitted a variable annuity contract to be based on a segregated asset account with sub-accounts and allowed the policyholder to direct the investment of his premium among the sub-accounts and reallocate these amounts among the sub-accounts at any time before annuitization. Revenue Ruling 82-55 55/  stated that a mutual fund would not be treated as open for investment by the public if it were closed to further public investment, even if members of the public continued to own shares and to reinvest the dividends from such shares in the mutual fund.

Revenue Rulings 82-54 and 82-55 seemed, superficially, to answer the major questions raised by Revenue Ruling 81-225, except than the question of whether the manager of the mutual fund(s) underlying a variable annuity had to be the insurance company issuer or an affiliate. Treasury and Service personnel, however, soon began raising the issue of whether the mutual fund underlying a variable annuity, even though literally described in situation five of Revenue Ruling 81-225, might be treated as owned by the policyholders if, in practice, the policyholders could purchase through the medium of an annuity something which resembled an investment available for purchase by the general public. 56/

In the early months, the government’s concern focused on mutual funds underlying a variable annuity that bore a resemblance to publicly available mutual funds (the clone funds). The Service suggested that a fund availableonly through the purchase of a variable annuity might be treated as publicly available if its investments were too similar to those of a publicly available fund, or if its manager or an affiliate also managed a publicly available fund with similar objectives. 57/

Clearly, "similar" investments and "similar" objectiveswere highly subjective tests. In fairly short order, the Service realized that it could not police differences among mutual funds. At that point,the Service’s concern shifted from resemblances between mutual funds underlying variable annuities and publicly available mutual funds, to resemblances between the ultimate investments (such as individual securities) purchased through variable annuities and investments available for purchase by the general public. Rather than attempting to police differences between mutual funds, the Service began mandating diversification of funds underlying variable annuities. 58/

The Service’s changing attitude was illustrated through a series of letters issued to persons with pending letter ruling requests involving variable or indexed annuities over the period October 1982 to April 1983. 59/ The Service imposed four requirements before a favorable ruling letter would be issued. First, the policyholder must not have a legally binding right to require the company to purchase specific investment items. For this purpose, the underlying investments, not the shares of the mutual fund holding them, were treated as the specific investment item. Second, the policyholder could not have a direct interest in specific investment items, but only a contractual claim against the company. Third, all of the letters required that the fund(s) underlying the annuity be diversified, although the definition of what constituted diversification changed several times over this period. Fourth, any FDIC or FSLIC governmental insurance must inure to the benefit of the fund as a whole, not directly to the benefitof any individual policyholder. 60/

The status of the letters was, however, unclear. Obviously, a company which secured a favorable letter ruling based on these four requirements could rely on the letter ruling unless it was revoked, or unless the company failed to comply with the representations upon which the letter ruling was based. But, what about a company that relied on the letters in devising its product, but did not request a letter ruling? Presumably these letters, similar to the final letter ruling upon which these letters related, did not have any precedential value. 61/  Yet, this seemed to provide an unfair benefit to those companies who could afford to obtain a letter ruling. Moreover, the usual justification for withholding precedential status from rulings, that they must be produced hastily in order to benefit the individual taxpayer in a timely manner 62/ , seems absent in this instance, since the Service conducted a lengthy study of the situation before issuing these letters.

A related question was the extent to which the Service’s litigating position would approximate its ruling position. The ruling position was clearly intended to establish safe harbors through the mechanical application of an admittedly arbitrary test. Because the Service did not decide its final standards until more than a year and a half after the issuance of Revenue Ruling 81-225 and almost two and a half years after its effective date, it would be manifestly unfair to apply these standards retroactively to companies that had no way of anticipating them. At the same time, a litigating position markedly more lenient than the ruling standard would encourage litigation, while providing a competitive disadvantage to those companies that made a good faith effort to comply with the law by seeking a letter ruling and complying with the requested representations.

Finally, even the status of Revenue Ruling 81-225, upon which the private letter rulings were based, was unclear. After all, Revenue Ruling 77-85,which was cited as the basis for Revenue Ruling 81-225, had foundered in the only court to consider its substance and had survived only becauseof procedural obstacles. 63/  The procedural obstacles would not have applied to a challenge to Revenue Ruling 81-225. 64/

As a result, the Treasury and the Service decided to seek legislative ratification, ultimately through the 1984 TRA, for Revenue Ruling 81-225 and the diversification standards applicable under its private letter rulings policy. 65/  The 1984 TRA, in effect, ratified Revenue Ruling 81-225 and its progeny, at least prospectively, by providing the Secretary of the Treasury with the authority to promulgate regulations pursuant to which a variable annuity contract based on investments that were inadequately diversified would not be treated as an annuity. 66/  For this purpose, a publicly available mutual fund was treated as a single, nondiversified investment, although a mutual fund open only to insurance companies and their segregated assetaccounts was treated as a separate investment in each of the assets held by the mutual fund. 67/  The 1984 TRA also mandated legislatively the position that had already been taken in private letter rulings, that the presence or absence of an independent investment adviser would have no impact on the tax treatment of a variable annuity. 68/

The Treasury has now implemented its authority, under the 1984 TRA, with regulations setting forth the diversification requirements. 69/  Under the general rule set forth in the regulations, a segregated account underlying a variable annuity must have at least five investments, and limits are set on the proportion of the account that can be invested in any one, two, three, or four investments. 70/  The regulations also establish two alternative rules and special transitional rules for starting up and liquidating accounts. 71/ For purposes of these rules, a publicly available mutual fund is treated as a single investment, but a mutual fund that is not publicly available is ignored, so that the annuity is treated as investing in the underlying investments of the nonpublic fund. 72/

C. Restrictions on access

The restrictions on investment control and the diversification requirements might have served, superficially, to answer the question as to why a variable annuity owner should receive special tax benefits not available to the person who places his funds directly in investments identical to those underlying the annuity. After the issuance of Revenue Rulings 77-85, 80-274, and 81-225, the simple answer could be that it was impossible for a variable annuity owner to ensure that his funds would be placed in the same investments that he would have directed if he invested directly.

The simple answer was not, however, a very satisfying one. Admittedly, the government was forcing the annuity owner to relinquish investment control,which was very important to the owner, in order to receive the favorable tax benefits. No policy reason has ever been provided, however, to justify the government’s approach of forcing people to relinquish control over their assets as a condition to the receipt of favorable tax benefits.

Congress, therefore, began trying to limit favorable tax treatment in ways that would promote a social goal, namely, enabling people to provide for their retirement. 73/  With the enactment of TEFRA, the 1984 TRA, and the 1986 TRA, Congress imposed ever more stringent penalties on the use of annuity funds before retirement, or the failure to use annuity funds at retirement. 74/ 

This series of legislation modified the tax treatment of annuities in several ways. First, any amount which the policyholder receives, directly or indirectly, from a nonqualified annuity as a withdrawal, loan, or consideration for the assignment of the annuity, other than on annuitization, is includible in ordinary income to the extent it represents an increase in the value of the annuity. 75/  Gratuitous transfers are effectively treated as if they were for value, and a partial withdrawal is treated as coming first out of the increase in the annuity’s value to the extent thereof, and only thereafter from nontaxable investment in the contract. Second, a 10% penaltyis imposed on the taxable portion of withdrawals other than in the form of a life annuity from a nonqualified annuity prior to death, disability,or attainment of age 59½. 76/  Third, annuity proceeds have to be paid to a holder’s beneficiary after the holder’s death under a schedule similar to the distribution requirements for a qualified plan. 77/  Finally, annuity treatment is not available at all in the case of an annuity held by a corporate owner. 78/ 

The net effect of TEFRA, the 1984 TRA, and the 1986 TRA was to bring the restrictions on variable annuities much closer to the restrictions on other retirement programs funded with after-tax contributions. At this point, the tax treatment of variable annuities and nondeductible Individual Retirement Accounts (IRAs) are virtually identical, except that (1) IRAs are subject to a $2,000 per person annual cap on contributions (and to a $2,250 annual limit on the combined contributions of an employee and a nonemployed spouse), and (2) withdrawals from an IRA are treated as coming out of income and the initial investment on a pro rata basis, while withdrawals from an annuity are treated as coming first out of income. 79/  The tax treatment of nonqualified annuities is virtually identical to the tax treatment of a qualified employer plan that is 85% or more attributable to employee contributions, although the employer plan is subject to a number of additional restrictions necessary to maintain qualified status. 80/  Major requirements for qualified plans include a limitation on annual additions of the lesser of $30,000 or 25% of compensation, and a requirement that employee contributions plus matching employer contributions, if any, not be made disproportionately on behalf of highly compensated employees. 81/ 

IV. FUTURE POLICY

The government’s first attempts to regulate modern variable annuities seem to have primarily involved identifying of the annuities that present a perceived potential for abuse, and then preventing their issuance or imposing penalties on their owners. After the enactment of TEFRA, the 1984 TRA, and the 1986 TRA, and the issuance of numerous rulings that impose restrictions or penalties on annuities, it is time to step back and analyze whether the goals intended to be achieved by the favorable tax benefits accorded annuities are, in fact, promoted by the current tax structure.

The reason for granting tax benefits to annuity owners is presumed to be the promotion of retirement security. Thus, any reasonable taxing system should treat annuities and other after-tax contributions to retirement plans similarly, except when differential treatment is either necessary or justified by other public policy considerations.

Similar treatment of these plans is not, however, the only goal. Favorable tax benefits are being accorded taxpayers to foster a specific goal ofencouraging retirement savings. Restrictions that do not foster these goals will merely discourage retirement savings and undercut the purpose of the favorable tax benefits. At the same time, favorable tax benefits should obviously be limited to prevent someone from obtaining these tax benefits while not truly saving for retirement.

The restrictions on investment control and the diversification standards are difficult to justify under either the standard of treating similar investments similarly, or the standard of imposing restrictions in such a way as to foster the underlying public policy. Neither an employee contribution account in a qualified employer plan nor a nondeductible IRA is subject to any restrictions on the owner’s right to direct the account into nondiversified investments. 82/  Perhaps one could argue that retirement funds should be diversified as a matter of prudence. If so, the standard should require a prudent investment, and not mere diversification. For example, under the present Section 817(h) regulations, annuity funds may be invested entirely in Alaskan gold mines, so long as the fund holds investments in at least five Alaskan gold mines. 83/ 

By contrast, dollar amount contributions to annuities remain unlimited, while employee contributions both to qualified plans and IRAs are now subject to maximum dollar and percentage of compensation limitations under Sections 415 and 219, respectively. These limitations are designed to ensure that tax benefits are limited to a reasonable provision for retirement, and it is not clear why annuities should provide an unlimited vehicle for tax-favored retirement savings. At a minimum, a dollar limitation might be provided in the case of deferred annuities. Immediate annuities (i.e., those in which payout begins immediately on purchase) may present a different set of policy considerations. Inasmuch as they typically have no cash value, provide limited investment return, and have as their predominant purpose assuring that the annuitant will not outlive his or her benefits, Congress could well find that the goals achieved by immediate annuities warrant favorable tax benefits without regard to dollar limits. Certainly the potential to abuse the favorable tax aspects of such annuities seems minimal, since the annuitant is taxed as benefits are received, and benefits are not available until they are received.

The exact limits on contributions to annuities are to a large degree arbitrary, and perhaps the $2,000 limit currently applicable to IRAs is too low. If the limit is too low, however, it should presumably be raised for all retirement savings, not just for annuities. There does not appear to be any reason for more restrictively limiting the amount of dollar contributions to nondeductible IRAs and after-tax contributions to qualified plans, and not limiting the amount of dollar contribution to deferred annuities.

The specific limitations that should be imposed on annuities obviously are a topic for political debate. What should be beyond debate, however, is that the government should refrain from imposing new and unjustifiable restrictions on annuities out of a vague sense that all annuities are abusive, and that taxpayers should recognize that they cannot have the favorable tax benefits accorded to a retirement program without accepting the restrictions imposed on these programs.


  1. For purposes of this article, the term "annuity" will refer only to nonqualified annuities, which are annuities not issued as part of a qualified plan or individual retirement arrangement. A discussion of the tax treatment of qualified annuities is beyond the scope of this article.
  2. Pub. L. No. 99-514, 100 Stat. 2085 (1986).
  3. See 1 J. Mertens, LAW OF FEDERAL INCOME TAXATION § 6A.01,(M. Weinstein ed. 1987). The "3% rule" was intended to reflect the approximate rate of return in the average annuity at the time of passage of the Revenue Act of 1934. H.R. REP. NO. 704, 73rd Cong. 2d Sess. 21 (1933).
  4. The tax law has, at all times, permitted the holder of an annuity contract to defer taxation on any increases in the annuity value until the surrender of the annuity or annuitization, although the method of taxing the annuity proceeds has varied. Prior to the enactment of the RevenueAct of 1934, ch. 277, 48 Stat. 680 [hereinafter Revenue Act of 1934], an annuitant was not taxed until he had received payments under the annuityequal to the total premiums or other consideration paid. 1918, 1921, 1924, and 1926 Revenue Acts § 213(b)(2); 1928 and 1932 Revenue Acts § 22(b)(2).
  5. Beginning with the 1934 Revenue Act, the law was changed to require the taxation of some portion of each annuity payment as it was received. Under the prior law, an amount equal to 3% of the total consideration paid for the annuity contract was taxed to the policyholder in each year of annuitization and the balance of the annuity payments was exempt from taxation until the annuitant had recovered the entire investment in the contract, after which time the entire amount of each annuity payment was taxable.1934, 1936 and 1938 Revenue Acts § 22(b)(2); Internal Revenue Code of 1939 § 22(b)(2).

    The Internal Revenue Code of 1954 adopted a third method of taxation, which remains in effect today under the Internal Revenue Code of 1986. Under this method, a portion of each annuity payment is tax-free and the remaining amount is taxable. The tax-free portion is determined by dividing the annuitant’s basis in the annuity by the expected return, and then by multiplying the resulting fraction by the amount of the payment. In the case of an annuity for a life or lives, the expected return is the amount of each payment times the number of payments which can be expected, given the life expectancy of the annuitant(s). I.R.C. § 72.

  6. Frankel, Variable Annuities, Variable Insurance and Separate Accounts, 51 Boston University Law Rev. 177 (1971) [hereinafter Frankel].
  7. In the case of annuities other than variable annuities, state laws are generally modeled after the Standard Valuation Law of the National Association of Insurance Commissioners, which requires that insurance companies set aside reserves equal to the present value of future benefits. Until recently, highly conservative interest assumptions were utilized to obtain the present value.
  8. As an example, the applicable state law could require that an insurance company utilize a rate of interest no greater than 5.5% to obtain the present value of future benefits under a particular contract. If a net premium of $1,000 were paid under the contract and the company guaranteed that the annuitization value of the contract would increase by 10% per year until the annuitization date, ten years after issuance, then the company would be providing that the benefit under the contract would be ($1000) x (1.1)10, or $2,593.74, in 10 years. If the $2,593.74 benefit were discounted at 5.5% per year, it would produce a present value of approximately $1,518, which is the amount the company must set aside as a reserve. The insurance company would have a very difficult problem setting aside reserves of $1,518 on the receipt of each $1,000 of premiums. Recent changes in the Standard Valuation Law have lessened this problem, but the changes have not eliminated the reserve problems of guaranteed annuities.

    An insurance company that issues variable annuities, by contrast, would not assume any investment risk. As a result, this insurance company would only be required to set up reserves equal to the cash value of the contract at issuance, even though after 10 years the value of the contract could actually increase by a compound rate of 10% per year.

  9. Investment Company Act of 1940, ch. 686, § 2(a)(17), 54 Stat.789 [hereinafter Investment Company Act of 1940].
  10. 359 U.S. 65 (1959).
  11. See supra note 4 (discussing method of taxation adopted by the 1954 Code).
  12. See I.R.C. § 61(a)(15).
  13. Section 802, as in effect prior to 1959, subjected life insurance companies to very favorable taxation provisions. The term "life insurance company" was defined to include companies which were "engaged in the business of issuing … annuity contracts" and which met certain other tests. I.R.C. § 801 (1954).
  14. I.R.C. § 803(b) (1954).
  15. I.R.C. § 816. Until 1984, this definition was contained in Section 801.
  16. Prior to 1959, section 804 of the 1954 Code contained the provisions regarding a life insurance company’s deduction for its reserves. From 1959 through 1983, different deductions or exclusions from income based on reserves were available in computing taxable investment income (I.R.C. §§ 804(a) and 805) and gain from operations (I.R.C. § 809(a)(1) and (d)(2)).This deduction now is contained in Section 805(a)(2).
  17. Pub. L. 86-89, 73 Stat. 112 (1959).
  18. I.R.C. § 72(e). Before amendment by the Tax Equity and Fiscal Responsibility Act of 1982 (hereinafter "TEFRA"), Pub. L. No.97-248, 96 Stat. 324 (1982), even withdrawn amounts were not taxable until withdrawals exceeded the investment in the contract. Effective August 13, 1982 with respect to contracts purchased after this date which were not purchased under qualified plans, partial withdrawals are fully taxable to the extent the cash value immediately before the withdrawal exceeds the investment in the contract. Special transitional rules are provided by TEFRA for contracts to which amounts had been added both on or before and after August 14, 1982. I.R.C. § 72(e)(5)(B).
  19. I.R.C. § 72(b).
  20. Regs. § 1.72-4(d)(3).
  21. I.R.C. § 72(a).
  22. I.R.C. § 72(e)(1)(A).
  23. I.R.S. § 801(b)(1)(A) (1954).
  24. See Variable Annuity Life, 359 U.S. at 72 n.14 (majority opinion), 81-83 (concurring opinion) (discussion of valuation of an annuity unit underthe contract).
  25. Frankel, supra note 5, at 1.
  26. Section 4 of the Investment Company Act of 1940 divides registered companies into face-amount certificate companies, unit investment trusts, and management companies. "Management companies" are further classified into open-end companies and closed-end companies by section 5(a). Since face-amount certificate companies have specified purposes incompatible with treatment as segregated asset accounts and closed-end companies are unsuitable if the issuer of the variable annuity intends to continue selling variable annuities, unit investment trusts or open-end companies (mutual funds) are the logical ways of structuring segregated asset accounts.
  27. Unit investment trusts (UITs) may not make substitutions of underlying securities without Securities and Exchange Commission approval. InvestmentCompany Act of 1940, § 26(b). To escape the operational problems caused by this restriction, UITs generally invest through mutual funds.
  28. Investment Annuity, Inc. v. Blumenthal, 442 F. Supp. 681, 693(D.D.C. 1977), rev’d 609 F.2d 1 (D.C. Cir. 1979), cert. denied, 446 U.S. 981 (1980).
  29. Rev. Rul. 77-85, 1977-1 C.B. 12. In Revenue Ruling 77-85, theService held that no part of the accounts maintained under the investment annuity contracts was taxable to the issuing insurance company as a segregated asset account under I.R.C. § 801(g)(1). Id. The sole issue was how the policyholders should be taxed. Id. at 15
  30. Before the Service recognized the tax avoidance potential of investmentannuities, it issued several private rulings that were favorable to the tax treatment of such annuities. See, e.g., I.R.S. Letter Rulings 7208091300A, August 9, 1972 and 7204041250A, April 4, 1972. Indeed, one private letter ruling was issued and revoked during the pendency of litigation concerning the validity of Revenue Ruling 77-85. See I.R.S. Letter Ruling 7747111, August 29, 1977 revoked by I.R.S. Letter Ruling 7805020, September 13,1978.
  31. Rev. Rul. 77-85, 1977-1 C.B. 12, 14 (emphasis in original).
  32. Id. at 15.
  33. Investment Annuity, Inc. v. Blumenthal, 442 F. Supp. 681 (D.D.C. 1977), rev’d 609 F.2d 1 (D.C. Cir. 1979), cert. denied, 446 U.S. 981 (1980).
  34. I.R.C. § 7421(a). The Act prohibits pre-enforcement review of most service actions.
  35. 28 U.S.C. § 2201 (1987).
  36. 609 F.2d at 4, 8-10. Thus, the plaintiffs in a suit challenging the validity of Revenue Ruling 77-85 should have been policyholders. All existing policyholders, however, had been granted relief under section 7805(b). Decisions by the Insurance Commissioner of the Commonwealth of Pennsylvania and the Securities and Exchange Commission based on Revenue Ruling 77-85 prevented the sale of any future investment annuities. Without any aggrieved policyholders to file suit in the district court, Tax Court, or Court of Claims, the insurance companies had to file suit and challenge the validity of Revenue Ruling 77-85. In doing so, the insurance companies opened themselves up to a challenge under the Anti-Injunction Act, I.R.C. § 7421(a), and the tax exemption to the Declaratory Judgment Act,28 U.S.C. § 2201 (1987).
  37. Pub. L. No. 98-369, 98 Stat. 494 (1984).
  38. Rev. Rul. 80-274, 1980-2 C.B. 27.
  39. Rev. Rul. 81-225, 1981-2 C.B. 12.
  40. Rev. Rul. 80-274 states that "[t]o the extent that a policyholder under an annuity contract with a life insurance company possesses substantial incidents of ownership in an account established by the insurance company at the direction of the policyholder, the policyholder may be consideredthe owner of the account for federal income tax purposes." Rev. Rul.80-274, 1980-2 C.B. 27, 28.
  41. Rev. Rul. 80-274, 1980-2 C.B. 27.
  42. Id. at 28.
  43. Id.
  44. Id. at 28-29.
  45. E.g., I.R.S. Letter Ruling 7748012, August 30, 1977; I.R.S. Letter Ruling 7849013, September 6, 1978; I.R.S. Letter Ruling 7906058, November 9, 1978; I.R.S. Letter Ruling 8008135, November 30, 1979; and I.R.S. Letter Ruling 8015065, January 15, 1980.
  46. Rev. Rul. 80-274, 1980-2 C.B. 27, 28-29.
  47. See, e.g., I.R.S. Letter Ruling 9008113, November 28, 1980; I.R.S. Letter Ruling 9008128, November 28, 1980; I.R.S. Letter Ruling 9008129, November 28, 1980; and I.R.S. Letter Ruling 9008137, November 28, 1980.
  48. The Service stated that "the purchaser of an ‘investment’annuity contract, by means of which the purchaser individually selected and controlled one or more investments in a portfolio comprising a separate account of the life insurance company issuing the contract, is considered the owner of the underlying investments for federal income tax purposes."Rev. Rul. 81-225, 1981-2 C.B. 12, 13-14.
  49. Rev. Rul. 81-225, 1981-2 C.B. 12.
  50. Id. at 13.
  51. Id.
  52. Id. at 14. The rationale for Revenue Ruling 81-225 is not fully clear. It appears to be more assertion than analysis:

      In situations one, two, three and four, the policyholder has investmentcontrol over the mutual fund shares and possesses sufficient other incidents of ownership to be considered the owner of the mutual fund shares for federal income tax purposes. In each of these situations, the mutual fund shares are available for purchase not only by the prospective purchaser of the deferred variable annuity, but also by other members of the general publiceither directly (as in situations one, two, and three) or indirectly (as in situation four). The policyholder’s position in each of these situations is substantially identical to what his or her position would have been had the mutual fund shares been purchased directly (or indirectly, as insituation four).

    Rev. Rul. 81-225, 1981-2 C.B. 12, 14.

    Revenue Ruling 81-225 further provided that:

      In situation five, the shares of XY Fund are not separate investment assets; XY Fund is nothing more than the alter ego of IC [insurance company]….IC possesses sufficient incidents of ownership to be considered the owner of the underlying assets for federal income tax purposes.

    Id. at 14.

  53. Rev. Rul. 81-225 itself provided relief for periods prior to December 31, 1980, and later relief for certain kinds of contracts. IR-82-19 (February 3, 1982) extended the period for filing information returns and statements for 1980 to March 15, 1981. Revenue Ruling 82-55, 1982-1 C.B.12-13, clarified the rules applicable to contracts described in situations one through four to which payments had been made both before and after December 31, 1980.
  54. IR-81-114 (September 25, 1981).
  55. Rev. Rul. 81-225, 1981-2 C.B. 12, 14. The term "affiliate"was not defined in Revenue Ruling 81-225.
  56. Rev. Rul. 82-54, 1982-1 C.B. 11.
  57. Rev. Rul. 82-55, 1982-1 C.B. 12-13.
  58. Revenue Ruling 81-225 held that policyholders would be considered the owners of those shares of certain variable annuity contracts whose purchase payments were invested solely in publicly available mutual fund shares. Rev. Rul. 81-225, 1981-2 C.B. 12-14.
  59. Revenue Ruling 82-54 noted that "the policyholders’ position in each situation [described in Revenue Ruling 81-225] was substantially identical to what it would have been had the mutual fund shares been purchased directly by the policyholders" and they were thus considered the owner for federal tax purposes. Rev. Rul. 82-54, 1982-1 C.B. 11.
  60. Revenue Ruling 82-54 noted that "the policyholders’ position in each situation [described in Revenue Ruling 81-225] was substantiallyidentical to what it would have been had the mutual fund shares been purchased directly by the policyholders" and they were thus considered the ownerfor federal tax purposes. Rev. Rul. 82-54, 1982-1 C.B. 11.
  61. See, e.g., I.R.S. Letter Ruling 8332022, April 29, 1983.
  62. Id.
  63. I.R.C. § 6110(j)(3).
  64. See Gerald G. Portney, Letter Rulings: An Endangered Species?, 36 TAX LAWYER 751, 755 (1983).
  65. See supra notes 41-46 and accompanying text (discussing Investment Annuity, Inc., in which a challenge to Rev. Rul. 77-85 was dismissed as violating both the Anti-Injunction Act, I.R.C. § 7421(a), and the tax exemption to the Declaratory Judgment Act, 28 U.S.C. § 2201 (1987)).
  66. Indeed, one district court did reject the holding of Rev. Rul. 81-225 in Christoffersen v. United States, 578 F. Supp 398 (D. Iowa, 1984), rev’d, 749 F.2d 513 (8th Cir. 1984), cert. denied, 473 U.S. 905 (1985). Reversing, the Eighth Circuit held the taxpayer owners of an investment contract to be the beneficial owners of dividends from its mutual fund investments, and characterized it as a "wrap around annuity."749 F.2d at 515. In addition, the plaintiffs’ ownership was not considered impaired by their right to convert the assets into an annuity in the year 2021. Id. at 516.
  67. Pub. L. No. 98-369, 98 Stat. 494 (1984).
  68. Id. § 211(a) (codified at I.R.C. § 817(h)).
  69. I.R.C. § 817(h)(4).
  70. I.R.C. § 817(h)(5).
  71. Regs. § 1.817-5.
  72. Regs. § 1.817-5(b).
  73. Regs. § 1.817-5(c).
  74. Regs. § 1.817-5(f).
  75. STAFF OF JOINT COMM. ON TAXATION, 97TH CONG., 2D SESS., GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE TAX EQUITY AND FISCAL RESPONSIBILITY ACT OF 1982 (Comm. Print 1982); S. REP. NO. 494, 97th Cong., 2d Sess. 350 (1982).
  76. I.R.C. § 72(e), (q), (s) (these provisions are discussed in the text accompanying notes 68-70).
  77. I.R.C. § 72(e).
  78. I.R.C. § 72(q).
  79. I.R.C. § 72(s).
  80. I.R.C. § 72(u).
  81. Compare I.R.C. § 408(a)(1) with I.R.C. § 72(e)(2)-(e)(4).
  82. I.R.C. § 72(e)(7).
  83. I.R.C. §§ 415(c)(1), 401(a)(4).
  84. Employees’ Retirement Income Security Act of 1974, Pub. L. 93-406, § 404(c), 88 Stat. 829.
  85. Reg. § 1.817-5(b).