CAI Home > Resources
Update
on The Federal Taxation of Annuities:
A Success Story
Original
Article: The Federal Taxation of Annuities: A Success Story
To the Editor:
The purpose
of this letter is to provide a brief update to my article, The
Federal Taxation of Annuities: A Success Story published in the
May 1995 issue of this Journal. In my article, I mentioned that
some banks recently have begun offering arrangements which they
claim should be treated as deferred annuities for Federal income
tax purposes. As mentioned in the article, if a contract is both
a "debt instrument" and an annuity contract issued
by other than an insurance company, it is subject to taxation
as a debt instrument under the original issue discount ("OID")
provisions of the Internal Revenue Code (the "Code"),
rather than as an annuity contract under section 72 of the Code,
unless it qualifies for the annuity exception to the OID provisions
set forth in Code section 1275(a)(1)(B)(i).
In this connection,
the article considered one such bank arrangement marketed under
the name Retirement CD and stated generally that, in my opinion,
a bank-issued "annuity" like the Retirement CD does
not qualify for the section 1275(a)(1)(B)(i) annuity exception,
and thus is not an annuity for tax purposes, at least prior to
its maturity. I concluded that, at least during the deferral
stage prior to maturity, such a bank-issued arrangement should
be taxable as a debt instrument under the OID provisions. At
the time the article went to press, there was no clear guidance
on this issue, and I indicated that it would be valuable for
the Internal Revenue Service to publish such guidance.
On April 7,
1995, the Internal Revenue Service issued proposed regulations
stating that an annuity contract issued by other than an insurance
company will satisfy the section 1275(a)(1)(B)(i) annuity exception,
and thus will not be treated as a debt instrument under the OID
rules:
only if all payments under the contract are periodic payments
that --
(A) are made
at least annually for the life (or lives) of one or more individuals;
(B) do not increase
at any time during the term of the contract; and
(C) are part
of a series of payments that begins within one year of the date
of the initial investment in the contract. Prop. Treas. Reg.
section 1.1275-1(d)(2)(i).
The requirement
that all payments under the contract be periodic payments operates
to prevent a contract with a commutation right or surrender right
from qualifying for this exception.
The requirement
that payments must begin within one year of the initial investment
precludes a deferred annuity issued by other than an insurance
company from satisfying the proposed regulations. In this connection,
the rule that payments cannot increase at any time during the
term of the contract prevents a contract that is in substance
a deferred annuity from avoiding the proposed regulations by
providing a pattern of very small payments beginning within one
year from the initial investment, followed by a series of much
higher payments beginning more than one year from that investment.
In addition,
the proposed regulations provide that an annuity issued by a
noninsurer does not fail to qualify for the section 1275(a)(1)(B)(i)
annuity exception merely because it provides for a payment (or
payments) made by reason of the death of one or more individuals.
See Prop. Treas. Reg. 1.1275-1(d)(2)(ii). While it is not entirely
clear from the face of the proposed regulations, it does not
appear that a contract providing payments for life with guaranteed
payments for a certain period, e.g., 10 years, would satisfy
the proposed regulations. The reason for this is that payments
for the stated period are guaranteed in all events, and thus
are not made by reason of the death of one or more individuals.
Perhaps the final regulations will clarify this issue.
The preamble
to the proposed regulations states that they do not apply to
an annuity contract issued by other than an insurance company
which is not a debt instrument. The preamble indicates that an
annuity will be considered a debt instrument for this purpose
if it provides for a "guaranteed return." It appears
that an annuity contract without a surrender or commutation right,
guaranteed maturity value, or guaranteed payment stream would
not provide a guaranteed return, and thus would not be a debt
instrument subject to the proposed regulations. The preamble
states, "(f)or example, that an annuity contract under which
payments are wholly contingent on the continued life of an individual
generally is not a debt instrument for federal income tax purposes."
It should be noted, however, that the preamble provides further
that an annuity without a guaranteed return will nevertheless
be considered a debt instrument for this purpose if a return
is guaranteed by another instrument (e.g., where an annuity that
is not a debt instrument is issued in combination with a life
insurance contract that, together, effectively provide for a
guaranteed return).
The proposed
regulations are effective for annuity contracts which are held
on or after the date that is 30 days after the final regulations
are published in the Federal Register. Also, the proposed regulations
do not apply to annuity contracts purchased prior to April 7,
1995 (i.e., the date the proposed regulations were published
in the Federal Register), but do apply to any additional investment
in a contract made on or after that date, unless the investment
is required under a binding contractual obligation entered into
prior to that date. See Prop. Treas. Reg. 1.1275-1(d)(2)(iii).
In short, the
proposed regulations do not apply to an annuity contract issued
by other than an insurance company which is (1) purchased prior
to April 7, 1995 (assuming no additional premiums are paid after
that date), or (2) purchased prior to the effective date of the
final regulations but which is not held on that date.
A public hearing
on the proposed regulations has been scheduled for August 8,
1995, at the National Office of the Internal Revenue Service
in Washington, D.C. Hence, there is more to come regarding the
application of the annuity exception under Code section 1275(a)(1)(B)(i)
to Aannuities@ issued by other than insurance companies.
I hope that
your readers find this update helpful.
Mark E. Griffin
Davis & Harman
Washington, D.C.
JOURNAL
OF THE AMERICAN SOCIETY OF CLU & ChFC.JULY 1995
Reprinted
with the permission from the Journal of the American Society
of CLU & ChFC,
Vol. XLIX, No. 3 (May 1995).
Copyright 1995 by the American Society of CLU & ChFC,
270 S. Bryn Mawr Avenue, Bryn Mawr, PA 19010-2195.
Distribution prohibited without publisher's permission.