Partial annuity rider allocations create separate contracts

Plain-English summary

A life insurer proposed adding a deferred-income-annuity rider to a variable annuity contract. An owner could irrevocably transfer part of the contract's accumulation value to the rider while leaving the remainder available under the original contract. The IRS ruled that each partial transfer is governed by IRC § 72(a)(2). The rider portion created by each transfer is treated as a separate contract, the investment in the original contract is allocated proportionately between the portions, and each rider portion receives its own annuity starting date. Later withdrawals from the remaining accumulation value are taxed without using the investment allocated to the rider portion.

Ruling snapshot

• Question: How does IRC § 72 apply when part of an annuity contract's accumulation value is irrevocably allocated to a deferred-income-annuity rider?
• Outcome: Approved, each partial allocation creates a separate contract with proportionate investment and its own annuity starting date
• Key authorities: IRC §§ 72(a), 72(b), 72(c), and 72(e); Treas. Reg. §§ 1.72-2 and 1.72-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201632004 Third Party Communication: None
Release Date: 8/5/2016 Date of Communication: Not Applicable
Index Number: 72.00-00
Person To Contact:
------------------- -------------------, ID No. ----------------
---------------------------------------------- Telephone Number:
------------------------------------------------------------ --------------------
----- Refer Reply To:
------------------------ CC:FIP:B04
----------------------------------------- PLR-104385-15
Date:
May 03, 2016

Legend

Taxpayer = ------------------------------------------------------------------------------------------
---------------------------
State A = ------------
Company B = ------------------------------------------------------------------------------------------
-------------------------
Jurisdictions = ------------------------------------------------------

Dear --------------

 This is in reply to your letter requesting certain rulings under § 72 of the Internal

Revenue Code (the “Code”).

                                                 FACTS

    Taxpayer is a life insurance company incorporated under the laws of State A. It

files a consolidated tax return with Company B on a calendar year basis using the
accrual method of accounting. Taxpayer is a life insurance company as defined by
§ 816(a) and is licensed to conduct business in Jurisdictions.

   Taxpayer issues a non-qualified, individual, flexible premium deferred variable

annuity contract (the “Contract”). The Contract provides an accumulation period and a
payout period. During the accumulation period, the owner can take withdrawals from
the Contract’s “Accumulation Value,” which is the sum of the values attributable to the
investment options offered under the Contract which the owner has selected. Taxpayer
plans to offer the Contract with a deferred income annuity (“DIA”) payout rider (the
“Rider”). The Rider will allow the owner to apply some or all of the Contract’s

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Accumulation Value to the annuity option described in the Rider. The DIA option will
provide a series of life annuity payments commencing on a scheduled future date.
Once the Accumulation Value is transferred to the Rider, that amount is no longer
available for withdrawal. However, any Accumulation Value that is not transferred to the
Rider will remain available for withdrawal. Taxpayer has requested rulings under
§§ 72(a), (b), and (e) regarding the treatment of withdrawals and annuity payments in
these circumstances.

    The Contract provides for flexible premium payments, subject to certain

restrictions. Premiums cannot be paid at any time after the earliest of (a) the date the
accumulation period ends, (b) the date the Accumulation Value is zero, or (c) the
owner’s death (unless the owner’s surviving spouse continues the Contract in
accordance with § 72(s)).

   During the accumulation period, the owner can surrender the Contract or take

withdrawals from the Accumulation Value. Surrender charges and certain state taxes
may apply to surrenders and withdrawals.

   A death benefit is payable if the owner of the Contract dies during the

accumulation period. The amount of the death benefit equals the Accumulation Value
on the applicable valuation date, plus the amount of any additional death benefit
provided by a rider to the Contract. If the owner dies during the payout period, the
remaining portion (if any) of the interest in the Contract will be distributed at least as
rapidly as under the method of distribution being used as of the date of death.

  The owner may add the Rider to the Contract when the Contract is issued. The

owner, annuitant, and beneficiary under the Rider are identical to those under the
Contract. When added to the Contract, the Rider becomes part of the Contract and is
subject to all applicable, non-conflicting terms of the Contract.

   The Rider amends the Contract to provide the owner with an option to allocate

some or all of the Accumulation Value towards an annuity payout (the “DIA Payments”)
that will commence on a specified future date, and may choose to make multiple
allocations of Accumulation Value over time. Each allocation of Accumulation Value to
the Rider will entitle the owner to DIA Payments that are calculated using Taxpayer’s
annuity purchase rates for DIAs as of the date of the allocation applicable to the age
and gender of the annuitant, the date the DIA Payments are scheduled to begin (the
“DIA Start Date”), and other relevant factors. The DIA Start Date cannot extend beyond
a specified age of the annuitant, and the annuitant cannot be changed after the initial
allocation to the Rider.

   The DIA Payments are life-contingent, fixed annuity payments that will be made

at least annually and under which the owner can choose to include a period certain or
other refund feature. Regardless of the number or timing of allocations made to the
Rider, all DIA Payments will commence on the same DIA Start Date, will be payable

PLR-104385-15 3

under the same life-contingent annuity option, will be based on the same annuitant’s
life, and will be paid at the same frequency.

   The owner cannot change the DIA payment option after the first allocation to the

Rider is made. However, prior to the DIA Start Date the owner can change the
frequency at which DIA Payments will be made, e.g., from monthly to quarterly. After
the DIA Start Date, the payment frequency cannot be changed. The owner also can
change the DIA Start Date before DIA Payments begin, subject to certain restrictions.

   To the extent that the entire amount of the Accumulation Value is not applied to

the Rider, all contractual benefits continue to apply to the remaining Accumulation
Value, including the right to apply that Accumulation Value to another annuity option
under the Contract or to withdraw the remaining Accumulation Value in part or in full.
However, after any amount of the Accumulation Value is transferred to the Rider, that
amount is no longer part of the Contract’s Accumulation Value and cannot be accessed;
the Rider does not provide a withdrawal or surrender right of amounts transferred to it.

   If the annuitant (or an owner who is not the annuitant) dies before the DIA Start

Date, no DIA Payments will be made but the Rider may provide for a lump sum death
benefit. If applicable, the death benefit will equal the sum of all amounts previously
allocated to the Rider, without any subsequent interest or earnings. This amount is
added to the Contract’s Accumulation Value at death, and then is governed by the
death benefit provisions in the Contract. After the DIA Start Date, any death benefit is
governed by the DIA payment option the owner chose.

                      ADDITIONAL REPRESENTATIONS

1. The Contract will comply with § 72(s).

2. The Contract will be treated as an annuity contract under the state insurance
   laws and regulations of any state in which it is issued.

                           REQUESTED RULINGS
   

3. Section 72(a)(2) will apply each time Accumulation Value is transferred from the
   Contract to the Rider if, immediately after the transfer, the Contract continues to
   have an Accumulation Value.

4. At the time a transfer to which § 72(a)(2) applies is made from the Contract to the
   Rider:

PLR-104385-15 4

   a.     Pursuant to § 72(a)(2)(A), the portion of the Contract from which the DIA
          Payments associated with that transfer will be made will be treated as a
          separate contract for purposes of § 72;

   b.     Pursuant to § 72(a)(2)(B), for purposes of applying §§ 72(b), (c), and (e) a
          pro rata portion of the investment in the contract with respect to the
          Contract will be allocated between the Contract and the separate contract
          that is treated as having arisen by virtue of such transfer, with the pro rata
          allocation determined as of the transfer date based on the percentage of
          Accumulation Value transferred; and

   c.     Pursuant to § 72(a)(2)(C), a separate annuity starting date will be
          determined with respect to each separate contract that is treated as
          having arisen by virtue of the transfer to the Rider.

                              LAW AND ANALYSIS

   Section 72(a)(1) provides that, except as otherwise provided in Chapter 1 of the

Code, gross income includes any amount received as an annuity (whether for a period
certain or during one or more lives) under an annuity, endowment, or life insurance
contract.

   Section 72(a)(2), in relevant part, provides that if any amount is received as an

annuity for a period of 10 years or more or during one or more lives under any portion of
an annuity, the rules of subparagraphs (A)-(C) of § 72(a)(2) shall apply. Subparagraph
(A) of § 72(a)(2) provides that such portion shall be treated as a separate contract for
purposes of § 72. Subparagraph (B) of § 72(a)(2) provides that for purposes of applying
subsections (b), (c), and (e) of § 72, the investment in the contract shall be allocated pro
rata between each portion of the contract from which amounts are received as an
annuity and the portion of the contract from which amounts are not received as an
annuity. Subparagraph (C) of § 72(a)(2) provides that a separate annuity starting date
under § 72(c)(4) shall be determined with respect to each portion of the contract from
which amounts are received as an annuity.

   Section 72(b)(1) provides that gross income does not include that part of any

amount received as an annuity under an annuity, endowment, or life insurance contract
which bears the same ratio to such amount as the investment in the contract (as of the
annuity starting date) bears to the expected return under the contract (as of such date).

   Under § 1.72-2(b) of the Income Tax Regulations, amounts are considered as

“amounts received as an annuity” only if all of the following tests are met: (1) the
amounts are received on or after the annuity starting date, (2) the amounts are payable
in periodic installments at regular intervals over a period of more than one full year from
the annuity starting date, and (3) the amounts payable are determinable either directly

PLR-104385-15 5

from the terms of the contract or indirectly from the use of either mortality tables or
compound interest computations, or both (if the contract is a variable contract, § 1.72-
2(b)(3) provides an alternative formulation of this requirement).

    Section 72(c)(4) defines “annuity starting date” as the first day of the first period

for which an amount is received as an annuity under the contract. Under § 1.72-4(b)(1),
the first day of the first period for which an amount is received as an annuity is the later
of (1) the date upon which the obligations under the contract became fixed, or (2) the
first day of the period which ends on the date of the first annuity payment.

   Section 72(c)(1) provides that, for purposes of the exclusion ratio under § 72(b),

the “investment in the contract” as of the annuity starting date is the aggregate amount
of premiums or other consideration paid for the contract, minus the aggregate amount
received under the contract before such date, to the extent that such amount was
excludable from gross income. Under § 72(c)(2), this amount is then reduced by the
value of the refund feature, if any.

   Section 72(e)(6) provides that for purposes of § 72(e), the “investment in the

contract” as of any date is the aggregate amount of premiums or other consideration
paid for the contract before such date, minus the aggregate amount received under the
contract before such date, to the extent that such amount was excludable from gross
income.

   Here, to the extent that an irrevocable election to allocate Accumulation Value to

the Rider is made with respect to less than all of the Accumulation Value under the
Contract, the DIA Payments will be made under a portion of the Contract while the
remaining portion of the Contract’s Accumulation Value is administered according to the
terms of the Contract. As a result, the election to allocate a portion of the Accumulation
Value to the Rider will be a transaction to which § 72(a)(2) applies. Accordingly, at the
time of such transfer, (A) a separate contract will be treated as arising for purposes of
§ 72, (B) a pro rata portion of the investment in the contract will be allocated between
that separate contract and the Contract, based on the percentage of Accumulation
Value to which the allocation applied, and (C) a separate annuity starting date under
§ 72(c)(4) will be determined with respect to the resulting DIA Payments.

     Hence, if the Contract owner takes a withdrawal from the Contract following an

election to allocate Accumulation Value to the Rider, the withdrawal will be taxable
under § 72(e) without regard to the investment in the contract that was allocated to the
Rider, i.e., to the separate contract that § 72(a)(2)(A) treated as arising when such
transfer was made. If one or more additional transfers to the Rider are made after the
first, each of the subsequent allocations will be treated as another transaction to which
§ 72(a)(2) applies if made with respect to less than all of the Accumulation Value in the
Contract. In such case, the same treatment described above will apply to each of the
subsequent allocations of Accumulation Value to the Rider.

PLR-104385-15 6

                                    RULINGS

   Based on the facts submitted and the representations made, we hold as follows:

(1) Section 72(a)(2) will apply each time that Accumulation Value is irrevocably
allocated from the Contract to the Rider if, immediately after the transfer, the
Contract continues to have an Accumulation Value.

(2) At the time § 72(a)(2) applies to an irrevocable allocation from the Contract to the
Rider:

   (a)    Pursuant to § 72(a)(2)(A), the portion of the Contract from which the DIA
          Payments associated with that allocation will be made will be treated as a
          separate contract for purposes of § 72;

   (b)    Pursuant to § 72(a)(2)(B), for purposes of applying §§ 72(b), (c), and (e) a
          pro rata portion of the investment in the contract with respect to the
          Contract will be apportioned between the Contract and the separate
          contract that is treated as having arisen by virtue of such allocation, with
          the pro rata allocation determined as of the allocation date based on the
          percentage of Accumulation Value allocated; and

   (c)    Pursuant to § 72(a)(2)(C), a separate annuity starting date will be
          determined with respect to each separate contract that is treated as
          having arisen by virtue of the allocation to the Rider.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. In particular, no opinion is expressed regarding the meaning of
the terms “cash value” or “cash surrender value” as they appear in § 72 or as applicable
to the Contract and Rider, on the application of § 72(u) (including § 72(u)(4)), or whether
the Contract complies with § 72(s).

    Temporary or final regulations pertaining to one or more of the issues addressed

in this ruling have not yet been adopted. Therefore, this ruling will be modified or
revoked by the adoption of temporary or final regulations, to the extent the regulations
are inconsistent with any conclusion in the letter ruling. See, § 11.04 of Rev. Proc.
2016-1, 2016-1 I.R.B. 1, 59. However, when the criteria in § 11.06 of Rev. Proc. 2016-
1, 2016-1 I.R.B. 1, 60 are satisfied, a ruling is not revoked or modified retroactively
except in rare or unusual circumstances.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury

PLR-104385-15 7

statement executed by an appropriate party. While this office has not verified any of
the material submitted in support of the request for rulings, it is subject to verification on
examination.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent. A copy of this letter
must be attached to any income tax return to which it is relevant.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                    Sincerely,



                                    Rebecca L. Baxter
                                    Senior Technician Reviewer, Branch 4
                                    (Financial Institutions & Products)

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