Investment advisory fees paid out of an annuity's cash value to the owner's adviser are not a taxable distribution to the owner

Plain-English summary

A life insurance company planned to offer deferred annuity contracts designed to work with an outside investment adviser who helps the owner choose how to allocate the contract's cash value. The owner authorizes the company to deduct the adviser's fee (capped at 1.5 percent of the contract's cash value per year, and only for advice about the annuity) directly from the contract and pay it to the adviser. Normally, money pulled out of an annuity before the payout phase can be a taxable "amount received" under section 72(e). The company asked the IRS to rule that these advisory fees are not an amount received by the owner. The IRS agreed: because the fees pay only for investment advice tied to the annuity, the contract itself is liable for them, and the owner cannot redirect them, the fees are an expense of the contract rather than a distribution to the owner. The ruling does not cover any fee that pays for advice on other assets or other services, which would be a taxable amount received.

Ruling snapshot

• Question: Are investment advisory fees deducted from an annuity's cash value and paid to the owner's adviser an "amount received" by the owner under § 72(e)?
• Outcome: Approved (fees are not an "amount received" by the owner)
• Key authorities: IRC § 72(e); Treas. Reg. § 1.72-1, § 1.72-2, § 1.72-11

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202144004 Third Party Communication: None
Release Date: 11/5/2021 Date of Communication: Not Applicable
Index Number: 72.00-00
Person To Contact:
--------------------- --------------------, ID No. -----------------
-------------------------- Telephone Number:
------------------------------------------------------------ ---------------------
------------------------------ Refer Reply To:
----------------------------- CC:FIP:B04
------------------------------- PLR-101957-21
Date:
July 27, 2021

Legend:

Taxpayer = --------------------------------------------------------------------------------------------------

Parent = ----------------------------------------------------------------

Dear -----------------:

This letter responds to Taxpayer’s request for a letter ruling that the payment of certain
investment advisory fees from an annuity contract will not be treated as an amount
received by the owner of that annuity contract for purposes of section 72(e) of the
Internal Revenue Code.

                                                 FACTS

Taxpayer is a life insurance company within the meaning of section 816(a). Taxpayer is
an indirect subsidiary of Parent but does not join in the filing of a consolidated return
with Parent. Taxpayer proposes to offer two types of non-qualified deferred annuity
contracts (the “Adviser Contracts”). Each Adviser Contract will be issued to and owned
by an individual or issued to and owned by “a trust or other entity as an agent for a
natural person” within the meaning of section 72(u)(1) (the “Owner”).

Each Adviser Contract is an annuity contract under the law of the jurisdiction where
issued. Each Adviser Contract qualifies for treatment as an annuity contract for federal
PLR-101957-21 2

income tax purposes, including by complying with the requirements of section 72(s).
Each Adviser Contract is comprised of an accumulation phase and a payout phase.
During the accumulation phase, the cash value of an Adviser Contract is credited with
interest based on options the Owner selects from a menu provided by Taxpayer (the
“Options”). The types of Options available under an Adviser Contract differ depending
on whether the contract is a Fixed-Indexed Adviser Contract or a Hybrid Adviser
Contract, as described below.

The Options under a Fixed-Indexed Adviser Contract are declared rate and index-based
interest crediting strategies that are supported by Taxpayer’s general account. The cash
value of a Fixed-Indexed Adviser Contract is credited with interest in accordance with
formulas reflected in those Options. A declared rate Option credits interest based on an
interest rate that is set by Taxpayer in advance of each crediting period, subject to a
guaranteed minimum rate set in accordance with state standard nonforfeiture law. The
index-based Options credit interest based on the positive performance of one or more
specified market indexes over each crediting period, subject to a cap, participation rate,
or other limit. While negative performance of the index over the crediting period may
mean that the Fixed-Indexed Adviser Contract is not credited with any interest for that
period, the negative performance of the index does not reduce the Fixed-Indexed
Adviser Contract’s cash value. In addition, under state standard nonforfeiture law, a
Fixed-Indexed Adviser Contract provides a guaranteed minimum surrender value for the
contract as a whole, calculated using a specified percentage of the purchase
payment(s) and a guaranteed minimum interest rate.

Hybrid Adviser Contracts are generally not variable contracts within the meaning of
section 817(d) and do not provide benefits that vary with the performance of separate
account assets. Rather, the declared rate and index-based Options under a Hybrid
Adviser Contract are supported by Taxpayer’s general account and certain hedging
instruments held in a non-unitized separate account. The cash value of a Hybrid Adviser
Contract is credited with interest in accordance with formulas reflected in those Options.
The declared rate Option credits interest based on an interest rate that is set by
Taxpayer in advance of each crediting period, subject to a guaranteed minimum rate set
in accordance with state standard nonforfeiture law. The index-based Options credit
interest based on the positive or negative performance of a specified market index over
each crediting period, subject to a cap, floor, participation rate, buffer, or other limit, and
the results are not dependent on the performance of the separate account. The Hybrid
Adviser Contracts will be registered as securities with the Securities and Exchange
Commission (“SEC”).

However, Hybrid Adviser Contracts may also offer variable Options. To the extent that
the Owner chooses a variable Option, the cash value of the Hybrid Adviser Contract will
fluctuate up or down with the actual investment performance and market value of
separate account assets corresponding to the selected variable Options. To the extent
that a Hybrid Adviser Contract provides variable Options, the contract will be a variable
contract within the meaning of section 817(d). Just like non-variable Hybrid Adviser
PLR-101957-21 3

Contracts, variable Hybrid Adviser Contracts will be registered as securities with the
SEC.

The Adviser Contracts are designed for an Owner who will receive ongoing investment
advice from an investment adviser (the “Adviser”) on how to allocate an Adviser
Contract’s cash value (within the meaning of section 72(e)(3)(A)(i)) among the available
Options. The Adviser is expected to take into account factors such as (1) the Owner’s
personal risk tolerance and investment timeline, (2) the interest rate and market
environment, (3) the menu of Options available under the Adviser Contract, and (4) the
various other benefits and features available under the Adviser Contract. The Adviser
will be licensed to provide investment advice in accordance with all applicable laws and
regulations. The Adviser and the firm with which the Adviser is associated (if any) may
or may not be affiliated with Taxpayer.

In consideration for the Adviser’s investment advice, the Owner will authorize
investment advisory fees (the “Fees”) to be paid periodically to the Adviser from the
Adviser Contract’s cash value in a separate agreement between the Owner and
Taxpayer (the “Authorization”). The Fees will be determined based on an arms-length
transaction between the Owner and the Adviser, or, if the Owner and the Adviser are
related parties, the Fees will not exceed those the Adviser charges unrelated parties.
The Fees will not exceed an amount equal to an annual rate of 1.5% of the Adviser
Contract’s cash value (within the meaning of section 72(e)(3)(A)(i)), determined at the
time and in the manner provided in the Authorization or other written agreement with the
Adviser but in all events based on such cash value during the period to which the Fees
relate. The Fees will compensate the Adviser only for investment advice that the
Adviser provides to the Owner with respect to the Adviser Contract, and not for any
other services. The Fees will not result in any reduction in fees related to any other
asset or for any other service.

Taxpayer will pay the Fees directly to the Adviser or the firm with which the Adviser is
associated. During any period for which the Authorization is in effect, the Adviser
Contract will be solely liable for paying the Fees and the Fees will not be paid directly by
the Owner. Similarly, the Owner will not have the right to direct payment of the Fees for
any other purpose or to any other person. The Adviser will not receive a commission for
the sale of the Adviser Contract from Taxpayer, but in some cases, Taxpayer may pay
the Adviser a wholesaling fee or marketing allowance.

                             REQUESTED RULING

Taxpayer requests a ruling that the Fees Taxpayer deducts from the Adviser Contract’s
cash value and remits to the Adviser or the firm with which the Adviser is associated will
not be treated as an “amount received” by the Owner of the Adviser Contract for
purposes of section 72(e).
PLR-101957-21 4

                              LAW AND ANALYSIS

Law

Section 72 distinguishes between an “amount received as an annuity” under an annuity,
endowment, or life insurance contract and an “amount not received as an annuity”
under those contracts. Section 1.72-1(b) of the Income Tax Regulations provides that
“amounts received as an annuity” are amounts which are payable at regular intervals
over a period of more than one full year from the date on which they are deemed to
begin, provided the total of the amounts so payable or the period for which they are to
be paid can be determined as of that date. See §1.72-2(b)(2), (3). Any other amounts to
which the provisions of section 72 apply are considered to be “amounts not received as
an annuity.”

Section 1.72-2(b)(2) provides that amounts are considered “amounts received as an
annuity” only in the event that the following tests are met:

  (i) They must be received on or after the “annuity starting date” as that term is
  defined in §1.72-4(b) (the first day of the first period for which an amount is
  received as an annuity);

  (ii) They must be payable in periodic installments at regular intervals (whether
  annually, semiannually, quarterly, monthly, weekly, or otherwise) over a period of
  more than one full year from the annuity starting date; and

  (iii) Except as indicated in §1.72-2(b)(3) (relating to variable contracts), the total
  of the amounts payable must be determinable at the annuity starting date either
  directly from the terms of the contract or indirectly by the use of either mortality
  tables or compound interest computations, or both, in conjunction with such
  terms and in accordance with sound actuarial theory.

Section 1.72-11(a)(1) describes “amounts not received as an annuity” as any amount
received under an annuity contract if the amount:

  (i) does not meet the requirements set forth in §1.72-2(b) for amounts received
  as an annuity;

  (ii) meets the requirements of §1.72-2(b) for amounts received as an annuity but
  the annuity payments received differ in either amount, duration, or both, from
  those originally provided under the contract; or

  (iii) meets the requirements of §1.72-2(b) for amounts received as an annuity but
  the annuity payments are received by a beneficiary after the death of an
  annuitant (or annuitants) in full discharge of the obligation under the contract and
  solely because of a guarantee.

PLR-101957-21 5

Section 72(e) applies to any “amount not received as an annuity” under an annuity,
endowment, or life insurance contract. Section 72(e)(2)(A) provides that if any amount
which is not received as an annuity is received on or after the annuity starting date, it is
included in gross income. Section 72(e)(2)(B) provides that if any amount which is not
received as an annuity is received before the annuity starting date, it is included in gross
income to the extent allocable to income on the contract and is not included in gross
income to the extent allocable to the investment in the contract.

Analysis

In this case, the Fees are integral to the operation of the Adviser Contract. During any
period for which the Authorization is in effect, the Owner will receive ongoing investment
advice from the Adviser with respect to the Adviser Contract so that the Owner may
properly utilize the Adviser Contract. The Adviser is expected to help the Owner select
Options related to the Adviser Contract. Taxpayer has represented that the Fees will not
serve as consideration for anything other than investment advice provided by the
Adviser in relation to the Adviser Contract. Furthermore, Taxpayer has represented that
the Fees will not exceed an annual rate of 1.5% of the Adviser Contract’s cash value
based on the period to which the Fees relate. Based on Taxpayer’s representations, the
Fees will only be used to pay for investment advisory services relating to the Adviser
Contract. Because the Adviser Contracts are designed to work with an Adviser, the
Adviser Contract is solely liable for the Fees. The Fees do not constitute compensation
to the Adviser for services related to any assets of the Owner other than the Adviser
Contract or any services other than investment advice services with respect to the
Adviser Contract. Therefore, the Fees are an expense of the Adviser Contract, not a
distribution to the Owner.

                                     RULING

The Fees that Taxpayer deducts from the Adviser Contract’s cash value and remits to
the Adviser will not be treated as an “amount received” by the Owner of the Adviser
Contract for purposes of section 72(e).

                                    CAVEATS

The ruling contained in this letter is based upon information and representations
submitted by Taxpayer and accompanied by penalty of perjury statements executed by
appropriate parties. 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.

The ruling contained in this letter does not apply to any amount paid by Taxpayer that
compensates the Adviser for services related to assets other than the Adviser Contract
or for any services provided other than investment advice services with respect to the
PLR-101957-21 6

Adviser Contract. Any such amount would be an “amount received” by the Owner of the
Adviser Contract for purposes of section 72(e).

Except as specifically set forth above, no opinion is expressed or implied concerning the
federal tax consequences of the proposed transaction under any other provision of the
Internal Revenue Code or Income Tax Regulations.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

Taxpayer must attach a copy of this letter ruling to any tax return to which it is relevant.

In accordance with a power of attorney on file in this office, a copy of this ruling is being
furnished to your authorized representatives.

                                   Sincerely,



                                   Rebecca L. Baxter
                                   Senior Technician Reviewer, Branch 4
                                   Office of Associate Chief Counsel
                                   (Financial Institutions and Products)

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