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

Plain-English summary

A life insurance company plans to offer non-qualified deferred annuity contracts designed to be managed with the help of an investment adviser. The owner authorizes the insurer to deduct the adviser's fees directly from the contract's cash value and pay them to the adviser. The fees are capped at 1.5% of the contract's cash value per year, are set at arm's length, and pay only for investment advice about the contract itself (not any other assets or services). The insurer asked whether pulling those fees from the contract counts as an "amount received" by the owner under § 72(e), which would ordinarily trigger income tax on the withdrawal. The IRS ruled no: because the fees are integral to operating the contract, the contract (not the owner) is liable for them, and they pay only for advice on the contract, the fees are an expense of the contract rather than a distribution to the owner. The ruling does not cover any fee that compensates the adviser for other assets or services, which would be treated as an amount received.

Ruling snapshot

• Question: Are investment advisory fees deducted from an annuity contract's cash value and paid to the adviser an "amount received" by the owner under § 72(e)?
• Outcome: Approved (the fees are not an amount received by the owner, subject to the stated limits)
• Key authorities: IRC §§ 72(e), 72(e)(3)(A)(i); Treas. Reg. §§ 1.72-1(b), 1.72-2(b), 1.72-11(a)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202218007 Third Party Communication: None
Release Date: 5/6/2022 Date of Communication: Not Applicable
Index Number: 72.00-00
Person To Contact:

----------------------- ---------------------, ID No. -----------------
----------------------------------------------------------- Telephone Number:
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---------------------------- Refer Reply To:
-------------------------- CC:FIP:B04
PLR-116196-21
Date:
February 03, 2022

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
a subsidiary of Parent and joins in the filing of consolidated returns with Parent.
Taxpayer proposes to offer two types of non-qualified deferred annuity contracts
(referred to herein as 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
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
earnings or interest based on options the Owner selects f rom a menu provided by
Taxpayer (the “Options”). The types of Options available under an Adviser Contract
differ depending on whether the contract is a Variable Adviser Contract or a Hybrid
Adviser Contract, as described below.
PLR-116196-21 2

Variable Adviser Contracts are variable annuity contracts within the meaning of section
817(d). A Variable Adviser Contract’s cash value fluctuates up or down with the actual
investment performance and market value of the separate account assets
corresponding to the selected Options. A Variable Adviser Contract also may offer
hybrid investment Options, such as the ones described in the paragraph below, a fixed
account Option, or one or more declared rate Options. A fixed account Option provides
a guaranteed minimum interest crediting rate plus the potential opportunity for additional
interest credits at Taxpayer’s discretion. 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 Variable Adviser Contracts will be registered as securities with the Securities and
Exchange Commission (SEC).

Hybrid Adviser Contracts are 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 Options under a Hybrid Adviser Contract are declared rate and index -based
crediting strategies that 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 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 Contract, and (4) the various
other benefits and features available under the Contract. The Adviser will be licensed to
provide investment advice in accordance with all applicable laws and regulations. The
Adviser and the firm the Adviser is associated with (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. 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
PLR-116196-21 3

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 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. 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 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 Contract’s cash
value and remit to the Adviser will not be treated as an “amount received” by the Owner
of the Contract for purposes of section 72(e).

                              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 (the
“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 section
1.72-1(b)(2) and (3) of the Regulations. 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) of the Regulations 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 paragraph (b) of section 1.72-4 of the Regulations (the first day of the
   first period for which an amount is received as an annuity under the contract);

   (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

PLR-116196-21 4

   (iii) Except as indicated in subparagraph 1.72-2(b)(3) of the Regulations (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) of the Regulations 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 section 1.72-2(b) of the
   Regulations for amounts received as an annuity;

   (ii) meets the requirements of section 1.72-2(b) of the Regulations 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 section 1.72-2(b) of the Regulations 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.

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 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 Contract so that the Owner may properly
utilize the Contract. The Adviser is expected to help the Owner select Options related
to the 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
Contract. Furthermore, Taxpayer has represented that the Fees will not exceed an
annual rate of 1.5% of the Contract’s cash value based on the period in which the fees
related. Based on Taxpayer’s representations, the Fees will only be used to pay for
investment advisory services relating to the Contract. Because the Contracts are
designed to work with an Adviser, the 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 Contract or any services other than investment advice services
with respect to the Contract. Therefore, the Fees are an expense of the Contract, not a
distribution to the Owner.
PLR-116196-21 5

                                      RULING

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

                                     CAVEATS

The ruling contained in this letter is based upon information and representations
Taxpayer submitted, accompanied by penalty of perjury statements executed by
appropriate parties. This office has not verified any of the material submitted in support
of the ruling request and it is subject to verification on examination.

The ruling contained in this letter does not apply to any amount paid by Taxpayer that
compensate the Adviser for services related to assets other than the Contract or for any
services provided other than investment advice services with respect to the Contract.
Any such amount would be an “amount received” by the Owner of the 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 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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