Annuities, Life Insurance, and Long-Term Care Insurance Products (Portfolio 546)

Tax Management Portfolio, Annuities, Life Insurance, and Long-Term Care Insurance Products, No. 546, discusses the federal income tax treatment of select life insurance company products.

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Tax Management Portfolio, Annuities, Life Insurance, and Long-Term Care Insurance Products, No. 546, discusses the federal income tax treatment of select life insurance company products. Reflecting the view that life insurance companies provide a valuable social function, the Code traditionally extended favorable federal income tax treatment to life insurance company products. As life insurance companies, in reaction to developments in the economy and the markets, have attempted to add investment features to insurance products, Congress has acted to prevent supposed abuses of tax-deferring and tax-sheltering features of life insurance and annuities. In particular, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) and the Deficit Reduction Act of 1984 (“DEFRA”), which together made substantial changes to the taxation of insurance companies and a number of their key products.
This portfolio analyzes the federal income taxation of non-qualified annuities, life insurance products, pre-1985 flexible premium contracts, corporate-owned life insurance, modified endowment contracts, and modified guaranteed contracts. The portfolio also examines the relatively new product of qualified longterm care insurance. The portfolio discusses the rules governing variable contracts and the reactions of Congress and the Treasury with respect to the marked increase in investor-friendly features associated with these products. Finally, the portfolio details the rules concerning the tax-free exchange of endowment, annuity and life insurance contracts.


Gordon Pehrson, a partner in the Washington office of Hopkins & Sutter, is a nationally recognized expert on the taxation of insurance companies and their products. Mr. Pehrson is a graduate of the College of William & Mary (A.B. 1964) and the University of Michigan School of Law (J.D. cum laude 1967), where he was elected to the Order of the Coif. From 1977 through 1981, Gordon was an adjunct professor of law in the graduate tax program at Georgetown University. In 1990, he was elected as a member of the American Law Institute.

Philip J. Bieluch, founder of Bieluch & Associates, has extensive experience in life insurance product development. Phil is a leading expert on class action litigation involving life insurance products. Further, he regularly advises clients with respect to the taxation of insurance products and has spoken on the topic at numerous legal and actuarial meetings. Having graduated Trinity College of Hartford (B.S. 1976), he went on to become a Fellow of the Society of Actuaries in 1981. He is also a Member of the American Academy of Actuaries, a Fellow of the Conference of Consulting Actuaries, a Chartered Life Underwriter, and a Chartered Financial Consultant.

Lee Christie is a partner in the Chicago office of Hopkins & Sutter whose practice focuses on tax matters for insurance industry clients, including property and casualty insurers, life and health insurers, HMOs, Blue Cross organizations, insurance trade associations, and insurance guaranty associations. He graduated from Illinois Wesleyan University in 1981 and Harvard Law School in 1984. Lee has served as Chair of the Subcommittee on Life Insurance Companies of the ABA Tax Section Committee on Insurance Companies.

Bobby Dexter, who is in the Washington office of Hopkins & Sutter, secured his B.A. degree magna cum laude from Yale University in 1989 and his J.D. in 1992 from Harvard Law School, where he was a member of the Harvard Law Review.


Detailed Analysis

I. Introduction

A. General Scope of Portfolio

B. Guiding Forces Behind New Products

C. Summary of Portfolio Content

II. Annuities

A. In General

B. Specific Types of Annuity Contracts

C. General Rule of Inclusion in Income

D. Exclusion Ratio

1. In General

2. Fixed Annuities

3. Variable Annuities

4. Exclusion Ratio Where Two or More Annuity Elements Purchased for a Single Consideration

5. Deduction Where Death Precedes Recovery of Entire Investment in the Contract

6. Unrecovered Investment in the Contract

E. Definition of Terms

1. Investment in the Contract

a. In General

b. Special Rules

c. Refund Feature

d. Effect of Contract Transfer on Investment in the Contract

2. Expected Return

F. Amounts Not Received as Annuity

1. In General

2. Allocation of Amounts to Investment in the Contract or Income on the Contract

a. Interest First Rule

b. Cost Recovery Rule

c. Application of Both "Interest First" and "Cost Recovery" Rules in Some Circumstances

d. Impact of Contract Exchanges on Grandfathering of Pre-August 14, 1982 Contracts

3. Loans Treated as Distributions

4. Retained Policyholder Dividends

5. Contract Gifts and Other Transfers Without Full and Adequate Consideration

a. Transfer of the Contract

b. Transfer of Income from Contract

6. Special Rules for Certain Non-Interest and Non-Annuity Payments

7. Investment in the Contract for Purposes of § 72(e)

8. Anti-Abuse Rule

G. Contract Transfers

1. Treatment of Transferor

2. Rules for Certain Transferees

H. Lump Sum Annuity Option

I. Interest Payment Agreements

J. Penalty for Premature Distributions

1. General Rule and Specific Exceptions

2. Substantially Equal Periodic Distributions

K. Requirements for Classification as an Annuity Contract

1. Required Distribution Where Contract Holder Dies Before Entire Interest Is Distributed - General Rule

2. Lifetime Payments to a Designated Beneficiary

3. Failure to Comply With § 72(s) and Possible Means of Correction

L. Annuity Contracts Not Held by Natural Persons

1. General Rule

2. Exception to General Rule Where Contract Held by Agent of Natural Person

3. Other Exceptions to General Rule

M. Adjusted Basis Restrictions on Sale of Annuity Contract

N. Exclusions from Application of Section 72

1. Code and Regulatory Provisions

2. "Wraparound" Annuities

O. Insolvency Issues

III. Life Insurance Contracts

A. Definition of Life Insurance Contract

1. Background

2. Deficit Reduction Act of 1984

3. Definition of "Life Insurance Contract"

4. Life Insurance Contract Under Applicable Law

a. State or Foreign Law Requirements

b. Risk-Shifting and Risk-Distribution

5. Cash Value Accumulation Test

a. In General

b. Special Rules for Applying the Cash Value Accumulation Test

6. Cash Value Corridor Test/Guideline Premium Limitation/Reasonable Mortality Charges

a. Cash Value Corridor

b. Guideline Premium Limitation

c. Reasonable Mortality Charges

7. Computational Rules

a. In General

b. Exceptions to General Computational Rules

(1) Guideline Level Premium

(2) Special Rule - Funeral/Burial Insurance

8. Specific Definition of Terms

a. Premiums Paid

b. Cash Surrender Value

c. Net Surrender Value

d. Death Benefit

(1) In General

(2) Accelerated Death Benefits

e. Future Benefits

f. Other Additional Benefits

g. Qualified Additional Benefits

(1) In General

(2) Nature of Qualified Additional Benefits

h. Adjustments

(1) Changes Within the First 15 Years After Issuance of Contract

(2) Recapture Ceiling Where Change Occurs Within Five Years of Contract Issuance

(3) Recapture Ceiling Where Change Occurs Within Sixteen Years of Issuance But After Five Years of Issuance

9. Contracts Failing to Meet Requirements of Section 7702(a)

a. Income Inclusion

b. Treatment of Amount Paid on Death of Insured

c. Continued Treatment of Contract as Insurance Contract

d. Reasonable and Unreasonable Error

10. Treatment of Endowment Contracts

11. Twenty-Pay Contracts

12. Church Self-Funded Death Benefits

13. Treasury Regulations

B. Special Rules for Pre-1985 Flexible Premium Contracts

C. Leveraged Life Insurance ("COLI")

1. In General

2. Deductibility of Policy Loan Interest Prior to 1996

a. General Rule

b. "Four-Out-of-Seven Exception"

3. Congressional Amendment of Section 264 in 1996

4. Congressional Amendment of Section 264 in 1997

5. Ongoing Controversy

D. Income of Policyholders

1. In General

2. Life Insurance Policy Proceeds

a. In General

b. Accelerated Death Benefits

(1) In General

(2) Special Rules for Payments to Chronically Ill Insureds

(3) Terminally Ill Individual

(4) Chronically Ill Individual

3. Transfers of Life Insurance Contracts

a. Gratuitous Transfers

b. Transfer for Valuable Consideration

(1) In General

(2) Exceptions

(3) Multiple Transfers

(4) Treatment of Transferor

4. Payment at Date Later Than Death

a. Proration

b. Amount Held By Insurer

c. Multiple Beneficiaries

(1) In General

(2) Computations

(a) Independently Determined Amounts

(b) Dependently Determined Amounts

(c) Payments to Secondary Beneficiaries

(d) Nonperiodic Payments

d. Interest

5. Certain Flexible Premium Contracts

a. In General

b. Flexible Premium Life Insurance Contract

c. Guideline Premium Limitation

(1) In General

(2) Special Computational Rules

(3) Adjustments for Subsequent Changes

d. Premiums Paid

e. Applicable Percentage

f. Cash Value

g. Qualified Additional Benefits

IV. Modified Endowment Contracts

A. General Commentary

B. Code Provisions & Selected Issues

1. General Rule

2. The 7-Pay Test

3. Computational Rules

a. General Rules

b. Reduction in Benefits During First Seven Contract Years

c. Material Changes

(1) In General

(2) Clarifications in 1989 RRA

(3) Certain Benefit Additions Not Treated as Material Changes

d. Contracts with Death Benefits of $10,000 or Less

e. Certain Collection Expenses

f. "Last-to-Die" or "Last-Survivor" Contracts

4. Failure to Satisfy the 7-Pay Test

5. Definitions for § 7702A Purposes

a. Amount Paid

b. Contract Year

6. Treatment of Non-Annuity Distributions Received Under Modified Endowment Contracts

7. Anti-Abuse Rule

8. Penalty for Taxable Distributions from Modified Endowment Contracts

V. Qualified Long-Term Care Insurance

Introductory Material

A. General Rules

B. Tax Consequences

C. Definition of Qualified Long-Term Care Insurance Contract

D. Definition of Qualified Long-Term Care Services

1. In General

2. Definition of "Chronically Ill Individual"

E. Aggregate Payments in Excess of Limits

F. Treatment of Coverage Provided as Part of a Life Insurance Contract

G. State-maintained Plans

H. Consumer Protection Provisions

1. Specific Requirements

2. Nonconforming States

I. Pre-1997 Long-Term Care Insurance Contracts

1. In General

2. Certain Exchanges or Changes

VI. Variable Contracts and Modified Guaranteed Contracts

A. Variable Contracts

1. Increases and Decreases in Reserves

2. Adjustment to Basis of Assets Held in Segregated Asset Account

3. Separate Accounting

4. Definition of Variable Contract

a. In General

b. Contracts Qualified as Variable Contracts

5. Assumed Rate of Interest

a. Special Rules - Qualification of Variable Contract Reserves as "Life Insurance Reserves"

b. Additional Separate Computations

6. Variable Contracts as Annuity Contracts

7. Treatment of Nondiversified Contracts

a. General Rule

b. Relief for Failed Contracts

(1) Inadvertent Failures

(2) Procedure for Obtaining Relief

c. Diversification Safe Harbor

d. Start-up Period

e. Liquidation Period

f. Market Fluctuations

g. Special Rule for Investments in United States Obligations

h. Look-Through Rule in Certain Cases

i. Double Look-Through

j. Independent Investment Advisors

k. Government Securities Fund

8. Investor Control and Related Issues

a. Background

b. Post-Christoffersen Legislation and its Impact

c. Extent of IRS Flexibility

d. Single Customer Accounts

e. Clone Accounts

9. Issuance of Variable Contracts by Offshore Insurers

B. Modified Guaranteed Contracts

1. In General

2. Computation of Reserves

3. Segregated Assets under Modified Guaranteed Contracts Marked to Market

a. General Rule

b. Special Rule for Computing Life Insurance Reserves

c. Regulatory Guidance

VII. Tax-Free Contract Exchanges

A. Section 1035

1. Overview

a. General Rule

b. Specific Exceptions to § 1035

c. Definitions

(1) Endowment Contract

(2) Annuity Contract

(3) Life Insurance Contract

d. Exchanges Involving Foreign Persons

e. Common Exchanges

(1) Policy Update and Similar Exchanges

(2) Annuity Contract Exchanges

(3) Exchanges Involving Multiple Contracts

(4) Partial Exchanges

(a) Exchanges Occurring on or after June 30, 2008

(b) Exchanges Occurring before June 30, 2008

B. Deemed Exchanges and Other Transactions

1. Specific Issues

a. Change of Insureds

b. Addition of Investment Options

c. Reinsurance

d. Exchange of Deferred Annuity for Immediate Annuity

e. Exchange of Second-to-Die for Single-Life Policy

f. Change of Policy Loan Interest Accruals

2. Grandfathered Contracts

a. Impact of Deemed Exchange on Grandfathered Contracts

b. Areas Potentially Affected by Loss of Grandfathered Status

(1) Definition of Life Insurance

(2) Mortality and Expense Charges Used in Applying § 7702

(3) Changes Resulting in Modified Endowment Contract Status

3. Other Potential Effects of Contract Modifications

4. Intra-Company Exchanges

5. Insolvency Issues

a. Serially Funded Exchanges

b. Exchanges Involving Receipt of Cash by the Policyholder

c. Contract Modifications


Working Papers

Table of Worksheets

Worksheet 1 List of Relevant IRS Guidance




Treasury Regulations:

Legislative History:

Treasury Rulings:



Treatises and Books: