Income Tax Definition of Life Insurance and Annuity Contracts (Portfolio 528)

Tax Management Portfolio 528 T.M., Income Tax Definition of Life Insurance and Annuity Contracts, addresses the definition of a life insurance or annuity contract for federal tax purposes. To view this Portfolio, visit Bloomberg Tax for a free trial. 

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Description

Tax Management Portfolio 528 T.M., Income Tax Definition of Life Insurance and Annuity Contracts, addresses the definition of a life insurance or annuity contract for federal tax purposes. This Portfolio considers when a contract is treated as a life insurance contract for federal tax purposes, including when a contract is subject to the special rules applicable to a life insurance contract that also constitutes a modified endowment contract, or “MEC”. This Portfolio also discusses various types of annuity contracts. In addition, this Portfolio addresses the diversification requirements and so-called “investor control” doctrine that apply to variable life insurance and annuity contracts, and discusses life insurance and annuity contract that provide long-term care coverage.

This Portfolio does not consider the federal income tax rules applicable to life insurance and annuity contracts, for example, the exclusion from gross income of death benefit proceeds and the taxation of annuity payments; deductions related to the purchase of life insurance policies and annuity contracts; the federal income tax rules applicable to dispositions of life insurance policies and annuity contracts; international aspects; and valuation. These rules are discussed in Tax Management Portfolio 529 T.M., Taxation of Life Insurance and Annuity Products. In addition, a discussion of the taxation of the issuer of the contract, generally a life insurance company subject to special tax rules in Subchapter L of the Code, is beyond the scope of this Portfolio.

As life insurance and annuity products are used in a variety of contexts, the tax treatment of these products is an issue that arises under a broad array of Code sections. For example, these products may be used in the qualified retirement plan context and thus raise tax issues under Subchapter D of the Code, and may be used generally in the compensation context. These products are also commonly used in the context of estate and gift tax planning, thus raising tax issues under Subtitle B of the Code.

This Portfolio focuses on the federal income tax definition of “nonqualified” life insurance and annuity products. Life insurance and annuity tax issues relating to qualified retirement plans, employee compensation, and to estate and gift tax rules are covered in other Tax Management Portfolios. See, e.g., 386 T.M., Insurance-Related Compensation, and 826 T.M., Life Insurance.Similarly, this Portfolio focuses on life insurance and annuity contracts issued by commercial insurance companies. A discussion of “private” annuities can be found in 805 T.M., Private Annuities and Self-Canceling Installment Notes.

This Portfolio may be cited as Griffin, Springfield, Keene, and Peak, 528 T.M., Income Tax Definition of Life Insurance and Annuity Contracts.

Authors

Mark E. Griffin

Mark E. Griffin. BA, magna cum laude, Hamilton College (1981), JD, cum laude, Syracuse University College of Law (1984), LLM in Taxation, Georgetown University Law Center (1988); Tax Law Specialist, Office of Assistant Commissioner, Exempt Organizations Technical Division, Internal Revenue Service, Washington, D.C. (1985–1986); Attorney-Advisor, U.S. Tax Court, Washington, D.C. (1986–1988). Mr. Griffin is a member of the New York State Bar, District of Columbia Bar, American Bar Association (Taxation Section), and Association of Life Insurance Counsel, and is a member and former officer of the Federal Bar Association (Taxation Section). He is co-author of 529 T.M., Taxation of Life Insurance and Annuity Products, and a contributing author of the Annuities Answer Book (5th ed., 2017). He is a frequent writer and speaker on the federal income taxation of insurance products.

Craig R. Springfield

Craig R. Springfield, B.S.B.A., magna cum laude, and M.S. in Accounting, University of Central Florida (1985 and 1987, respectively), J.D., with honors, University of Florida (1990), LL.M. in Taxation, New York University (1991). Mr. Springfield is co-author of Life Insurance & Modified Endowments (2nd ed. Society of Actuaries, 2015) and a contributing author of the Annuities Answer Book (5th ed., 2017). He frequently writes and speaks on tax and insurance topics. He is a member of the District of Columbia Bar and the American Bar Association Section of Taxation, where he previously served as chair of its Committee on Insurance Companies.

Bryan W. Keene

Bryan W. Keene, B.S., University of Florida (1994), and J.D., with honors, University of Florida (1998). Mr. Keene is a member of the District of Columbia Bar, the Florida Bar, the American Bar Association (Section of Taxation), and the Federal Bar Association (Taxation Section). He also serves on the Board of Governors for the Association of Life Insurance Counsel (2017–2020), is a former chair of the Insurance Companies Committee of the American Bar Association's Section of Taxation, and a former vice chair of the Taxation Section of the Association of Life Insurance Counsel. Mr. Keene also is a contributing author to the Annuities Answer Book (5th ed., 2017) and a frequent speaker and writer on federal income tax issues affecting life insurance and annuity products.

Alison R. Peak

Alison R. Peak, B.S., Highest Distinction, University of Kansas (2002); J.D., cum laude, American University, Washington College of Law, Line Editor for the Journal of Gender and Social Policy, Mussey-Gillett Fellow (2005); LL.M. in Taxation, Distinction, Georgetown University Law Center, Thomas B. Chetwood, SJ, Prize for Highest Academic Average (2007). Ms. Peak is a member of the New York State Bar, District of Columbia Bar, American Bar Association (Taxation Section), and Federal Bar Association (Taxation Section). She is a contributing author of the Annuities Answer Book (5th ed., 2017). She publishes often in the area of insurance taxation and she is a frequent speaker at tax and insurance conferences.

Table of Contents

Detailed Analysis
I. What Is Insurance?
Introductory Material
A. Helvering v. Le Gierse
B. Application of the Le Gierse Standard to Insurance Contracts
1. In General
2. Mortality Neutrality
C. Combination Contracts
II. What is a Life Insurance Contract?
A. Historical Background
B. Life Insurance Contract Defined
1. Applicable Law Requirement
2. Cash Value Accumulation Test
3. Guideline Premium Limitation / Cash Value Corridor Test
a. Guideline Premium Limitation
b. Premiums Paid
c. Section 7702(f)(6)
d. Cash Value Corridor
4. Definitions, Actuarial Assumptions, and Computational Rules
a. Future Benefits
b. Interest Rate Guarantees
c. Mortality Charge Assumption
(1) General Reasonable Mortality Charge Rule
(2) TAMRA Interim Mortality Rule
(3) IRS Safe Harbor Guidance on Reasonable Mortality
d. Expense Charge Assumption
e. Cash Surrender Value (CSV)
f. Age
g. QABs and Non-QABs
h. Computational Rules
5. Adjustment Rule
6. Product-Specific and Other Issues
a. Joint and Survivorship and First-to-Die Contracts
b. Variable and Equity Indexed Contracts
c. Net Rate Products
d. Contracts with Dual Cash Values
e. Reversionary Annuities
C. Failures Under §7702
1. Section 7702(g) Income on the Contract
2. Waivers of Reasonable Errors
3. Closing Agreement Procedures
D. Effective Date of §7702
III. What is a Modified Endowment Contract (or ‘MEC’)?
Introductory Material
A. Definition of a MEC — 7-Pay Test
1. Calculation of 7-Pay Premiums
2. Rollover Rule for Cash Surrender Value Upon an Exchange or Other Material Change
3. Calculation of “Amount Paid”
B. Accounting for Changes in a Contract's Terms or Benefits
1. Reduction in Benefits
a. General Reduction in Benefits Rule of §7702A(c)(2)
b. Special Reduction in Benefits Rule of §7702A(c)(6) for Joint and Survivorship Life Insurance Contracts
2. Material Change Rule
a. In General
b. Necessary Premium Test
C. Correction of Inadvertent MECs
1. Introduction
2. Rev. Proc. 2008-39
a. In General
b. Scope
c. Corrective Action
d. Toll Charge Calculation
D. Effective Date of §7702A
IV. What Constitutes an Annuity Contract?
A. In General
1. The Absence of a Formal Definition
2. Various Types of Annuity Contracts
B. After-Death Distribution Requirements
1. Historical Background
2. Section 72(s) in General
3. Identity of the “Designated Beneficiary”
4. Spousal Continuation
5. Identity of the “Holder”
6. Applying the At-Least-as-Rapidly Rule Before the Annuity Payments Commence
7. Consequences of Failing to Satisfy §72(s)
C. Non-Natural Owners
1. Historical Background
2. Section 72(u)(1) and the Agency Exclusion
3. Exceptions to §72(u)(1)
4. Consequences of Failing to Satisfy §72(u)
D. Amortization of Principal and Earnings
E. Permanent Annuity Purchase Rate Guarantees
F. Maximum Annuity Starting Date
G. Customary Practice
H. Product Designs
1. Deferred Income Annuity Contracts
2. Contingent Deferred Annuity Contracts
I. Distinguishing Annuity Contracts from Debt Instruments
V. Variable Contracts
A. In General
B. Definition of Variable Contract
C. Diversification Requirements
1. In General
2. Basic Requirements
3. Regulated Investment Company Safe Harbor
4. Rules of Application Involving the “Issuer” of Investments
a. Aggregation of Securities of the Same Issuer
b. Government Agencies as Separate Issuers
5. Defined Terms
a. Segregated Asset Account
b. Security
c. Government Security
d. Real Property and Related Terms
e. Commodity and Interest in a Commodity
f. Value
g. Undefined Terms
6. Look-Through Rules
7. Testing Periods
a. In General
b. Start-Up Period
c. Liquidation Period
8. Special Rules
a. Variable Life Insurance Contracts
b. Government Money Market Funds
c. Market Fluctuations
9. Tax Consequences and Corrections of Non-Diversification
D. Investor Control
1. In General
2. IRS Published Guidance
3. Judicial Decisions
a. Christoffersen v. United States
b. Webber v. Commissioner
4. Relationship of the Investor Control Doctrine to the §817(h) Diversification Requirements
VI. Accelerated Death Benefits and Long-Term Care Insurance Riders
A. Introduction
1. Life Insurance ADBs
2. Annuity-Long-Term Care Insurance Combinations
B. Qualified Long-Term Care Insurance Riders to Life Insurance Contracts
1. Requirements Limiting Investment Orientation
a. Coverage Only of QLTC Services
b. Medicare Coordination
c. Restrictions on Cash Values, Loan Values, and Assignments
2. Separate Contract Rule for Long-Term Care Insurance Riders
3. Consumer Protection Requirements
4. Effective Date and Material Change Relief
C. Section 101(g) Chronic Illness Benefits
D. Application of the Per Diem Limitation
E. Reporting Requirements for ADBs
1. Reporting of Charges for QLTCI Riders
2. Reporting of Chronic Illness Benefits
F. Treatment of ADBs Under §72, §7702 and §7702A

Working Papers

Table of Worksheets
Worksheet 1 Staff of Jt. Comm. On Tax'n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 at 645 (Comm. Print 1985) (Excerpt)
Worksheet 2 Staff of Jt. Comm. On Tax'n, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 at 366 (Comm. Print 1982) (Excerpt)
Worksheet 3 H.R. Rep. No. 83-1337 at 11; Report to Accompany H.R. 8300 (1954) (Excerpt)
Worksheet 4 S. Rep. No. 83-1622 at 12; Report to Accompany H.R. 8300 (1954) (Excerpt)
Worksheet 5 H.R. Rep. No. 73-704 at 20; The Revenue Bill of 1934 (Excerpt)
Worksheet 6 U.S. Dept. of Treasury, The Income Tax Treatment of Pensions and Annuities, Appendix D (1947)
Worksheet 7 OGC Op. No. 09-06-11 (New York State Ins. Dept.)