August 30, 2022
IRS rules annuity contract fees that insurance company paid to financial advisor from policy cash values are not 'amounts received' by policy owners
In four recently published private letter rulings (PLRs 202232004, 202232005, 200232012, 202232013), the IRS has ruled that fees an insurance company deducts from the cash value of an annuity contract and remits to a financial adviser will not be treated as amounts received by the contract owner for IRC Section 72(e) purposes, and, therefore, will not be included in the contract owner's taxable income.
The facts of the four PLRs are substantially similar. The taxpayer (Taxpayer) requesting the letter ruling is a life insurance company, as defined in IRC Section 816(a). Taxpayer proposes to offer nonqualified deferred annuity contracts, known as "Adviser Contracts," which will be issued to and owned by either an individual or a trust or other agent of an individual (Owner), as defined in IRC Section 72(u)(1).
The Adviser Contracts constitute annuity contracts under local law and qualify to be treated as annuity contracts for federal income tax purposes. Each Advisor Contract consists of: (1) an accumulation phase, when the cash value of the contract is credited with interest based on options the Owner selects from a menu Taxpayer provided; and (2) a payout phase. Further, the Adviser Contracts are fixed-indexed annuities that are not variable contracts under IRC Section 817(d).
The Adviser Contracts are specifically designed for an Owner to receive ongoing investment advice from an investment adviser (Adviser) on how to allocate the contract's cash value among available options. The Adviser must consider: (1) the Owner's personal risk tolerance and investment timeline; (2) the interest rate and current market environment; (3) the menu of options available under the contract; and (4) other benefits and features available under the contract. The Owner will compensate the Adviser for investment advice by authorizing investment advisory fees (Fees) to be paid from the Adviser Contract's cash value under a separate agreement between the Owner and Taxpayer (Authorization). The Fees must be determined under an arm's-length standard and may not exceed 1.5% of the Adviser Contract's cash value annually. Taxpayer pays the Fees directly to the Adviser.
Under IRC Section 72(a), gross income includes amounts received as annuities under an annuity, endowment or life insurance contract; these amounts are subject to the exclusion ratio provided under IRC Section 72(b). IRC Section 72 distinguishes between amounts received as annuities under an annuity, endowment or life insurance contract and those not received as annuities. Amounts received as annuities are amounts payable at regular intervals over more than one year from the date on which they are deemed to begin; the total amount to be paid or the period over which they are to be paid must be determinable (Treas. Reg. Section 1.72-1(b)). All other amounts are considered not received as an annuity.
Any amount that is not received as an annuity and is received on or after the annuity start date must be included in gross income (IRC Section 72(e)(2)(A)). Under IRC Section 72(e)(2)(B), an amount that is not received as an annuity and is received before the annuity start date must be "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 and ruling
The IRS noted that "the Fees are integral to the operation of the Adviser Contract," as they compensate the Adviser for providing the Owner with investment advice to "properly utilize the Adviser Contract." "Because the Adviser Contracts are designed to work with an Adviser," the IRS observed, "the Adviser Contract is solely liable for the Fees." The IRS also noted that 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." Based on the taxpayer's representations, the IRS concluded that "the Fees are an expense of the Adviser Contract, not a distribution to the Owner." The IRS therefore ruled that the Fees that Taxpayer pays to the Adviser from the cash value of the Adviser Contract will not be considered an amount received by the Owner for IRC Section 72(e) purposes.
These rulings illustrate the importance of carefully establishing the roles and relationships of the various parties to the arrangement. In prior rulings involving payments of investment advisory fees out of policy cash values, the IRS has reached a different conclusion regarding whether the fees are an expense of the policyowner or the contract.