rr-03-92.pdf

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Part I

Section 61. B Gross Income Defined

26 CFR 1.61-1: Gross Income
(Also '' 801, 817, 7702; 1.817-5)

Rev. Rul. 2003-92

ISSUES

Under the facts set forth below, will the holder of a variable annuity or life
insurance contract be considered to be the owner, for federal income tax purposes, of
the partnership interests that fund the variable contract if interests in the partnerships
are available for purchase by the general public? What are the income tax
consequences to the holder of the contract if that holder is considered to be the owner
of the partnership interests that fund the variable contract?

FACTS

Situation 1
. IC is a life insurance company subject to tax under ' 801 of the
Internal Revenue Code. In states where it is authorized to do so, IC offers deferred
variable annuity contracts. IC has developed a variable annuity contract (AAnnuity@) for
sale only to Aqualified purchasers@
1
that are Aaccredited investors@
2
or to no more than
one hundred accredited investors. IC is not required to register Annuity under the
federal security laws.

Contract Holder, an individual qualifying as both a qualified purchaser and an
accredited investor, purchases Annuity from IC
. Annuity contains a number of
provisions common to deferred annuity contracts, including the right of Contract Holder
to surrender Annuity in part or entirely for cash (subject to a surrender charge) and the
right to convert (at future dates chosen by Contract Holder) the accumulated values

1
Under 15 U.S.C. ' 80a-2(a)(51) a Aqualified purchaser” is an individual, or
other specified entity, that satisfies certain threshold financial requirements.

2
The term Aaccredited investor,@ as defined by 15 U.S.C. ' 77b(a)(15), and
amplified by 17 CFR ' 230.501(a), is also an investor that satisfies certain financial
criteria. An accredited investor may be either an individual or certain enumerated
entities. Because the criteria to be an accredited investor are similar to, but not identical
to, the criteria that must be met to be a qualified purchaser it is possible for an
accredited investor to also be a qualified purchaser. It is also possible for an investor to
qualify only as either an accredited or qualified investor.

2
under Annuity into a stream of periodic payments under one of several settlement
options.

The assets supporting Annuity are held in a segregated asset account that is
maintained separately from IC
=s other accounts. The segregated asset account is
divided into 10 sub-accounts (ASub-accounts@). Each Sub-account=s assets and
liabilities are maintained separately from the assets and liabilities of other Sub-
accounts. At the time of purchase, Contract Holder specifies the premium allocation
among the available Sub-accounts. Contract Holder may change the allocation of
subsequent premiums at any time.

Each Sub-account available under Annuity invests in interests in a partnership
(APartnership@). None of the Partnerships are publicly traded partnerships under
' 7704. All of the Partnerships are exempt from registration under federal security laws.
Interests in each Partnership are sold in private placement offerings and are sold only to
qualified purchasers that are accredited investors or to no more than one hundred
accredited investors.

Each Partnership has an investment manager that selects the Partnership=s
specific investments. Contract Holder may not act as an investment manager or
independently own any interest in any Partnership offered under Annuity. In addition,
Contract Holder will have no voting rights with respect to any Partnership interest held
by any Sub-account.

Each Sub-account will at all times meet the asset diversification test set forth in
' 1.817-5(b)(1) of the Income Tax Regulations.

Situation 2
. The facts are the same as those in Situation 1, except IC offers, and
Contract Holder purchases, a variable life insurance contract (ALIC@) that qualifies as a
life insurance contract under ' 7702.

Situation 3
. The facts are the same as those in Situation 1, except that (i)
Contract Holder purchases both an Annuity and an LIC and (ii) interests in each
Partnership are available for purchase only through the purchase of an Annuity, an LIC,
or other variable contracts from insurance companies.

LAW

Section 61(a) provides that the term "gross income" means all income from
whatever source derived, including gains derived from dealings in property, interest, and
dividends.

Section 817, which was enacted by Congress as part of the Deficit Reduction Act
of 1984 (Pub. L. No. 98-369) (the “1984 Act”), provides rules regarding the tax

3
treatment of variable life insurance and annuity contracts. Section 817(d) defines a
Avariable contract@ as a contract that provides for the allocation of all or part of the
amounts received under the contract to an account that, pursuant to State law or
regulation, is segregated from the general asset accounts of the company and that
provides for the payment of annuities, or is a life insurance contract. In the legislative
history of the 1984 Act Congress expressed its intent to deny life insurance treatment to
any variable contract if the assets supporting the contract include funds publicly
available to investors:
The conference agreement allows any diversified fund to be used as the
basis of variable contracts so long as all shares of the funds are owned by
one or more segregated asset accounts of insurance companies, but only
if access to the fund is available exclusively through the purchase of a
variable contract from an insurance company. . . . In authorizing Treasury
to prescribe diversification standards, the conferees intend that the
standards be designed to deny annuity or life insurance treatment for
investments that are publicly available to investors . . .
H.R. Conf. Rep. No. 98-861, at 1055 (1984).

Section 817(h)(1) provides that a variable contract based on a segregated asset
account shall not be treated as an annuity, endowment, or life insurance contract unless
the segregated asset account is adequately diversified in accordance with regulations
prescribed by the Secretary.
If a segregated asset account is not adequately
diversified, income earned by that segregated asset account is treated as ordinary
income received or accrued by the policyholders.

Approximately two years after enactment of ' 817(h), the Treasury Department
issued proposed and temporary regulations prescribing the minimum level of
diversification that must be met for an annuity or life insurance contract to be treated as
a variable contract within the meaning of ' 817(d). The preamble to the regulations
stated as follows:
The temporary regulations . . . do not provide guidance concerning the
circumstances in which investor control of the investments of a segregated
asset account may cause the investor, rather than the insurance
company, to be treated as the owner of the assets in the account. For
example, the temporary regulations provide that in appropriate cases a
segregated asset account may include multiple sub-accounts, but do not
specify the extent to which policyholders may direct their investments to
particular sub-accounts without being treated as owners of the underlying
assets. Guidance on this and other issues will be provided in regulations
or revenue rulings under section 817(d), relating to the definition of
variable contracts.
51 FR 32633 (Sept. 15, 1986). The text of the temporary regulations served as the text
of proposed regulations in the notice of proposed rulemaking. See
51 FR 32664 (Sept.

4
15, 1986). The final regulations adopted, with certain revisions not relevant here, the
text of the proposed regulations.

Prior to enactment of § 817, the Service issued a number of revenue rulings
regarding when the owner of an annuity contract will be treated as the owner of the
assets that fund the annuity. In the revenue rulings, the Service relied on long standing
tax principles. See
generally, Commissioner v. Sunnen, 333 U.S. 591 (1948); Helvering
v. Clifford, 309 U.S. 331 (1940); Corliss v. Bowers, 281 U.S. 376 (1930). The revenue
rulings consider whether the contract owners described in each ruling have retained
sufficient incidents of ownership, as described in cases cited above, over the assets or
retain sufficient control over the assets to be treated as the owners of those assets.

Rev. Rul. 77-85, 1977-1 C.B. 12, concludes that if a purchaser of an "investment
annuity" contract selects and controls the investment assets in the separate account of
the issuing life insurance company, then the purchaser will be treated as the owner of
those assets for federal income tax purposes. Thus, any interest, dividends, or other
income derived from the investment assets are includible in the gross income of the
purchaser. Similarly, Rev. Rul. 80-274, 1980-2 C.B. 27, holds that if a purchaser of an
annuity contract may select and control the certificates of deposit supporting the
contract, then the purchaser is treated as the owner of the certificates of deposit for
federal income tax purposes. In Rev. Rul. 80-274, the insurance company could not
dispose of the deposit or convert it into a different asset. The insurance company did,
however, have the power to withdraw the deposit from a failing savings and loan
association.

Rev. Rul. 81-225, 1981-2 C.B. 12, describes four situations in which investments
in mutual fund shares to fund annuity contracts are treated as owned by the
policyholder rather than by the issuing insurance company, and one situation in which
the issuing insurance company is treated as the owner of the mutual fund shares. In
Situation 1, the investment assets in the segregated account supporting the annuity
contracts consisted solely of shares in a single, publicly available mutual fund managed
by an independent investment advisor. Situation 2 is similar to Situation 1, except that
the publicly available mutual fund was managed by the issuing insurance company or
one of its affiliates. Situation 3 also is similar to Situation 1, except that the segregated
asset account supporting the annuity contracts consisted of five sub-accounts. Each
sub-account was invested in the shares of a different mutual fund. Shares of the mutual
funds were offered for sale to the general public. The policyholder retained the right to
allocate or reallocate funds among the five sub-accounts during the life of the annuity
contract. Situation 4 is similar to Situation 2, except that the mutual fund did not sell
shares directly to the public. The shares of the mutual fund were available only through
the purchase of an annuity contract or by participation in an investment plan account of
the type described in Rev. Rul. 70-525, 1970-2 C.B. 144. Situation 5 also was similar to
Situation 2, except that the shares in the mutual fund were available only through the
purchase of an annuity contract.

5
Rev. Rul. 81-225 concludes that the policyholders in Situations 1 through 4 had
sufficient control and other incidents of ownership to be treated as the owners of the
mutual fund shares for federal income tax purposes. The ruling reaches the opposite
conclusion in Situation 5, because the sole function of the mutual fund in Situation 5
was to provide an investment vehicle that allows the issuing insurance company to meet
its obligations under its annuity contracts and the insurance company possessed
sufficient incidents of ownership to be treated as the owner of the underlying portfolio of
assets of the mutual fund for federal income tax purposes.

In Rev. Rul. 82-54, 1982-1 C.B. 11, the purchasers of certain annuity contracts
could direct the issuing insurance company to invest in the shares of any one or any
combination of three mutual funds that were not available to the public. One mutual
fund invested primarily in common stocks, another in bonds, and the third in money
market investments. Policyholders could allocate their premium payments among the
three funds and had an unlimited right to reallocate contract values among the funds
prior to the maturity date of the annuity contract. The ruling concludes that the
policyholders' ability to choose among general investment strategies (for example,
between stock, bonds, or money market funds) either at the time of the initial purchase
or subsequent thereto, did not constitute control sufficient to cause the policyholders to
be treated as the owners of the mutual fund shares.

In Christoffersen v. United States
, 749 F.2d 513 (8
th
Cir.), rev=g 578 F. Supp. 398
(N.D. Iowa 1984), the Eighth Circuit considered the federal income tax ownership of the
assets supporting a segregated asset account. The taxpayers in Christoffersen
purchased a variable annuity contract that reflected the investment return and market
value of assets held in an account that was segregated from the general asset account
of the issuing insurance company. The taxpayers had the right to direct that their
premium payments be invested in any one or a combination of six publicly traded
mutual funds. The taxpayers could reallocate their investment among the funds at any
time. The taxpayers also had the right upon seven days notice to withdraw funds,
surrender the contract, or apply the accumulated value under the contract to provide
annuity payments.

The Eighth Circuit held that, for federal income tax purposes, the taxpayers, not
the issuing insurance company, owned the mutual fund shares that funded the variable
annuity. The court concluded that the taxpayers Asurrender few of the rights of
ownership or control over the assets of the sub-account@ that supported the annuity
contract. Christoffersen
, 749 F.2d at 515. According to the court, Athe payment of
annuity premiums, management fees and the limitation of withdrawals to cash [did] not
reflect the lack of ownership or control as the same requirements could be placed on
traditional brokerage or management accounts.@ Id
. at 515-16. Thus, the taxpayers
were required to include in gross income any gains, dividends, or other income derived
from the mutual fund shares.

6
ANALYSIS

In Situation 1, Sub-accounts hold interests in Partnerships available for purchase
other than by purchasers of Annuity or other variable contracts from insurance
companies. Therefore, for federal income tax purposes, Contract Holder is the owner of
the interests in Partnerships held by Sub-accounts. As a result, pursuant to ' 61(a),
Contract Holder must include in its gross income any interest, dividends, or other
income derived from the interests in the Partnerships in the year in which the interest,
dividends, or other income is earned.

In Situation 2, Sub-accounts hold interests in Partnerships available for purchase
other than by purchasers of LIC or other variable contracts from insurance companies.
Therefore, for federal income tax purposes, Contract Holder is the owner of the interests
in Partnerships held by Sub-accounts. As a result, pursuant to ' 61(a), Contract Holder
must include any interest, dividends, or other income derived from the Partnerships in
gross income in the year in which the interest, dividends, or other income is earned.

In Situation 3, Sub-accounts hold interests in Partnerships available for purchase
only by a purchaser of an Annuity, a LIC, or other variable contracts from insurance
companies. Therefore, for federal income tax purposes, IC
owns the interests in
Partnerships that fund the Sub-accounts. As a result, pursuant to ' 61(a), any interest,
dividends, or other income derived from the Partnerships is not included in Contract
Holder=s gross income in the year in which the interest, dividends, or other income is
earned.

HOLDINGS

Under the facts set forth above, the holder of a variable annuity or life insurance
contract will be considered to be the owner, for federal income tax purposes, of the
partnership interests that fund the variable contract if interests in the partnerships are
available for purchase by the general public. If the holder of a variable annuity or life
insurance contract is considered to be the owner of the partnership interests that fund
the variable contract, pursuant to ' 61(a), the contract holder must include any interest,
dividends, or other income derived from the partnership interests in gross income in the
year in which the interest, dividends, or other income is earned.

EFFECT ON OTHER REVENUE RULING

Rev. Rul. 81-225, 1981-2 C.B. 12 is hereby clarified and amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is James Polfer of the Office of Associate
Chief Counsel (Financial Institutions and Products). For further information regarding
this revenue ruling contact Mr. Polfer at (202) 622-3970 (not a toll-free call).