rr-03-91.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 61. B Gross Income Defined

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

Rev. Rul. 2003-91

ISSUE

Under the facts set forth below, will the holder of a variable contract be
considered to be the owner, for federal income tax purposes, of the assets that fund the
variable contract? Will income earned on those assets be included in the income of the
holder in the year in which it is earned?

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 variable life
and variable annuity contracts that qualify as variable contracts under ' 817(d)
(AContracts@).

The assets that fund the Contracts are segregated from the assets that fund IC=s
traditional life insurance products. IC maintains a separate account (ASeparate
Account@) for the assets funding the Contracts, and the income and liabilities associated
with the Separate Account are maintained separately from IC=s other accounts.

The Separate Account is divided into various sub-accounts (ASub-accounts@).
Each Sub-account=s assets and liabilities are maintained separately from the assets and
liabilities of other Sub-accounts. Interests in the Sub-accounts are not available for sale
to the public. Rather, interests in the Sub-accounts are available solely through the
purchase of a Contract. IC
engages an independent investment advisor (“Advisor”) to
manage the investment activities of each Sub-account.
1
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.

Twelve sub-accounts are currently available under the Contracts, but IC may
increase or decrease this number at any time. However, there will never be more than

1
For these purposes, the term investment officer refers to anyone whose
responsibilities include giving investment advice or making investment decisions relating
to assets held in a Sub-account and to any person who directly or indirectly supervises
the work performed by such individual.

-2-
20 Sub-accounts available under the Contracts. Each Sub-account offers a different
investment strategy. The currently available Sub-accounts include a bond fund, a large
company stock fund, an international stock fund, a small company stock fund, a
mortgage backed securities fund, a health care industry fund, an emerging markets
fund, a money market fund, a telecommunication fund, a financial services industry
fund, a South American stock fund, an energy fund and an Asian markets fund.

An individual (“Holder”) purchases a life insurance Contract (“LIC”). At the time
of purchase, Holder specifies the allocation of premium paid among the then available
Sub-accounts. Holder may change the allocation of premiums at any time, and Holder
may transfer funds from one Sub-account to another. Holder is permitted one transfer
between Sub-accounts without charge per thirty-day period. Any additional transfers
during this period are subject to a fee assessed against the cash value of LIC.

There is no arrangement, plan, contract, or agreement between Holder and IC
or
between Holder and Advisor regarding the availability of a particular Sub-account, the
investment strategy of any Sub-account, or the assets to be held by a particular sub-
account. Other than Holder's right to allocate premiums and transfer funds among the
available Sub-accounts as described above, all investment decisions concerning the
Sub-accounts are made by IC
or Advisor in their sole and absolute discretion.
Specifically, Holder cannot select or recommend particular investments or investment
strategies. Moreover, Holder cannot communicate directly or indirectly with any
investment officer of IC or its affiliates or with Advisor regarding the selection, quality, or
rate of return of any specific investment or group of investments held in a Sub-account.
Holder has no legal, equitable, direct, or indirect interest in any of the assets held by a
Sub-account. Rather, Holder has only a contractual claim against IC
to collect cash
from IC in the form of death benefits, or cash surrender values under the Contract.

All decisions concerning the choice of Advisor or the choice of any of IC
=s
investment officers that are involved in the investment activities of Separate Account or
any of the Sub-accounts, and any subsequent changes thereof, are made by IC
in its
sole and absolute discretion. Holder may not communicate directly or indirectly with IC
concerning the selection or substitution of Advisor or the choice of any IC
=s investment
officers that are involved in the investment activities of Separate Account or any of the
Sub-accounts.

Situation 2
: The facts are the same as Situation 1 except that Holder purchases
an annuity Contract (“Annuity”).

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.

-3-
A long standing doctrine of taxation provides that Ataxation is not so much
concerned with the refinements of title as it is with actual command over the property
taxed--the actual benefit for which the tax is paid.@ Corliss v. Bowers
, 281 U.S. 376
(1930). The incidence of taxation attributable to ownership of property is not shifted if
the transferor continues to retain significant control over the property transferred, Frank
Lyon Company v. United States, 435 U.S. 561 (1978); Commissioner v. Sunnen, 333
U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940), without regard to whether
such control is exercised through specific retention of legal title, the creation of a new
equitable but controlled interest, or the maintenance of effective benefit through the
interposition of a subservient agency. Christoffersen v. U.S.
, 749 F.2d 513 (8
th
Cir.),
rev=g
578 F. Supp. 398 (N.D. Iowa 1984).

Rev. Rul. 77-85, 1977-1 C.B. 12, considers a situation in which the individual
purchaser of a variable annuity contract retained the right to direct the custodian of the
account supporting that variable annuity to sell, purchase, and exchange securities or
other assets held in the custodial account. The purchaser also was able to exercise an
owner=s right to vote account securities either through the custodian or individually.
The Service concluded that the purchaser possessed Asignificant incidents of
ownership@ over the assets held in the custodial account. The Service reasoned that if
a purchaser of an "investment annuity" contract may select and control the investment
assets in the separate account of the life insurance company issuing the contract, then
the purchaser is 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
included in the purchaser=s gross income.

In Rev. Rul. 80-274, 1980-2 C.B. 27, the Service, applying Rev. Rul. 77-85,
concludes that, if a purchaser of an annuity contract may select and control the
certificates of deposit supporting the contract, then the purchaser is considered the
owner of the certificates of deposit for federal income tax purposes. Similarly, Rev. Rul.
81-225, 1981-2 C.B. 12, concludes that investments in mutual fund shares to fund
annuity contracts are considered to be owned by the purchaser of the annuity if the
mutual fund shares are available for purchase by the general public. Rev. Rul. 81-225
also concludes that, if the mutual fund shares are available only through the purchase of
an annuity contract, then the sole function of the fund is to provide an investment
vehicle that allows the issuing insurance company to meet its obligations under its
annuity contracts and the mutual fund shares are considered to be owned by the
insurance company. Finally, in Rev. Rul. 82-54, 1982-1 C.B. 11, the purchaser of
certain annuity contracts could allocate premium payments among three funds and had
an unlimited right to reallocate contract value among the funds prior to the maturity date
of the annuity contract. Interests in the funds were not available for purchase by the
general public, but were instead only available through purchase of an annuity contract.
The Service concludes that the purchaser=s ability to choose among general investment
strategies (for example, between stock, bonds, or money market instruments) either at
the time of the initial purchase or subsequent thereto, does not constitute control

-4-
sufficient to cause the contract holders to be treated as the owners of the mutual fund
shares.

In Christoffersen v. U.S.
, the Eighth Circuit considered the federal income tax
consequences of the 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 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 Asurrendered 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 a 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.

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
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).

-5-

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

ANALYSIS

The determination of whether Holder possesses sufficient incidents of ownership
over Sub-account assets to be deemed the owner of the assets supporting LIC and
Annuity depends on all of the relevant facts and circumstances.

Holder may not select or direct a particular investment to be made by either the
Separate Account or the Sub-accounts. Holder may not sell, purchase, or exchange
assets held in the Separate Account or the Sub-accounts. All investment decisions
concerning the Separate Account and the Sub-accounts are made by IC
or Advisor in
their sole and absolute discretion.

The investment strategies of the Sub-accounts currently available are sufficiently
broad to prevent Holder from making particular investment decisions through
investment in a Sub-account. Only IC
may add or substitute Sub-accounts or
investment strategies in the future. No arrangement, plan, contract, or agreement exists

-6-

between Holder and IC
or between Holder and Advisor regarding the specific
investments or investment objective of the Sub-accounts. In addition, Holder may not
communicate directly or indirectly with Advisor or any of IC
=s investment officers
concerning the selection, quality, or rate of return of any specific investment or group of
investments held by Separate Account or in a Sub-account.

Investment in the Sub-accounts is available solely through the purchase of a
Contract, thus, Sub-accounts are not publicly available. The ability to allocate premiums
and transfer funds among Sub-accounts alone does not indicate that Holder has control
over either Separate Account or Sub-account assets sufficient to be treated as the
owner of those assets for federal income tax purposes.

Based on all the facts and circumstances, Holder does not have direct or indirect
control over the Separate Account or any Sub-account asset. Therefore, Holder does
not possess sufficient incidents of ownership over the assets supporting either LIC or
Annuity to be deemed the owner of the assets for federal income tax purposes. So long
as LIC and Annuity continue to satisfy the diversification requirements of ' 817(h) and
IC
’s and Holder’s future conduct is consistent with the facts of this ruling, Holder will not
be required to include the earnings on the assets held in Separate Account or any of the
Sub-accounts in income under ' 61(a).

HOLDING

Under the facts set forth above, the holder of a variable contract will not be
considered to be the owner, for federal income tax purposes, of the assets that fund the
variable contract. Therefore, any interest, dividends, or other income derived from the
assets that fund the variable contract is not included in the holder’s gross income in the
year in which the interest, dividends, or other income is earned.

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).