Application of Sec. 72(e) to annuity advisory fees

Editors: Brian Hagene, CPA, CGMA, and Mark G. Cook, CPA, CGMA

In IRS Letter Ruling 202422004, the Service ruled in response to a taxpayer’s question whether certain investment advisory fees paid from an annuity contract would be treated as an amount received in income by the annuity contract owner under Sec. 72(e).

Background

The taxpayer is a life insurance company under Sec. 816(a). The taxpayer plans to offer three types of nonqualified deferred annuity contracts (adviser contracts). Each adviser contract will be provided to and owned by either an individual or “a trust or other entity [acting] as an agent for a natural person” within the meaning of Sec. 72(u)(1).

Each adviser contract is recognized as an annuity contract under the laws of the jurisdiction in which it is issued and meets the requirements to qualify for treatment as an annuity contract for federal income tax purposes, including those under Sec. 72(s). The contracts consist of two phases: accumulation and payout. In the accumulation phase, the contract’s cash value is credited with earnings or interest, depending on the options offered by the taxpayer that are chosen by the contract’s owner. The available options vary depending on the type of contract (variable adviser contract, a fixed-indexed adviser contract, or a hybrid adviser contract).

Variable adviser contracts are variable annuity contracts within the meaning of Sec. 817(d). Variable adviser contracts provide options for segregated asset accounts holding diversified portfolios, ensuring investment separation and diversification for tax purposes. The actual investment performance and market value of the selected options’ assets affect the cash value of a variable adviser contract. Moreover, these contracts may also provide a fixed-account option or one or more declared-rate options.

A fixed-account option guarantees a minimum interest rate, with the possibility of additional interest credits at the taxpayer’s discretion. Before each crediting period, a declared-rate option credits interest is based on a predetermined rate set by the taxpayer, with a guaranteed minimum rate stemming from state laws. The variable adviser contracts will either be registered as securities with the SEC or sold as unregistered securities in private deals using exemptions from the Securities Act of 1933, P.L. 73-22, and the Investment Company Act of 1940, P.L. 76-768.

The fixed-indexed adviser contracts are not considered variable annuity contracts under Sec. 817(d). They offer declared-rate and index-based interest crediting strategy options supported by the taxpayer’s general account. Declared-rate options use a predetermined rate set by the taxpayer with a state-required minimum, whereas index-based options depend on the performance of market indexes with caps and limits. For instance, if the market index performs negatively, it will not reduce the contract’s cash value. Further, state laws confirm there is a guaranteed minimum surrender value based on the purchase payments and a minimum interest rate.

Hybrid adviser contracts are not variable annuity contracts within the meaning of Sec. 817(d). Hybrid adviser contracts are similar to fixed-indexed adviser contracts; they offer declared-rate and index-based crediting strategies supported by the taxpayer’s general account and certain hedging instruments held in a nonunitized separate account. The hybrid adviser contracts will be registered as securities with the SEC.

The adviser contracts are planned for an owner who regularly receives investment advice from an adviser on how to manage the contract’s cash value among the available options under Sec. 72(e)(3)(A)(i). The adviser will consider many factors, such as the owner’s risk tolerance, investment timeline, the market and interest rate environment, and the contracts’ options or benefits. The adviser will be licensed and follow all relevant laws and regulations. Moreover, the adviser and their firm are allowed to be related to the taxpayer.

For the adviser’s investment advice, the owner of the contract will authorize investment advisory fees (the fees) from the contract’s cash value via a separate agreement with the taxpayer (the authorization). The fees will be set based on an arm’s-length transaction between the owner and the adviser, and if the parties are related, the fees will be the same as what the adviser charges unrelated parties. Moreover, according to the contract, the fees are limited to 1.5% of the contract’s cash value per year. Lastly, these fees cover only the investment advice for the contract, excluding any other services.

The taxpayer will directly pay the fees to the adviser, and the adviser contract, not the owner, will cover the fees. Moreover, the owner is not allowed to use the fees for anything except the contract. Although the adviser can never charge the taxpayer a commission for the sale of a contract from the taxpayer, they might receive other fees, such as a wholesaling fee or marketing allowance.

Sec. 72 and the regulations

Sec. 72 distinguishes an “amount received as an annuity” from an “amount not received as an annuity” under annuity, endowment, or life insurance contracts. Regs. Sec. 1.72-1(b) states that “amounts received as an annuity” are payments made at regular intervals (annually, quarterly, etc.) over a period longer than one year from their start date and that require the total amounts and the payment period to be determined as of the start date.

According to Regs. Sec. 1.72-2(b)(2), “amounts received as an annuity” must meet the following criteria:

• They must be received on or after the annuity’s starting date;
• They must be paid at regular intervals, such as annually, quarterly, monthly, etc.; and
• The total payable amount must be determined at the annuity’s starting date, using either mortality tables or compound interest computations, or both, based on actuarial theory.

Regs. Sec. 1.72-11(a)(1) defines “amounts not received as an annuity” as any payments under an annuity contract that fall under any of the following criteria:

• The payments do not meet the requirements in Regs. Sec. 1.72-2(b) for annuity payments;
• The payments meet those requirements, but the amounts, durations, or both are different from what was originally stated in the contract; or
• The payments meet the requirements but are received by a beneficiary after the annuitant’s death, satisfying the contract’s obligations solely due to a guarantee. Moreover, Sec. 72(e) covers any “amount not received as an annuity” from an annuity, endowment, or life insurance contract.According to Sec. 72(e)(2)(A), receiving any nonannuity amount on or after the annuity start date is considered gross income. Sec. 72(e)(2)(B) provides that a nonannuity amount received before the annuity start date is considered gross income unless it is allocable to the investment in the contract.

Analysis

In this situation, the fees are essential for operating the adviser contract. When the authorization is in effect, the owner will receive ongoing investment advice from the adviser regarding the adviser contract. The adviser will assist the owner in choosing among the options related to the adviser contract, and the fees will cover only investment advice related to the adviser contract and nothing else. Because the adviser contract is designed to work with the adviser, the adviser contract is responsible for the fees, and the fees are not considered compensation for any other services related to the owner’s assets. Therefore, the IRS concluded that the fees are an expense of the adviser contract, not a payout to the owner.

Consequently, the IRS ruled that the fees the taxpayer deducts from the adviser contract’s cash value and remits to the adviser will not be treated as gross income to the contract’s owner for the purposes of Sec. 72(e).

Editor Notes

Brian Hagene, CPA, CGMA, is partner/owner at Mathieson, Moyski, Austin & Co. LLP in Lisle, Ill., with CPAmerica. Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with CPAmerica or SingerLewak LLP.