PLR 1046008: life insurance rider does not alter section 7702 calculations

Plain-English summary

The IRS ruled that a rider on flexible-premium variable universal life insurance policies could provide guaranteed annual withdrawals or loans without changing the policies' section 7702 calculations. During the rider benefit period, the policy's cash surrender value includes the greater of the policy value and the annual rider benefit. The IRS concluded that this treatment applies when determining the net single premium under the cash value accumulation test and the guideline premium limitation. The ruling also concluded that the rider benefit was not a change in future benefits requiring a new section 7702 computation because it was unknown at issue whether and when the benefit would operate. The ruling was based on the taxpayers' representations and was limited to the described policies and rider.

Ruling snapshot

• Question: Does a guaranteed withdrawal and loan rider change the policy's cash surrender value or the section 7702 premium calculations?
• Outcome: Approved
• Key authorities: IRC § 7702, including §§ 7702(b), 7702(c), 7702(d), 7702(e), 7702(f)(2)(A), and 7702(f)(7)(A)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201046008 Third Party Communication: None
Release Date: 11/19/2010 Date of Communication: Not Applicable
Index Number: 7702.00-00, 7702.02-00,
7702.17-00 Person To Contact:
---------------------, ID No. -----------------
-------------------- Telephone Number:
---------------------------------------------------- ---------------------
---------------------------------- Refer Reply To:
--------------------------------------------- CC:FIP:B04
PLR-151414-08
PLR-151415-08
Date:
August 13, 2010

Legend

Insurance Company 1 = ------------------------------------------------------------------------
State 1 = ------------
Jurisdictions = ------------------------------------------------------------------------

Insurance Company 2 = ------------------------------------------------------------------------
State 2 = -------------
Parent = ------------------------------------------------------
Charge A = -----------------------------------
Charge B = -----------------------------
Date C = -----------------------------
Benefit = ------------------------
Rider Benefit = -----------------------------------------------------
Rider = ------------------------------------------------------------------------
Rider Conditions = -----------------
D Percentage = ------------------------------------------------
Annual Rider Benefit = ------------------------------------------------------------------------
E Limit = -------------------------------------------------------
F Policy Year = ----------------------
Insured’s Age G = -----------------------
H Policy Years = ---------------------
J = --
K = ----
L = ---------
M = ----
N = ----
P = ---------
Q = -------------
R = -----
S = ----
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T = ----

Dear -----------------:

   Taxpayers have requested rulings regarding the application of § 7702 of the

Internal Revenue Code (Code) with respect to the Rider Benefit Taxpayers intend to
offer.

                                      FACTS

    Insurance Company 1 is a stock life insurance company incorporated under

State 1 law. Insurance Company 1 is licensed to engage in the life insurance business
in Jurisdictions. Insurance Company 1 is a life insurance company within the meaning
of § 816(a).

  Insurance Company 2 is a stock life insurance company organized and operated

under State 2 law. Insurance Company 2 is licensed to engage in the life insurance
business in State 2. Insurance Company 2 is a life insurance company within the
meaning of § 816(a).

     Insurance Company 1 and Insurance Company 2 (together the “Taxpayers”) join

in the filing of a consolidated federal income tax return with Parent and other eligible
affiliates on an accrual accounting, calendar year basis.

   Taxpayers intend to market certain flexible premium variable universal life

insurance contracts (the “Policies”). Taxpayers represent the Policies are life insurance
contracts under the laws of the states and other jurisdictions in which they will be
issued. The Policies have flexible premiums, subject to certain requirements (e.g.,
compliance with § 7702). The Taxpayers intend to offer a rider (the “Rider”) with the
Policies; the Rider is designed to make available to policyholders a minimum annual
withdrawal or loan amount, irrespective of the investment performance of the Policy.

    The Policies will have a cash value (the “policy value”). The Taxpayers represent

that apart from the effect of the Rider (as described below), at all times the policy value
is the “cash surrender value,” within the meaning of § 7702(f)(2)(A), of the Policy. The
policy value is increased by premiums paid and by interest and other investment
earnings. The policyholder can pay premiums at any time, subject to certain constraints
stated in the Policy. Premiums (net of a premium charge, the maximum amount of
which is set forth in the policy specifications pages) are allocated to subaccounts,
generally as directed by the policyholder. In addition, each month a deduction is made
from the policy value for certain expense charges under the Policy, including Charge A,
Charge B (if applicable), an administrative charge, the charges for any riders attached
to the Policy, and a deduction for cost of insurance which is based on the 2001
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Commissioners’ Standard Ordinary (CSO) mortality tables. The maximum charge for
each of these items is set forth in the Policy, but the Taxpayers in their discretion may
charge less.

    A policyholder may choose to receive a loan under the Policy. The portion of the

policy value that constitutes the collateral in respect of policy debt (i.e., outstanding
policy loans and unpaid interest thereon) is allocated to the Loan Account. In general, if
the sum of policy debt exceeds the policy value, the Policy will be in default and will
terminate at the end of a grace period.

   The Policies may be surrendered for their net cash surrender value (NCSV). In

this regard, the NCSV equals the Cash Surrender Value less the policy debt and the
Cash Surrender Value of a Policy equals the policy value less any applicable Surrender
Charge. The Policy also allows withdrawals of a portion of the NCSV. Such
withdrawals also reduce the policy value and may reduce the Death Benefit (defined
below). Unless a no lapse guarantee applies (as discussed below in connection with
the Death Benefit), the Policy terminates when the NCSV equals zero.

     If the insured under a Policy (the “Insured”) dies while the Policy is in force, the

Taxpayers pay the Benefit upon receipt of due proof of death of the Insured. Subject to
a minimum death benefit section (discussed below), the Benefit equals (a) the Death
Benefit, plus (b) any death benefit payable under any supplementary benefit riders ------
--------------------------------------that forms part of the Policy, less (c) any outstanding policy
debt at the date of death.

    The Policies provide that the sum of the Death Benefit and any death benefit

payable ----------------------------------------under any supplementary benefit rider will never
be less than the minimum death benefit. In general, the minimum death benefit is equal
to the minimum death benefit factor for the age of the Insured multiplied by the policy
value on the date of death of the Insured. Minimum death benefit factors are set forth in
the policy specifications pages and differ depending on whether the Policy is intended to
satisfy the Cash Value Accumulation Test (CVAT) of § 7702(b) or the Guideline
Premium Limitation (GPL) and Cash Value Corridor Test (CVC Test) of § 7702(c) and
(d).

   Both the base Policy form and the Rider include certain “no lapse” guarantees.

Under these provisions, if certain requirements are satisfied, the Taxpayers guarantee
that a Policy will not lapse, even if the Policy otherwise would lapse due to insufficient
NCSV. Where the no lapse guarantee is operating to keep a Policy in force, the
Taxpayers remain liable for payment of the Benefit upon the death of the Insured.

   At the time a Policy is purchased, a policyholder can choose to include the Rider

as part of his or her Policy. The Rider offers certain benefits:
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    First, if the policyholder follows the Rider Conditions (i.e., pays premiums in a

prescribed manner, takes no withdrawals or loans prior to Date C, maintains a -------
Face Amount and death benefit option in a prescribed manner, and meets certain other
criteria), under the Rider, the policyholder is entitled to the Rider Benefit. Taxpayers
represent that the Rider and Rider Benefit are part of the Policies for state law purposes
and are not regulated or otherwise treated under state law as an annuity contract or as
some other type of non-life insurance contract. As discussed in more detail below, the
Rider Benefit guarantees that certain distributions can be made from the Policy after
Date A for a specified period of years, even though in the absence of the Rider Benefit
there might not be sufficient NCSV to make such distributions.

   Second, if the policyholder follows the Rider Conditions, the Rider guarantees

that the Policy will not lapse. Thus, if the policy value is dramatically reduced because
of losses in the subaccounts which underlie the Policy and, correspondingly, the net
amount at risk and cost of insurance charges substantially increase, the Rider
guarantees that the Policy will not lapse, even if there is insufficient NCSV to fund cost
of insurance and other expense charges under the Policy. Under this “no lapse”
guarantee, the Benefit remains payable upon the death of the Insured.

    The Rider is funded by a monthly charge that is assessed against the policy

value. This charge equals the product of the policy value on the monthly processing
date and the D Percentage shown on the policy specifications pages. If there is
insufficient NCSV to pay this charge and a no lapse guarantee is in effect, this charge is
waived.

   Under the Rider Benefit, annual payments up to the Annual Rider Benefit are

available upon request by the policyholder beginning on Date A and continue to be
available each year during the Rider Benefit Period, even though in the absence of the
Rider Benefit there may be insufficient NCSV in the Policy to make the distributions.

   The key features of the Rider Benefit are as follows:

● The Annual Rider Benefit. The Annual Rider Benefit is specified in a Policy at
issue, but may change after the date of issue if the policyholder does not follow
the Rider Conditions or if he or she modifies the scheduled length of the Benefit
Period prior to Date A. The Annual Rider Benefit is the maximum amount that is
available for distributions each Policy Year during the Rider Benefit Period (the
period beginning with Date A and ending when the sum of distributions equals or
exceeds the E Limit). The Annual Rider Benefit is determined based on a number
of factors, e.g., the planned premium payments, the Death Benefit under the
Rider Conditions, Date A, the Benefit Period, and the age, risk class, and sex of
the Insured.
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● The Benefit Period. The Benefit Period and Date A are both specified in the
Policy at issue and will only be modified if there is a change in the Rider
Conditions (as discussed below). The Benefit Period begins on Date A, which is
the date on which the policyholder becomes entitled to distributions under the
Rider Benefit if the Rider is in force on such date. The Benefit Period can begin
no earlier than the later of the F Policy Year and the Insured’s Age G, and must
be a period of at least H Policy Years. A policyholder generally may request a
longer Benefit Period (subject to the approval of the Taxpayers) anytime prior to
Date A, although doing so will make the Annual Rider Benefit smaller.

●   Maximum amount that can be paid under the Rider Benefit. The total amount of
    distributions that can be paid pursuant to the Rider Benefit equals the E Limit -----
    ---------------------------------------, which equals the product of the Annual Rider
    Benefit and the scheduled number of years for the Benefit Period as indicated on
    the policy specifications pages (or as modified prior to Date A).

●   Effect of receiving distributions that are smaller than the Annual Rider Benefit. A
    policyholder may choose to take distributions in a Policy Year after Date A in an
    amount that is smaller than the Annual Rider Benefit. Since the Rider Benefit
    generally remains in effect until distributions equal the E Limit, receiving
    distributions in an amount that is smaller than the Annual Rider Benefit has the
    effect of lengthening the period over which distributions under the Rider Benefit
    may be received.

●   Form of distributions. “Distributions” for purposes of the Rider Benefit include
    both of the following on and after Date A: (1) withdrawals of any portion of the
    Policy’s NCSV, as described in the surrender and withdrawals -------------- of the
    Policy, and (2) loans against the Policy’s NCSV, as described in the loan section
    of the Policy.

●   Mechanics of payment. If a policyholder is entitled to the Rider Benefit and the
    NCSV is insufficient to make a distribution of the Annual Rider Benefit, the policy
    value is increased by the excess of (a) the amount of the distribution requested
    (but not by more than the Annual Rider Benefit) over (b) the NCSV.

   If there is a deviation from the Rider Conditions, the Rider Benefit is generally

recalculated. If deviation from the Rider Conditions would cause the recalculated
Annual Rider Benefit to be reduced to zero, the Rider will terminate.

   Various other events, as specified in the Rider, also will result in the termination

of the Rider. For example, if distributions in any Policy Year on and after Date A exceed
the Annual Rider Benefit, the Rider terminates. Also, once total distributions on and
after Date A exceed the E Limit, the Rider terminates.
PLR-151414-08 6
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    Absent the Rider, the Policy’s minimum death benefit equals the product of (1)

the applicable minimum death benefit factor (the amount of which depends on the age
of the Insured and whether the Policy is intended to meet the CVAT or the CVC Test),
and (2) the policy value. The Taxpayers have structured the Rider to provide that,
during the Rider Benefit Period (i.e., beginning on Date A and continuing until the sum
of the distributions equals or exceeds the E limit), the minimum death benefit is
calculated by multiplying (1) the applicable minimum death
benefit factor by (2) the greater of (a) the policy value at such time, and (b) the Annual
Rider Benefit.

    Taxpayers attached to their submission Exhibit C as an illustration of the

operation of the Rider Benefit provided by the Rider under a Policy. The Policy covers a
female, non-smoker Insured who is age M at the time of issuance of the Policy, and the
illustration generally reflects growth of the policy value based on J% market returns and
current mortality and expense charges. In the R Policy Year (just before Date A),
however, it is assumed that there is a very substantial market decline which reduces the
policy value by K%. The illustration assumes that the Annual Rider Benefit specified at
issue is L, and the Rider Conditions contemplates (a) a Q ------- Face Amount, (b) an
option 1 level death benefit pattern at all times, (c) payments of premiums of $P per
year for the first seven Policy Years, and (d) no withdrawals or loans prior to Date A.
The Rider Conditions are followed in the illustration, and thus the Rider Benefit provides
that distributions up to the Annual Rider Benefit of $L may be received in each Policy
Year beginning with Date A (i.e., the beginning of Policy Year S, when the insured is
age T) and continuing for a period of M years (i.e., ending when the insured is age N).

                             REQUESTED RULINGS

   Taxpayers request the following rulings:

   1. The “cash surrender value,” for purposes of § 7702(f)(2)(A), of the Policy at
      any time is its cash value, and a Policy’s cash value is the greater of (i) the
      maximum amount to which the policyholder is entitled upon surrender of the
      Policy (determined without regard to any surrender charge or policy loan), or
      (ii) the maximum amount against which the policyholder can borrow under the
      Policy.

   2. Calculations of the net single premium under the cash value accumulation
      test and of the guideline premium limitation for the Policy are unaffected by
      the presence of the Rider Benefit.

                                       LAW

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    Section 7702 defines the term “life insurance contract” for all purposes of the

Code, including the death benefit exclusion under § 101(a). To satisfy this definition, a
life insurance contract must be a life insurance contract under “applicable law” and must
meet one of two tests set forth in § 7702, i.e., the “cash value accumulation test”
(CVAT) of § 7702(a)(1) and (b), or the “guideline premium limitation” and “cash value
corridor” tests of § 7702(a)(2), (c), and (d) (i.e., the GPL and CVC Test, respectively).
In general, § 7702 applies to all life insurance contracts issued after December 31,
1984. The Policies are subject to § 7702, and certain of the Policies are intended to
comply with the CVAT while others are intended to comply with the GPL and CVC Test.

    A contract meets the CVAT if, by its terms, the contract’s “cash surrender value,”

within the meaning of § 7702(f)(2)(A) may not at any time exceed the net single
premium (“NSP”) that would have to be paid at such time to fund the future benefits
under the contract. See § 7702(b)(1), (f)(2)(A), and (f)(4). The term “future benefits” is
defined for purposes of § 7702 to include death benefits, any endowment benefits
guaranteed under the contract, and reasonable charges for qualified additional benefits
(such as accidental death benefits) that are reasonably expected to be actually paid.
Under § 7702(b)(2), the NSP must be computed –

         (A) on the basis of interest at the greater of an annual
         effective rate of 4 percent or the rate or rates guaranteed on
         issuance of the contract,

         (B) on the basis of the rules of [§ 7702(c)(3)(B)(i), relating to
         reasonable mortality charges] (and, in the case of qualified
         additional benefits, [§ 7702(c)(3)(B)(ii), relating to reasonable
         expense charges]), and

         (C) by taking into account under [§ 7702(e)(1)(A) and (D),
         relating to certain computational rules] only current and
         future death benefits and qualified additional benefits.

   The guideline premium requirements of the GPL are met if, at all times, the sum

of the premiums paid under a life insurance contract does not exceed the “guideline
premium limitation” at that time. The guideline premium limitation as of any date is
defined in § 7702(c)(2) as the greater of the “guideline single premium” or the sum of
the “guideline level premiums” as of that date. For contracts entered into on or after
October 21, 1988, § 7702(c)(3)(B) provides that the “guideline single premium” shall be
based on:
(i) reasonable mortality charges which meet the
requirements (if any) prescribed in regulations and which
(except as provided in regulations) do not exceed the
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          mortality charges specified in the prevailing commissioners’
          standard tables (as defined in § 807(d)(5)) as of the time the
          contract is issued,

          (ii) any reasonable charges (other than mortality charges)
          which (on the basis of the company’s experience, if any, with
          respect to similar contracts) are reasonably expected to be
          actually paid, and

          (iii) interest at the greater of an annual effective rate of 6
          percent or the rate or rates guaranteed on issuance of the
          contract.

   Section 7702(c)(4) provides that the “guideline level premium” is the level annual

premium equivalent of the guideline single premium, payable until a deemed maturity
date between the insured’s attained ages 95 and 100, calculated assuming interest at
the greater of an annual effective rate of 4 percent or the rate or rates guaranteed on
issuance of the contract.

   A contract will comply with the CVC Test of § 7702(d) if the death benefit under

the Policy at all times is not less than a percentage set forth in § 7702(d)(2) multiplied
by the contract’s “cash surrender value,” as defined in § 7702(f)(2)(A).

   Section 7702 specifies a number of “computational rules” that must be followed

in calculating NSPs under the CVAT and guideline premiums under the GPL.
Specifically, NSPs and guideline premiums generally must be computed assuming that
the death benefit under the contract does not increase, that the contract’s maturity date
is no earlier than the day on which the insured attains age 95 and no later than the day
on which the insured attains age 100, that the death benefit is provided until the maturity
date, and that any endowment benefit under the contract, including its cash surrender
value on the deemed maturity date, does not exceed the least amount payable as a
death benefit at any time under the contract. See § 7702(e)(1) and (2).

   Section 7702(f)(2)(A) provides that for purposes of § 7702 “[t]he cash surrender

value of any contract shall be its cash value determined without regard to any surrender
charge, policy loan, or reasonable termination dividends.” The Code does not elaborate
on the meaning of the term “cash value” as used to define the term “cash surrender
value” in § 7702(f)(2)(A). The legislative history of § 7702 includes some discussion of
the terms “cash surrender value” and “cash value,” stating that:

          Cash surrender value is defined in the bill as the cash value
          of any contract (i.e., any amount to which the policyholder is
          entitled upon surrender and against which the policyholder
          can borrow) determined without regard to any surrender

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         charge, policy loan, or a reasonable termination dividend ….
         [A]mounts that are returned to a policyholder of a credit life
         insurance policy because the policy has been terminated
         upon full payment of the debt will not be considered part of
         any cash surrender value because, generally, such amount
         is not subject to borrowing under the policy.

DEFRA Senate Report, at 573; DEFRA House Report, at 1444, see also
DEFRA Bluebook, at 647.

   Proposed Treasury Regulation § 1.7702-2 provides that the “cash surrender

value” of a contract generally equals its “cash value.” The term “cash value,” in turn, is
defined as the greater of (i) the maximum amount payable under the contract
(determined without regard to any surrender charge or policy loan), or (ii) the maximum
amount that the policyholder can borrow under the contract.

   Section 7702(f)(7)(A) provides that if there is a change in the terms or benefits of

a contract which was not reflected in any previous determination or adjustment made
under § 7702, there shall be a proper adjustment in future determinations made under
§ 7702.

   The Joint Committee on Taxation’s “Bluebook” explanation of DEFRA states:

          The Act provides that proper adjustments be made for any
          change in the future benefits or any qualified additional
          benefit (or in any other terms) under the contract, which
          was not reflected in any previous determination made
          under the definitional section. Changes in the future
          benefits or terms of a contract can occur at the behest of
          the company or policyholder, or by the passage of time.
          However, proper adjustments may be different for a
          particular change, depending on which alternative test is
          being used or on whether the changes result in an increase
          or decrease in the future benefits. In the event of an
          increase in current or future benefits, the limitations under
          the cash value accumulation test must be computed
          treating the date of change, in effect, as a new date of
          issue for determining whether the changed contract
          continues to qualify as life insurance under the definition
          prescribed in the Act. Thus, if a future benefit is increased
          because of a scheduled change in death benefit or
          because of the purchase of a paid-up addition (or its
          equivalent), the change will require an adjustment and new
          computation of the net single premium definitional

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          limitation. Under the guideline premium limitation, an
          adjustment is required under similar circumstances, but the
          date of change for increased benefits should be treated as
          a new date only with respect to the changed portion of the
          contract. Likewise, no adjustment shall be made if the
          change occurs automatically, for example, a change due to
          the growth of the cash surrender value (whether by the
          crediting of excess interest or the payment of guideline
          premiums) or changes initiated by the company. If the
          contract fails to meet the recomputed limitations, a
          distribution of cash to the policyholder may be required.

STAFF OF THE J. COMM. ON TAX’N, 98TH CONG., GENERAL EXPLANATION OF THE REVENUE
PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 653-54 (J. Comm. Print 1984)
(“DEFRA Bluebook”). See also S. PRT. NO. 98-169, VOL. I, 577-578 (1984); H.R. REP.
NO. 98-432, PT. 2, at 1448 (1984).

                                  DISCUSSION

    The amount available on surrender or which can be borrowed (determined

without regard to surrender charges or policy loans taken) under the Policies constitutes
the “cash surrender value” for purposes of § 7702(f)(2)(A). During the Rider Benefit
Period, the amount that is available to be withdrawn or borrowed equals the greater of
the policy value and the Annual Rider Benefit, therefore, the “cash surrender value,”
within the meaning of § 7702(f)(2)(A), of a Policy at any time during the Rider Benefit
Period equals the greater of (i) the policy value at such time, and (ii) the Annual Rider
Benefit for the Policy Year.

   In addition, on the date of issue it is unknown whether and when the Rider

Benefit will ever operate to increase the cash value that is available for withdrawals or
loans. The factual circumstances here are not those described by the DEFRA
Bluebook’s discussion of a change in future benefits that require an adjustment.

   Based on the facts and the representations made by Taxpayers we hold that:

   1. The “cash surrender value,” for purposes of § 7702(f)(2)(A), of the Policy at
      any time is its cash value, and a Policy’s cash value is the greater of (i) the
      maximum amount to which the policyholder is entitled upon surrender of the
      Policy (determined without regard to any surrender charge or policy loan), or
      (ii) the maximum amount against which the policyholder can borrow under the
      Policy.

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   2. Calculations of the net single premium under the cash value accumulation
      test and of the guideline premium limitation for the Policy are unaffected by
      the presence of the Rider Benefit.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  This ruling is directed only to the Taxpayers requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

    Temporary or final regulations pertaining to one or more of the issues addressed

in this ruling have not yet been adopted. Therefore, this ruling will be modified or
revoked by the adoption of temporary or final regulations to the extent the regulations
are inconsistent with any conclusion in the letter ruling. See § 11.04 of Rev. Proc.
2008-1, 2008-1 I.R.B. 1, 50. However, when the criteria in § 11.06 of Rev. Proc. 2008-
1, 2008-1 I.R.B. 1, 51 are satisfied, a ruling is not revoked or modified retroactively
except in rare or unusual circumstances.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

   The rulings contained in this letter are based upon information and

representations submitted by the Taxpayers and accompanied by penalty of perjury
statements executed by the appropriate parties. While this office has not verified any
of the material submitted in support of the request for rulings, it is subject to verification
on examination.

                                    Sincerely,


                                    Donald J. Drees, Jr.
                                    Senior Technician Reviewer, Branch 4
                                    (Financial Institutions & Products)

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