Advisory fees paid from an annuity's cash value are not a taxable distribution to the owner

Plain-English summary

A life insurance company planned to offer non-qualified deferred annuity contracts (variable, fixed-indexed, and hybrid) designed to be managed with the help of a paid investment adviser. The owner would authorize the insurer to deduct the adviser's fee, capped at 1.5 percent of the contract's cash value per year, directly from the annuity and pay it to the adviser. Normally, money pulled out of an annuity before payout can be taxable to the owner as an "amount received" under § 72(e). The insurer asked the IRS to confirm these advisory fees would not be treated that way. Because the fees compensate the adviser only for advice about the annuity itself, the contract (not the owner) is solely liable for them, and they are capped and arm's-length, the IRS ruled the fees are an expense of the contract rather than a distribution to the owner, so they are not an "amount received" under § 72(e). This lets policyholders pay ongoing advisory fees from the annuity without triggering income tax on those amounts. This ruling is one of a set of three near-identical rulings issued the same day (see also 202052005 and 202052006).

Ruling snapshot

• Question: Are investment advisory fees deducted from an annuity's cash value and paid to the owner's adviser an "amount received" by the owner under § 72(e)?
• Outcome: Approved (fees are not an "amount received")
• Key authorities: IRC § 72(e); Treas. Reg. §§ 1.72-1, 1.72-2, and 1.72-11

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 202052004
Release Date: 12/24/2020
Index Number: 72.00-00

[Third Party Communication:
Date of Communication: Month DD, YYYY]

Person To Contact:
ID No.
Telephone Number:
Refer Reply To: CC:FIP:04
PLR-108424-20

Date: September 25, 2020

Legend

Taxpayer =
Parent =

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

This letter responds to Taxpayer's request for a letter ruling that the payment of certain
investment advisory fees from an annuity contract will not be treated as an amount
received by the owner of that annuity contract for purposes of section 72(e) of the
Internal Revenue Code.

                                                 FACTS

Taxpayer is a life insurance company within the meaning of section 816(a). Taxpayer is
a subsidiary of Parent. Taxpayer intends to offer three types of non-qualified deferred
annuity contracts (the "Adviser Contracts"). Each Adviser Contract will be issued to and
owned by an individual, or issued to and owned by a "trust or other entity as an agent
for a natural person" within the meaning of section 72(u)(1) (the "Owner").

Each Adviser Contract is an annuity contract under the law of the jurisdiction where
issued. Each Adviser Contract qualifies for treatment as annuity contract for federal
income tax purposes, including by complying with the requirements of section 72(s).
Each Adviser Contract is comprised of an accumulation phase and a payout phase.
During the accumulation phase, the cash value of an Adviser Contract is credited with
earnings or interest based on options the Owner selects from a menu provided by
Taxpayer (the "Options"). The types of Options available under an Adviser Contract
differ depending on whether the contract is a Variable Adviser Contract, a Fixed-
Indexed Adviser Contract, or a Hybrid Adviser Contract, as described below.

Variable Adviser Contracts are variable annuity contracts within the meaning of section
817(d). A Variable Adviser Contract's cash value fluctuates up or down with the actual
investment performance and market value of the separate account assets
corresponding to the selected Options. A Variable Adviser Contract also may offer a
fixed account Option or one or more declared rate Options. A fixed account Option
provides a guaranteed minimum interest crediting rate plus the potential opportunity for
additional interest credits at Taxpayer's discretion. A declared rate Option credits
interest based on an interest rate that is set by Taxpayer in advance of each crediting
period, subject to a guaranteed minimum rate set in accordance with state standard
nonforfeiture law. The Variable Adviser Contracts will be registered as securities with
the Securities and Exchange Commission (SEC).

Fixed-Indexed Adviser Contracts are not variable contracts within the meaning of
section 817(d) and do not provide benefits that vary with the performance of separate
account assets. Rather, the Options under a Fixed-Indexed Adviser Contract are
declared rate and index-based interest crediting strategies that are supported by
Taxpayer's general account. The cash value of a Fixed-Indexed Adviser Contract is
credited with interest in accordance with formulas reflected in those Options. A
declared rate Option credits interest based on an interest rate that is set by Taxpayer in
advance of each crediting period, subject to a guaranteed minimum rate set in
accordance with state standard nonforfeiture law. The indexed-based Options credit
interest based on the positive performance of one or more specified market indexes
over each crediting period, subject to a cap, participation rate, spread, or other limit.
While negative performance of the index over the crediting period may mean that the
Fixed-Indexed Adviser Contract is not credited with any interest for that period, the
negative performance of the index does not reduce annuity values. In addition, under
state standard nonforfeiture law, a Fixed-Indexed Adviser Contract provides a
guaranteed minimum surrender value for the contract as a whole, calculated using a
specified percentage of the purchase payment(s) and a guaranteed minimum interest
rate.

Hybrid Adviser Contracts are not variable contracts within the meaning of section 817(d)
and do not provide benefits that vary with the performance of separate account assets.
Rather, the Options under a Hybrid Adviser Contract are declared rate and index-based
crediting strategies that are supported by Taxpayer's general account and certain
hedging instruments held in a non-unitized separate account. The cash value of a
Hybrid Adviser Contract is credited with interest in accordance with formulas reflected in
those Options. The declared rate Option credits interest based on an interest rate that
is set by Taxpayer in advance of each crediting period, subject to a guaranteed
minimum rate set in accordance with state standard nonforfeiture law. The index-based
Options credit interest based on the positive or negative performance of a specified
market index over each crediting period, subject to a cap, floor, participation rate, buffer,
or other limit, and the results are not dependent on the performance of the separate
account. The Hybrid Adviser Contracts will be registered as securities with the SEC.

The Adviser Contracts are designed for an Owner who will receive ongoing investment
advice from an investment adviser (the "Adviser") on how to allocate an Adviser
Contract's cash value (within the meaning of section 72(e)(3)(A)(i)) among the available
Options. The Adviser is expected to take into account factors such as (1) the Owner's
personal risk tolerance and investment timeline, (2) the interest rate and market
environment, (3) the menu of Options available under the Adviser Contract, and (4) the
various other benefits and features available under the Adviser Contract. The Adviser
will be licensed to provide investment advice in accordance with all applicable laws and
regulations. The Adviser and the firm he or she is associated with (if any) may or may
not be affiliated with Taxpayer.

In consideration for the Adviser's investment advice, the Owner will authorize
investment advisory fees (the "Fees") to be paid periodically to the Adviser from the
Adviser Contract's cash value in a separate agreement between the Owner and
Taxpayer (the "Authorization"). The Fees will be determined based on an arms-length
transaction between the Owner and the Adviser. The Fees will not exceed an amount
equal to an annual rate of 1.5% of the Adviser Contract's cash value (within the
meaning of section 72(e)(3)(A)(i)), determined at the time and in the manner provided in
the Authorization but in all events based on such cash value during the period to which
the Fees relate. The Fees will compensate the Adviser only for investment advice that
the Adviser provides to the Owner with respect to the Adviser Contract, and not for any
other services. The Fees will not result in any reduction in fees related to any other
asset or for any other service.

Taxpayer will pay the Fees directly to the Adviser. During any period for which the
Authorization is in effect, the Adviser Contract will be solely liable for paying the Fees
and the Fees will not be paid directly by the Owner. Similarly, the Owner will not have
the right to direct payment of the Fees for any other purpose or to any other person.
The Adviser will not receive a commission from Taxpayer for the sale of the Adviser
Contract, but the Adviser's firm may receive a marketing or wholesaling allowance from
Taxpayer to promote Taxpayer's products or to act as intermediary between the Owner
and Taxpayer. In all cases, any wholesaling or marketing allowance Taxpayer may pay
will fall within requirements provided by state and federal regulatory agencies providing
oversight to the annuity industry.

                             REQUESTED RULING

Taxpayer requests a ruling that Fees Taxpayer deducts from the Adviser Contract's
cash value and remits to the Adviser will not be treated as an "amount received" by the
Owner of the Adviser Contract for purposes of section 72(e).

                              LAW AND ANALYSIS

Law

Section 72 distinguishes between an "amount received as an annuity" under an annuity,
endowment, or life insurance contract and an "amount not received as an annuity"
under those contracts. Section 1.72-1(b) of the Income Tax Regulations (the
"Regulations") provides that "amounts received as an annuity" are amounts which are
payable at regular intervals over a period of more than one full year from the date on
which they are deemed to begin, provided the total of the amounts so payable or the
period for which they are to be paid can be determined as of that date. See section
1.72-2(b)(2) and (3) of the Regulations. Any other amounts to which the provisions of
section 72 apply are considered to be "amounts not received as an annuity." See
section 1.72-11 of the Regulations.

Section 1.72-2(b)(2) of the Regulations provides that amounts "are considered 'amounts
received as an annuity' only in the event that the following tests are met:

  (i) They must be received on or after the 'annuity starting date' as that term is
  defined in §1.72-4(b) [of the Regulations (the first day of the first period for which
  an amount is received as an annuity)];

  (ii) They must be payable in periodic installments at regular intervals (whether
  annually, semiannually, quarterly, monthly, weekly, or otherwise) over a period of
  more than one full year from the annuity starting date; and

  (iii) Except as indicated in [§1.72-2(b)(3) of the Regulations (relating to variable
  contracts)], the total of the amounts payable must be determinable at the annuity
  starting date either directly from the terms of the contract or indirectly by the use
  of either mortality tables or compound interest computations, or both, in
  conjunction with such terms and in accordance with sound actuarial theory."

Section 1.72-11(a)(1) of the Regulations describes "amounts not received as an
annuity" as "amounts received under a contract to which section 72 applies [i.e. an
annuity contract] if either:

  (i) Paragraph (b) of §1.72-2 [(for amounts received as an annuity)] is inapplicable
  to such amounts.

  (ii) Paragraph (b) of §1.72-2 is applicable but the annuity payments received
  differ either in amount, duration, or both, from those originally provided under the
  contract, or

   (iii) Paragraph (b) of §1.72-2 is applicable, but such annuity payments are
   received by a beneficiary after the death of an annuitant (or annuitants) in full
   discharge of the obligation under the contract and solely because of a
   guarantee."

Section 72(e) applies to any "amount not received as an annuity" under an annuity,
endowment, or life insurance contract. Section 72(e)(2)(A) provides that if any amount
which is not received as an annuity is received on or after the annuity starting date, it is
included in gross income. Section 72(e)(2)(B) provides that if any amount which is not
received as an annuity is received before the annuity starting date, it is 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

In this case, the Fees are integral to the operation of the Adviser Contract. During any
period for which the Authorization is in effect, the Owner will receive ongoing investment
advice from the Adviser with respect to the Adviser Contract so that the Owner may
properly utilize the Adviser Contract. The Adviser is expected to help the Owner select
Options related to the Adviser Contract. Taxpayer has represented that the Fees will
not serve as consideration for anything other than investment advice provided by the
Adviser in relation to the Adviser Contract. Furthermore, Taxpayer has represented that
the Fees will not exceed an annual rate of 1.5% of the Adviser Contract's cash value
based on the period in which the fees related. Based on Taxpayer's representations,
the Fees will only be used to pay for ongoing investment advisory services relating to
the Adviser Contract. Because the Adviser Contract is designed to work with an
Adviser, the Adviser Contract is solely liable for the Fees. 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. Therefore, the Fees are an expense of the Adviser Contract,
not a distribution to the Owner.

                                     RULING

We rule that Fees Taxpayer deducts from the Adviser Contract's cash value and remits
to the Adviser will not be treated as an "amount received" by the Owner of the Adviser
Contract for purposes of section 72(e).

                                    CAVEATS

The ruling contained in this letter is based upon information and representations
submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. 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.

The ruling contained in this letter does not apply to any amount paid by Taxpayer that
compensate the Adviser for services related to assets other than the Adviser Contract
or for any services provided other than ongoing investment advice services with respect
to the Adviser Contract. Any such amount would be an "amount received" by the Owner
of the Adviser Contract for purposes of section 72(e).

Except as specifically set forth above, no opinion is expressed or implied concerning the
federal tax consequences of the proposed transaction under any other provision of the
Code or Regulations.

This letter ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

Taxpayer must attach a copy of this letter ruling to any tax return to which it is relevant.

In accordance with the power of attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                             Sincerely,

                                             Rebecca L. Baxter
                                             Senior Technician Reviewer, Branch 4
                                             (Financial Institutions & Products)

cc: