Investment advisory fees paid out of an annuity's cash value are not a taxable distribution to the owner

Plain-English summary

A life insurance company wanted to offer deferred annuity contracts designed to be managed with the help of an investment adviser. The owner would authorize the company to pull the adviser's fees (capped at an annual rate of 1.5% of the contract's cash value) directly out of the annuity and pay them to the adviser. The company asked whether those fee withdrawals count as an "amount received" by the owner under section 72(e), which would make them taxable to the owner as a distribution. The IRS ruled they do not. Because the fees pay only for investment advice about that specific annuity, the contract itself is liable for them, and the owner cannot redirect them, the fees are an expense of the contract rather than a payout to the owner. The IRS cautioned that the ruling is limited: if any part of the fee covers advice on other assets or other services, that portion would be treated as a taxable amount received by the owner.

Ruling snapshot

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

Full text (IRS public release)

 Internal Revenue Service                                    Department of the Treasury
                                                             Washington, DC 20224

 Number: 202232005                                           Third Party Communication: None
 Release Date: 8/12/2022                                     Date of Communication: Not Applicable
 Index Number: 72.00-00
                                                             Person To Contact:
 --------------                                              ---------------------, ID No. -----------------
 ------------------------------                              Telephone Number:
 --------------------------------------------------------    --------------------
 ------------------------                                    Refer Reply To:
 --------------------------------                            CC:FIP:B04
                                                             PLR-123621-21
                                                             Date:
                                                             May 16, 2022




 Taxpayer = ------------------------------------------------------------------------------------




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
proposes to offer certain non-qualified deferred annuity contracts (referred to herein as
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 an 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 (within the meaning of section
72(e)(3)(A)(i)) of an Adviser Contract is credited with interest based on options that the
Owner selects from a menu provided by Taxpayer (the “Options”).
PLR-123621-21                                 2


The Adviser Contracts are Fixed-Indexed annuities, which 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. The Options under a Fixed-Indexed Adviser
Contract are declared rate and index-based interest crediting strategies that are
supported by the 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 index-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 the Fixed-Indexed Adviser
Contract’s cash value. 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.

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 among the available Options. The Adviser is expected to take
into account factors such as (i) the Owner’s personal risk tolerance and investment
timeline, (ii) the interest rate and market environment, (iii) the menu of Options available
under the Adviser Contract, and (iv) 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 the
Adviser 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 arm’s-length
transaction between the Owner and the Adviser, or if the Owner and the Adviser are
related parties, the Fees will not exceed those the Adviser charges unrelated parties.
The Fees will not exceed an amount equal to an annual rate of 1.5% of the Adviser
Contract’s cash value, determined at the time and in the manner provided in the
Authorization or other written agreement with the Adviser 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.
PLR-123621-21                                  3

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 for the sale of the Adviser Contract from
Taxpayer, but in some cases, Taxpayer may pay the Adviser a wholesaling fee or
marketing allowance.

                                  REQUESTED RULING

Taxpayer requests a ruling that the 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 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), (3). Any other
amounts to which the provisions of section 72 apply are considered to be “amounts not
received as an annuity.”

Section 1.72-2(b)(2) 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 section 1.72-4(b) (the first day of the first period for which an amount is
       received as an annuity under the contract);

       (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 section 1.72-2(b)(3) (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.
PLR-123621-21                                 4

Section 1.72-11(a)(1) describes “amounts not received as an annuity” as any amount
received under an annuity contract if the amount:

       (i) does not meet the requirements set forth in section 1.72-2(b) for amounts
       received as an annuity;

       (ii) meets the requirements of section 1.72-2(b) for amounts received as an
       annuity but the annuity payments received differ in either amount, duration, or
       both, from those originally provided under the contract; or

       (iii) meets the requirements of section 1.72-2(b) for amounts received as an
       annuity but the 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 investment advisory services relating to the Adviser
Contract. Because the Adviser Contracts are 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.
PLR-123621-21                                  5

                                          RULING

The Fees that 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
Taxpayer submitted, accompanied by penalty of perjury statements executed by
appropriate parties. This office has not verified any of the material submitted in support
of the ruling request and it is subject to verification on examination.

The ruling contained in this letter does not apply to any amount paid by Taxpayer that
compensates the Adviser for services related to assets other than the Adviser Contract
or for any services provided other than 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
Internal Revenue Code or Income Tax Regulations.

This ruling letter is directed only to the taxpayer who requested 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 a power of attorney on file in this office, a copy of this ruling is being
furnished to your authorized representatives.



                                       Sincerely,



                                       Rebecca L. Baxter
                                       Senior Technical Reviewer, Branch 4
                                       Office of Associate Chief Counsel
                                       (Financial Institutions and Products)



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