[Federal Register Volume 63, Number 5 (Thursday, January 8, 1998)]
[Rules and Regulations]
[Pages 1054-1059]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-20]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8754]
RIN 1545-AS76
Debt Instruments With Original Issue Discount; Annuity Contracts
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
federal income tax treatment of certain annuity contracts. The
regulations determine which of these contracts are taxed as debt
instruments for purposes of the original issue discount provisions of
the Internal Revenue Code. The regulations provide needed guidance to
owners and issuers of these contracts.
DATES: Effective date: The regulations are effective February 9, 1998.
Applicability dates: For dates of applicability, see Sec. 1.1275-
1(j)(8).
FOR FURTHER INFORMATION CONTACT: Jonathan R. Zelnik, (202) 622-3930
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Sections 163(e) and 1271 through 1275 of the Internal Revenue Code
(Code) provide rules for the treatment of debt instruments that have
original issue discount (OID).
On February 2, 1994, the IRS and Treasury published in the Federal
Register (59 FR 4799) final regulations under the OID provisions. On
April 7, 1995, the IRS published in the Federal Register (60 FR 17731)
a notice of proposed rulemaking relating to the federal income tax
treatment of annuity contracts that are not issued by insurance
companies subject to tax under subchapter L of the Code. The proposed
regulations treat certain of these annuity contracts as debt
instruments for purposes of the OID provisions.
The IRS received a number of written comments on the proposed
regulations. In addition, on August 8, 1995, the IRS held a public
hearing on the proposed regulations. The proposed regulations, with
certain changes in response to comments, are adopted as final
regulations. The comments and changes are discussed below.
Explanation of Provisions
Certain Annuity Contracts
The OID provisions generally apply to issuers and holders of debt
instruments. The term debt instrument means any instrument or
contractual arrangement that constitutes indebtedness under general
principles of federal income tax law. See section 1275(a)(1) and
Sec. 1.1275-1(d).
Section 1275(a)(1)(B) excepts two types of annuity contracts from
the definition of debt instrument (and, therefore, from the OID
provisions). First, section 1275(a)(1)(B)(i) excepts an annuity
contract to which section 72 applies if the contract ``depends (in
whole or in substantial part) on the life expectancy of 1 or more
individuals.'' Second, section 1275(a)(1)(B)(ii) excepts an annuity
contract to which section 72 applies if the contract is issued by ``an
insurance company subject to tax under subchapter L'' and the
circumstances of the contract's issuance meet certain criteria.
The proposed regulations address only the first exception, which is
contained in section 1275(a)(1)(B)(i). Under the proposed regulations,
an annuity contract qualifies for the exception in section
1275(a)(1)(B)(i) only if all payments under the contract are periodic
payments that: (1) are made at least annually for the life (or lives)
of one or more individuals; (2) do not increase at any time during the
life of the contract; and (3) are part of a series of payments that
begins within one year of the date of the initial investment in the
contract. An annuity contract that is otherwise described in the
preceding sentence, however, does not fail to qualify for the exception
in section 1275(a)(1)(B)(i) merely because it also provides for a
payment (or payments) made by reason of the death of one or more
individuals. Thus, under the proposed regulations, the exception in
section 1275(a)(1)(B)(i) applies only to an immediate annuity contract
with level (or decreasing) payments for the life (or lives) of one or
more individuals. No deferred annuity contract qualifies for the
exception.
Several commentators questioned the approach of the proposed
regulations. In particular, they contended that the exception in
section 1275(a)(1)(B)(i) should not be limited to those annuity
contracts that require periodic payments to begin within one year of
the date of the initial investment in the contract. That is, deferred
annuities, if dependent in whole or substantial part on an individual's
(or several individuals') survival, should also qualify for the
exception in section 1275(a)(1)(B)(i).
[[Page 1055]]
Other commentators took issue with this point of view and contended
that the proposed regulations should be finalized without substantial
change.
After a careful review of this issue, the IRS and the Treasury have
modified the regulations to eliminate the requirement that annuity
distributions begin within one year of the date of the initial
investment in the contract. Instead, as suggested by the legislative
history, the final regulations interpret section 1275(a)(1)(B)(i) as
excepting from the definition of debt instrument only those annuity
contracts that contain terms ensuring that the life contingency under
the contract is both ``real and significant.'' H.R. Conf. Rep. No. 861,
98th Cong., 2d Sess. 887 (1984), 1984-3 (Vol. 2) C.B. 141. The Treasury
and the IRS have determined that the life contingency under an annuity
contract is ``real and significant'' within the meaning of the
legislative history only if, on the day the contract is purchased,
there is a high probability that total distributions under the contract
will increase commensurately with the longevity of the individual (or
individuals) over whose life (or lives) the distributions are to be
made. (These individuals are hereinafter referred to as annuitants.)
The final regulations, therefore, provide a two-pronged general rule:
An annuity contract qualifies for the exception in section
1275(a)(1)(B)(i) only if it both: (1) provides for periodic
distributions made at least annually for the life (or joint lives) of
an individual (or a reasonable number of individuals); and (2) contains
no terms or provisions that can significantly reduce the probability
that total distributions will increase commensurately with longevity.
The final regulations identify several types of terms and
provisions that can significantly reduce the probability that total
distributions under the contract will increase commensurately with
longevity. These terms and provisions include the availability of a
cash surrender option, the availability of a loan secured by the
contract, minimum payout provisions, maximum payout provisions, and
provisions that allow decreasing payouts. Subject to limited
exceptions, the presence of any of these terms or provisions causes an
annuity contract to fail to qualify for the exception in section
1275(a)(1)(B)(i). The list of identified terms and provisions in the
final regulations is not exclusive. A contract fails to qualify for the
exception in section 1275(a)(1)(B)(i) if the contract contains any
other term or provision that can significantly reduce the probability
that total distributions under the contract will increase
commensurately with longevity.
Cash Surrender Options and Loans Secured by the Contract
If the holder of an annuity contract can exchange or surrender all
or part of the contract for a distribution or for distributions that
are not contingent on life, the holder's decision whether, and when, to
exchange or surrender the contract can render the life contingency
insignificant. Similarly, if the holder of an annuity contract can
borrow against the contract, the holder's decision whether, and when,
to borrow can have a comparable effect. The final regulations,
therefore, provide that, if either the issuer or a person acting in
concert with the issuer explicitly or implicitly makes available either
a cash surrender option or a loan secured by the contract, then the
contract contains a term that can significantly reduce the probability
that total distributions on the contract will increase commensurately
with longevity. That availability, therefore, causes the contract to
fail to qualify for the exception in section 1275(a)(1)(B)(i).
Minimum Payout Provisions
If an annuity contract guarantees that a minimum amount will be
distributed regardless of the death of the individual (or individuals)
over whose life (or lives) payments are to be made, the minimum amount
is not subject to the life contingency. In addition, the larger the
minimum amount relative to aggregate expected distributions over the
remaining (joint) life expectancy of the annuitant (or annuitants), the
less likely it is that total distributions under the contract will
increase commensurately with the longevity of the annuitant (or
annuitants). A sufficiently large minimum amount renders the life
contingency virtually meaningless. For example, consider a contract
that provides for monthly distributions to begin on the annuity
starting date and to extend for the longer of the life of the annuitant
or 20 years, regardless of the annuitant's age. If the annuitant has a
life expectancy as of the annuity starting date of 5 years, it is
likely that distributions will be made for exactly 20 years, regardless
of when the annuitant dies. In this case, although the form of the
contract indicates that it depends on life, the existence of the
minimum payout provision significantly reduces the probability that
total distributions under the contract will depend on longevity.
Because the existence of a minimum payout provision can
significantly reduce the probability that total distributions under the
contract will increase commensurately with longevity, the existence of
any such provision generally causes the contract to fail to qualify for
the exception in section 1275(a)(1)(B)(i). The final regulations
provide only two exceptions to this general rule. First, an annuity
contract does not fail to be described in section 1275(a)(1)(B)(i)
merely because it contains a minimum payout provision that guarantees a
death benefit no greater than the unrecovered consideration paid for
the contract. Second, an annuity contract does not fail to be described
in section 1275(a)(1)(B)(i) merely because the contract provides that,
after annuitization, distributions may be guaranteed to continue for a
term certain that is no longer than one-half of the period of time from
the annuity starting date to the expected date of the ``terminating
death.''
The terminating death is the annuitant death that, in general,
causes annuity payments to cease under the contract. The expected date
of the terminating death is determined as of the annuity starting date
with respect to all then-surviving annuitants by reference to the
applicable mortality table prescribed under section
417(e)(3)(A)(ii)(I). See Rev. Rul. 95-6, 1995-1 C.B. 80, for the
applicable mortality table that is prescribed for this purpose as of
January 8, 1998.
Maximum Payout Provisions
If an annuity contract provides that distributions will cease if an
annuitant lives beyond a specified date, total distributions under the
contract may fail to increase commensurately with longevity. If the
specified date is relatively early (when compared to the annuitant's
life expectancy as of the annuity starting date), its existence
significantly reduces the probability that total distributions under
the contract will increase commensurately with longevity. Conversely,
if the specified date is very late (when compared to the annuitant's
life expectancy as of the annuity starting date), its existence does
not significantly reduce the probability that total distributions under
the contract will increase commensurately with longevity. For example,
consider an annuity contract that provides that distributions will be
made for the life of the annuitant but in no event for more than 30
years. If the annuitant is a relatively young person, this maximum
payout provision significantly attenuates the life contingency. On the
other hand, if the annuitant has a life expectancy of 10 years on the
annuity starting date, this maximum payout
[[Page 1056]]
provision is unlikely to determine the total distributions.
Because the existence of a maximum payout provision can
significantly reduce the probability that total distributions under the
contract will increase commensurately with longevity, the final
regulations provide that the existence of any maximum payout provision
generally causes the contract to fail to qualify for the exception in
section 1275(a)(1)(B)(i). There is a single exception to this general
rule in cases where the period of time between the annuity starting
date and the date after which (under the maximum payout provision) no
distributions will be made is at least twice as long as the period of
time from the annuity starting date to the expected date of the
terminating death.
Decreasing Payout Provisions
The connection between longevity and distributions under an annuity
contract is apparent in the case of a contract that provides for equal
annual distributions for life. For each year the annuitant lives,
another equal distribution is made. If distributions decrease over
time, this connection can become attenuated. Consider an annuity
contract that provides for a distribution upon annuitization of
$100,000 followed by annual distributions of $10 per year for life.
Although this contract provides for periodic distributions for life,
the pattern of the distributions causes the amount distributed to fail
to adequately reflect longevity.
If the amount of distributions under an annuity contract during any
contract year may be less than the amount of distributions during the
preceding year, the final regulations provide that this possibility can
significantly reduce the probability that total distributions under the
contract will increase commensurately with longevity. Thus, the
existence of this possibility generally causes the contract to fail to
qualify for the exception in section 1275(a)(1)(B)(i). There is a
single exception to this general rule for certain variable
distributions that are closely tied to investment experience,
inflation, or similar fluctuating criteria. In these cases, because the
provision can result in comparable increases in the amount of
distributions, the possibility that the distributions may decline from
year to year does not significantly reduce the probability that total
distributions under the contract will increase commensurately with
longevity.
Private and Charitable Gift Annuity Contracts
Several commentators expressed concerns that the proposed
regulations, if finalized, would alter the tax treatment traditionally
afforded private and charitable gift annuity contracts. Private annuity
contracts are typically issued as consideration in intra-family
transfers of property. Charitable gift annuity contracts are typically
issued by charitable institutions in exchange for a transfer of cash or
property greater in value than the annuity. Because these contracts may
call for periodic distributions to begin more than one year after they
are issued, there was concern that, under the proposed regulations,
they might fail to qualify for the exception in section
1275(a)(1)(B)(i).
In many cases, distributions under private and charitable gift
annuity contracts are entirely contingent on the survival of one
individual (or a small number of individuals). These contracts are not
indebtedness under general principles of federal income tax law and,
therefore, are not within the definition of debt instrument in section
1275(a)(1)(A). For almost all other private and charitable gift
annuities, the final regulations address the concern by removing the
requirement that the distributions begin within one year of the date of
the initial investment in the contract.
Annuity Contracts Issued by Foreign Insurance Companies
One commentator asked the IRS to clarify the treatment of annuity
contracts issued by a foreign insurance company that does not engage in
a trade or business within the United States. In particular, the
commentator asked for guidance on whether such an annuity contract
qualifies under section 1275(a)(1)(B)(ii), which provides a broad
exception from the definition of debt instrument for certain annuity
contracts issued by ``an insurance company subject to tax under
subchapter L.'' These regulations do not address the exception in
section 1275(a)(1)(B)(ii). The Treasury and the IRS, however, welcome
comments on the proper scope of that provision.
Certain Compensation Arrangements
Several commentators questioned whether the proposed regulations
apply to certain compensation arrangements whose distributions are
taxed under section 72. The timing rules of the OID provisions do not
apply to compensation arrangements that are subject to other specific
Code or regulations provisions. For example, if an arrangement is
described in the first sentence of section 404(a) or in section 404(b)
or if amounts under the arrangement are includible under sections 83,
403, or 457, or under Sec. 1.61-2, the arrangement is not subject to
the OID timing provisions. See also Secs. 1.1273-2(d) and 1.1274-1(a),
under which a nonpublicly traded debt instrument issued for services
has an issue price equal to its stated redemption price at maturity
and, therefore, has no OID.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations. Because the notice of proposed
rulemaking preceding the regulations was issued prior to March 29,
1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the Code, the notice of proposed
rulemaking was submitted to the Small Business Administration for
comment on its impact on small business.
Drafting Information
Several persons from the Office of Chief Counsel and the Treasury
Department participated in developing these regulations.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendment to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
removing the entries for ``Sections 1.1271-1 through 1.1274-5'' and
``Sections 1.1275-1 through 1.1275-5'' and adding the following entries
in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1271-1 also issued under 26 U.S.C. 1275(d).
Section 1.1272-1 also issued under 26 U.S.C. 1275(d).
Section 1.1272-2 also issued under 26 U.S.C. 1275(d).
Section 1.1272-3 also issued under 26 U.S.C. 1275(d).
Section 1.1273-1 also issued under 26 U.S.C. 1275(d).
Section 1.1273-2 also issued under 26 U.S.C. 1275(d).
[[Page 1057]]
Section 1.1274-1 also issued under 26 U.S.C. 1275(d).
Section 1.1274-2 also issued under 26 U.S.C. 1275(d).
Section 1.1274-3 also issued under 26 U.S.C. 1275(d).
Section 1.1274-4 also issued under 26 U.S.C. 1275(d).
Section 1.1274-5 also issued under 26 U.S.C. 1275(d). * * *
Section 1.1275-1 also issued under 26 U.S.C. 1275(d).
Section 1.1275-2 also issued under 26 U.S.C. 1275(d).
Section 1.1275-3 also issued under 26 U.S.C. 1275(d).
Section 1.1275-4 also issued under 26 U.S.C. 1275(d).
Section 1.1275-5 also issued under 26 U.S.C. 1275(d). * * *
Par. 2. Section 1.1271-0 is amended by adding entries for
paragraphs (i) through (j)(8) to Sec. 1.1275-1 to read as follows:
Sec. 1.1271-0 Original issue discount; effective dates; table of
contents.
* * * * *
Sec. 1.1275-1 Definitions.
* * * * *
(i) [Reserved]
(j) Life annuity exception under section 1275(a)(1)(B)(i).
(1) Purpose.
(2) General rule.
(3) Availability of a cash surrender option.
(4) Availability of a loan secured by the contract.
(5) Minimum payout provision.
(6) Maximum payout provision.
(7) Decreasing payout provision.
(8) Effective dates.
* * * * *
Par. 3. Section 1.1275-1 is amended by:
1. Revising the first sentence of paragraph (d).
2. Adding and reserving paragraph (i).
3. Adding paragraph (j).
The revision and additions read as follows:
Sec. 1.1275-1 Definitions.
* * * * *
(d) Debt instrument. Except as provided in section 1275(a)(1)(B)
(relating to certain annuity contracts; see paragraph (j) of this
section), debt instrument means any instrument or contractual
arrangement that constitutes indebtedness under general principles of
Federal income tax law (including, for example, a certificate of
deposit or a loan). * * *
* * * * *
(i) [Reserved]
(j) Life annuity exception under section 1275(a)(1)(B)(i)--(1)
Purpose. Section 1275(a)(1)(B)(i) excepts an annuity contract from the
definition of debt instrument if section 72 applies to the contract and
the contract depends (in whole or in substantial part) on the life
expectancy of one or more individuals. This paragraph (j) provides
rules to ensure that an annuity contract qualifies for the exception in
section 1275(a)(1)(B)(i) only in cases where the life contingency under
the contract is real and significant.
(2) General rule--(i) Rule. For purposes of section
1275(a)(1)(B)(i), an annuity contract depends (in whole or in
substantial part) on the life expectancy of one or more individuals
only if--
(A) The contract provides for periodic distributions made not less
frequently than annually for the life (or joint lives) of an individual
(or a reasonable number of individuals); and
(B) The contract does not contain any terms or provisions that can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants).
(ii) Terminology. For purposes of this paragraph (j):
(A) Contract. The term contract includes all written or unwritten
understandings among the parties as well as any person or persons
acting in concert with one or more of the parties.
(B) Annuitant. The term annuitant refers to the individual (or
reasonable number of individuals) referred to in paragraph (j)(2)(i)(A)
of this section.
(C) Terminating death. The phrase terminating death refers to the
annuitant death that can terminate periodic distributions under the
contract. (See paragraph (j)(2)(i)(A) of this section.) For example, if
a contract provides for periodic distributions until the later of the
death of the last-surviving annuitant or the end of a term certain, the
terminating death is the death of the last-surviving annuitant.
(iii) Coordination with specific rules. Paragraphs (j) (3) through
(7) of this section describe certain terms and conditions that can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). If a term or provision is not specifically
described in paragraphs (j) (3) through (7) of this section, the
annuity contract must be tested under the general rule of paragraph
(j)(2)(i) of this section to determine whether it depends (in whole or
in substantial part) on the life expectancy of one or more individuals.
(3) Availability of a cash surrender option--(i) Impact on life
contingency. The availability of a cash surrender option can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). Thus, the availability of any cash surrender
option causes the contract to fail to be described in section
1275(a)(1)(B)(i). A cash surrender option is available if there is
reason to believe that the issuer (or a person acting in concert with
the issuer) will be willing to terminate or purchase all or a part of
the annuity contract by making one or more payments of cash or property
(other than an annuity contract described in this paragraph (j)).
(ii) Examples. The following examples illustrate the rules of this
paragraph (j)(3):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to A
for cash. The contract provides that, effective on any date chosen
by A (the annuity starting date), X will begin equal monthly
distributions for A's life. The amount of each monthly distribution
will be no less than an amount based on the contract's account value
as of the annuity starting date, A's age on that date, and permanent
purchase rate guarantees contained in the contract. The contract
also provides that, at any time before the annuity starting date, A
may surrender the contract to X for the account value less a
surrender charge equal to a declining percentage of the account
value. For this purpose, the initial account value is equal to the
cash invested. Thereafter, the account value increases annually by
at least a minimum guaranteed rate.
(ii) Analysis. The ability to obtain the account value less the
surrender charge, if any, is a cash surrender option. This ability
can significantly reduce the probability that total distributions
under the contract will increase commensurately with A's longevity.
Thus, the contract fails to be described in section
1275(a)(1)(B)(i).
Example 2. (i) Facts. On March 1, 1998, X issues a contract to B
for cash. The contract provides that beginning on March 1, 1999, X
will distribute to B a fixed amount of cash each month for B's life.
Based on X's advertisements, marketing literature, or illustrations
or on oral representations by X's sales personnel, there is reason
to believe that an affiliate of X stands ready to purchase B's
contract for its commuted value.
(ii) Analysis. Because there is reason to believe that an
affiliate of X stands ready to purchase B's contract for its
commuted value, a cash surrender option is available within the
meaning of paragraph (j)(3)(i) of this section. This availability
can significantly reduce the probability that total distributions
under the contract will increase commensurately with B's longevity.
Thus, the contract fails to be described in section
1275(a)(1)(B)(i).
(4) Availability of a loan secured by the contract--(i) Impact on
life contingency. The availability of a loan secured by the contract
can significantly reduce the probability that total
[[Page 1058]]
distributions under the contract will increase commensurately with the
longevity of the annuitant (or annuitants). Thus, the availability of
any such loan causes the contract to fail to be described in section
1275(a)(1)(B)(i). A loan secured by the contract is available if there
is reason to believe that the issuer (or a person acting in concert
with the issuer) will be willing to make a loan that is directly or
indirectly secured by the annuity contract.
(ii) Example. The following example illustrates the rules of this
paragraph (j)(4):
Example. (i) Facts. On March 1, 1998, X issues a contract to C
for $100,000. The contract provides that, effective on any date
chosen by C (the annuity starting date), X will begin equal monthly
distributions for C's life. The amount of each monthly distribution
will be no less than an amount based on the contract's account value
as of the annuity starting date, C's age on that date, and permanent
purchase rate guarantees contained in the contract. From marketing
literature circulated by Y, there is reason to believe that, at any
time before the annuity starting date, C may pledge the contract to
borrow up to $75,000 from Y. Y is acting in concert with X.
(ii) Analysis. Because there is reason to believe that Y, a
person acting in concert with X, is willing to lend money against
C's contract, a loan secured by the contract is available within the
meaning of paragraph (j)(4)(i) of this section. This availability
can significantly reduce the probability that total distributions
under the contract will increase commensurately with C's longevity.
Thus, the contract fails to be described in section
1275(a)(1)(B)(i).
(5) Minimum payout provision--(i) Impact on life contingency. The
existence of a minimum payout provision can significantly reduce the
probability that total distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
Thus, the existence of any minimum payout provision causes the contract
to fail to be described in section 1275(a)(1)(B)(i).
(ii) Definition of minimum payout provision. A minimum payout
provision is a contractual provision (for example, an agreement to make
distributions over a term certain) that provides for one or more
distributions made--
(A) After the terminating death under the contract; or
(B) By reason of the death of any individual (including
distributions triggered by or increased by terminal or chronic illness,
as defined in section 101(g)(1) (A) and (B)).
(iii) Exceptions for certain minimum payouts--(A) Recovery of
consideration paid for the contract. Notwithstanding paragraphs
(j)(2)(i)(A) and (j)(5)(i) of this section, a contract does not fail to
be described in section 1275(a)(1)(B)(i) merely because it provides
that, after the terminating death, there will be one or more
distributions that, in the aggregate, do not exceed the consideration
paid for the contract less total distributions previously made under
the contract.
(B) Payout for one-half of life expectancy. Notwithstanding
paragraphs (j)(2)(i)(A) and (j)(5)(i) of this section, a contract does
not fail to be described in section 1275(a)(1)(B)(i) merely because it
provides that, if the terminating death occurs after the annuity
starting date, distributions under the contract will continue to be
made after the terminating death until a date that is no later than the
halfway date. This exception does not apply unless the amounts
distributed in each contract year will not exceed the amounts that
would have been distributed in that year if the terminating death had
not occurred until the expected date of the terminating death,
determined under paragraph (j)(5)(iii)(C) of this section.
(C) Definition of halfway date. For purposes of this paragraph
(j)(5)(iii), the halfway date is the date halfway between the annuity
starting date and the expected date of the terminating death,
determined as of the annuity starting date, with respect to all then-
surviving annuitants. The expected date of the terminating death must
be determined by reference to the applicable mortality table prescribed
under section 417(e)(3)(A)(ii)(I).
(iv) Examples. The following examples illustrate the rules of this
paragraph (j)(5):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to D
for cash. The contract provides that, effective on any date D
chooses (the annuity starting date), X will begin equal monthly
distributions for the greater of D's life or 10 years, regardless of
D's age as of the annuity starting date. The amount of each monthly
distribution will be no less than an amount based on the contract's
account value as of the annuity starting date, D's age on that date,
and permanent purchase rate guarantees contained in the contract.
(ii) Analysis. A minimum payout provision exists because, if D
dies within 10 years of the annuity starting date, one or more
distributions will be made after D's death. The minimum payout
provision does not qualify for the exception in paragraph
(j)(5)(iii)(B) of this section because D may defer the annuity
starting date until his remaining life expectancy is less than 20
years. If, on the annuity starting date, D's life expectancy is less
than 20 years, the minimum payout period (10 years) will last beyond
the halfway date. The minimum payout provision, therefore, can
significantly reduce the probability that total distributions under
the contract will increase commensurately with D's longevity. Thus,
the contract fails to be described in section 1275(a)(1)(B)(i).
Example 2. (i) Facts. The facts are the same as in Example 1 of
this paragraph (j)(5)(iv) except that the monthly distributions will
last for the greater of D's life or a term certain. D may choose the
length of the term certain subject to the restriction that, on the
annuity starting date, the term certain must not exceed one-half of
D's life expectancy as of the annuity starting date. The contract
also does not provide for any adjustment in the amount of
distributions by reason of the death of D or any other individual,
except for a refund of D's aggregate premium payments less the sum
of all prior distributions under the contract.
(ii) Analysis. The minimum payout provision qualifies for the
exception in paragraph (j)(5)(iii)(B) of this section because
distributions under the minimum payout provision will not continue
past the halfway date and the contract does not provide for any
adjustments in the amount of distributions by reason of the death of
D or any other individual, other than a guaranteed death benefit
described in paragraph (j)(5)(iii)(A) of this section. Accordingly,
the existence of this minimum payout provision does not prevent the
contract from being described in section 1275(a)(1)(B)(i).
(6) Maximum payout provision--(i) Impact on life contingency. The
existence of a maximum payout provision can significantly reduce the
probability that total distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
Thus, the existence of any maximum payout provision causes the contract
to fail to be described in section 1275(a)(1)(B)(i).
(ii) Definition of maximum payout provision. A maximum payout
provision is a contractual provision that provides that no
distributions under the contract may be made after some date (the
termination date), even if the terminating death has not yet occurred.
(iii) Exception. Notwithstanding paragraphs (j)(2)(i)(A) and
(j)(6)(i) of this section, an annuity contract does not fail to be
described in section 1275(a)(1)(B)(i) merely because the contract
contains a maximum payout provision, provided that the period of time
from the annuity starting date to the termination date is at least
twice as long as the period of time from the annuity starting date to
the expected date of the terminating death, determined as of the
annuity starting date, with respect to all then-surviving annuitants.
The expected date of the terminating death must be determined by
reference to the applicable mortality table prescribed under section
417(e)(3)(A)(ii)(I).
(iv) Example. The following example illustrates the rules of this
paragraph (j)(6):
[[Page 1059]]
Example. (i) Facts. On March 1, 1998, X issues a contract to E
for cash. The contract provides that beginning on April 1, 1998, X
will distribute to E a fixed amount of cash each month for E's life
but that no distributions will be made after April 1, 2018. On April
1, 1998, E's life expectancy is 9 years.
(ii) Analysis. A maximum payout provision exists because if E
survives beyond April 1, 2018, E will receive no further
distributions under the contract. The period of time from the
annuity starting date (April 1, 1998) to the termination date (April
1, 2018) is 20 years. Because this 20-year period is more than twice
as long as E's life expectancy on April 1, 1998, the maximum payout
provision qualifies for the exception in paragraph (j)(6)(iii) of
this section. Accordingly, the existence of this maximum payout
provision does not prevent the contract from being described in
section 1275(a)(1)(B)(i).
(7) Decreasing payout provision--(i) General rule. If the amount of
distributions during any contract year (other than the last year during
which distributions are made) may be less than the amount of
distributions during the preceding year, this possibility can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). Thus, the existence of this possibility
causes the contract to fail to be described in section
1275(a)(1)(B)(i).
(ii) Exception for certain variable distributions. Notwithstanding
paragraph (j)(7)(i) of this section, if an annuity contract provides
that the amount of each distribution must increase and decrease in
accordance with investment experience, cost of living indices, or
similar fluctuating criteria, then the possibility that the amount of a
distribution may decrease for this reason does not significantly reduce
the probability that the distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
(iii) Examples. The following examples illustrate the rules of this
paragraph (j)(7):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to F
for $100,000. The contract provides that beginning on March 1, 1999,
X will make distributions to F each year until F's death. Prior to
March 1, 2009, distributions are to be made at a rate of $12,000 per
year. Beginning on March 1, 2009, distributions are to be made at a
rate of $3,000 per year.
(ii) Analysis. If F is alive in 2009, the amount distributed in
2009 ($3,000) will be less than the amount distributed in 2008
($12,000). The exception in paragraph (j)(7)(ii) of this section
does not apply. The decrease in the amount of any distributions made
on or after March 1, 2009, can significantly reduce the probability
that total distributions under the contract will increase
commensurately with F's longevity. Thus, the contract fails to be
described in section 1275(a)(1)(B)(i).
Example 2. (i) Facts. On March 1, 1998, X issues a contract to G
for cash. The contract provides that, effective on any date G
chooses (the annuity starting date), X will begin monthly
distributions to G for G's life. Prior to the annuity starting date,
the account value of the contract reflects the investment return,
including changes in the market value, of an identifiable pool of
assets. When G chooses the annuity starting date, G must also choose
whether the distributions are to be fixed or variable. If fixed, the
amount of each monthly distribution will remain constant at an
amount that is no less than an amount based on the contract's
account value as of the annuity starting date, G's age on that date,
and permanent purchase rate guarantees contained in the contract. If
variable, the monthly distributions will fluctuate to reflect the
investment return, including changes in the market value, of the
pool of assets. The monthly distributions under the contract will
not otherwise decline from year to year.
(ii) Analysis. Because the only possible year-to-year declines
in annuity distributions are described in paragraph (j)(7)(ii) of
this section, the possibility that the amount of distributions may
decline from the previous year does not reduce the probability that
total distributions under the contract will increase commensurately
with G's longevity. Thus, the potential fluctuation in the annuity
distributions does not cause the contract to fail to be described in
section 1275(a)(1)(B)(i).
(8) Effective dates--(i) In general. Except as provided in
paragraph (j)(8) (ii) and (iii) of this section, this paragraph (j) is
applicable for interest accruals on or after February 9, 1998 on
annuity contracts held on or after February 9, 1998.
(ii) Grandfathered contracts. This paragraph (j) does not apply to
an annuity contract that was purchased before April 7, 1995. For
purposes of this paragraph (j)(8), if any additional investment in such
a contract is made on or after April 7, 1995, and the additional
investment is not required to be made under a binding contractual
obligation that was entered into before April 7, 1995, then the
additional investment is treated as the purchase of a contract after
April 7, 1995.
(iii) Contracts consistent with the provisions of FI-33-94,
published at 1995-1 C.B. 920. See Sec. 601.601(d)(2)(ii)(b) of this
chapter. This paragraph (j) does not apply to a contract purchased on
or after April 7, 1995, and before February 9, 1998, if all payments
under the contract are periodic payments that are made at least
annually for the life (or lives) of one or more individuals, do not
increase at any time during the term of the contract, and are part of a
series of distributions that begins within one year of the date of the
initial investment in the contract. An annuity contract that is
otherwise described in the preceding sentence does not fail to be
described therein merely because it also provides for a payment (or
payments) made by reason of the death of one or more individuals.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
Approved: December 19, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 98-20 Filed 1-7-98; 8:45 am]
BILLING CODE 4830-01-U
