Rev. Rul. 81-225
1981-2 C.B. 12, 1981-41 I.R.B. 5.
Internal Revenue Service
Revenue Ruling
GROSS INCOME; EARNINGS; WRAPAROUND ANNUITY CONTRACTS
Published: October 13, 1981
SECTION 61.--GROSS INCOME DEFINED, 26 CFR 1.61-1: Gross income
(Also Sections 72, 403, 408, 801, 7805; 1.72-1, 1.403(a)-1, 1.403(b)-1,
1.408- 3, 1.801-8, 301.7805-1.)
Gross income; earnings; wraparound annuity contracts. Life insurance
companies will not be considered the owners of mutual fund shares that are
held by the companies in connection with 'wraparound annuity' contracts
sold to policyholders. The policyholder is the owner and any earnings and
gains from the shares are included in the gross income of the policyholder.
However, the insurance company is considered to be the owner of mutual fund
shares in a situation in which the investments in the mutual fund shares
are controlled by the insurance company and the mutual fund shares are only
available through the purchase of an annuity from the insurance company.
Rev. Rul. 76-281 amplified.
ISSUE
Will the life insurance company or the policyholder be considered the
owner, for federal income tax purposes, of the mutual fund shares under the
circumstances described below?
FACTS
The terms 'deferred variable annuity' and 'policyholder,' as used in this
revenue ruling, are for descriptive convenience only and are not intended
to have any substantive legal significance.
Situation 1. IC is a life insurance company taxable under section 802 of
the Internal Revenue Code. In states where it is authorized to do so, IC
issues contracts purporting to be deferred variable annuity contracts.
A, an individual, purchased for cash a deferred variable annuity contract
(the 'contract'). The contract contains a number of provisions common to
deferred annuity contracts, including the right of the policyholder to
surrender the contract in part or entirely for cash (subject to a surrender
charge and/or contingent deferred sales load that decreases the longer the
contract is outstanding) and the right, at future dates of the purchaser's
choice, to convert the accumulated values under the contract into a stream
of periodic payments under one of several settlement options.
The net premium received under the contract is allocated solely to IC's
Variable Account 1. Pursuant to state law, Variable Account 1 is organized
as a unit investment trust and is registered under the Investment Company
Act of 1940, as amended.
IC has represented to policyholders that the assets of Variable Account 1
will be invested in SY Fund. XY Fund, whose shares are sold directly to the
general public through registered broker-dealers, is an open-end investment
company (a 'mutual fund') registered as an open-end management company
under the Investment Company Act of 1940, as amended. Although XY Fund has
a stated investment goal, XY's investment discretion has not otherwise been
limited. Existing shareholders of XY Fund may exchange their shares for a
contract without payment of any fee, sales charge or transfer charge. Under
the contract, IC has the right, with approval of the Securities and
Exchange Commission, to substitute another mutual fund for XY Fund if
investment in XY Fund is no longer possible, or if in the judgement of IC
such investment becomes inappropriate. In accordance with the terms of the
contract a purchaser may, in such event, surrender his or her contract.
Z, an investment management firm independent of IC, manages the
investments of XY Fund under an investment advisory and administrative
services contract with the fund.
A has the option to pay additional amounts to IC, which become part of
the consideration for the contract. All distributions received by IC from
the XY Fund are reinvested by IC through the purchase of additional shares
of XY Fund for Variable Account 1, which are allocated to the purchasers of
contracts on a pro rata basis.
IC deducts annually a contract administration fee of $20 from the
contract value of each contract on each contract anniversary prior to the
annuity starting date. In addition, IC deducts an amount, computed on a
daily basis, which is equal on an annual basis to 1.2 percent of the daily
net asset value of Variable Account 1. IC characterizes this fee as
reimbursement for mortality risks and for additional expenses.
In accordance with the Investment Company Act of 1940, as amended, IC
will vote the XY Fund shares held in Variable Account 1 in accordance with
instructions received from policyholders. XY Funds shares held in Variable
Account 1 as to which no timely voting instructions are received will be
voted by IC in proportion to the voting instructions that are timely
received.
Situation 2. The facts are the same as in Situation 1 except that XY Fund
is a mutual fund managed by IC, or an affiliate of IC, pursuant to an
investment advisory and administrative services contract. The shares of XY
Fund are sold to Variable Account 1 and,
as in Situation 1, to the general public.
Situation 3. The facts are the same as in Situation 1 except that
Variable Account 1 consists of 5 sub-accounts, each of which will be
invested solely in the shares of a single, different mutual fund identified
to the contract purchaser. Shares of each of these mutual funds are
offered for sale to the general public. A has the right initially to
designate and periodically to reallocate the cash value under the contract
among the 5 sub-accounts.
Situation 4. The facts are the same as those in Situation 2 except that
the shares are not sold directly to the public but are available only
through the purchase of an annuity contract or by participation in an
investment plan account of the type described in Rev. Rul. 70-525, 1970-2
C.B. 144.
Situation 5. The facts are the same as those in Situation 2 except that
the shares are not sold directly to the general public but are available
only through the purchase of an annuity contract.
LAW AND ANALYSIS
Section 61(a) of the Code provides that gross income means all income
from whatever source derived, including interest.
Rev. Rul. 77-85, 1977-1 C.B. 12, holds that the purchaser of an
'investment' annuity contract, by means of which the purchaser individually
selected and controlled one or more investments in a portfolio comprising a
separate account of the life insurance company issuing the contract, is
considered the owner of the underlying investments for federal income tax
purposes. Similarly, Rev. Rul. 80-274, 1980-2 C.B. 27, holds that the
purchaser of an annuity contract, by means of which the purchaser selected
and controlled specified certificates of deposit issued by a savings and
loan association, is considered the owner of the certificates for federal
income tax purposes. Under the facts of both rulings, the purchasers
possessed sufficient incidents of ownership with respect to the underlying
investments or certificates so that the interest, dividends, or other
income therefrom was held to be includible in gross income of the
purchasers under section 61(a) of the Code; the insurance companies did not
possess incidents of ownership adequate to make them the owners of the
underlying investments or certificates for federal income tax purposes.
In Situations 1, 2, 3, and 4 the policyholder has investment control over
the mutual fund shares and possesses sufficient other incidents of
ownership to be considered the owner of the mutual fund shares for federal
income tax purposes. In each of these situations, the mutual fund shares
are available for purchase not only by the prospective purchaser of the
deferred variable annuity, but also by other members of the general public
either directly (as in Situations 1, 2, and 3) or indirectly (as in
Situation 4). The policyholder's position in each of these situations is
substantially identical to what his or her position would have been had the
mutual fund shares been purchased directly (or indirectly, as in Situation
4). Although a mutual fund's diversified portfolio of securities is
controlled by the manager of the mutual fund and not by the policyholder,
this does not distinguish these situations from Rev. Ruls. 77-85 and 80-274
because the mutual fund themselves are securities the incidents of
ownership of which may be attributed to the policyholder in these
situations. Prior to the annuity starting date IC is, in such
circumstances, little more than a conduit between the policyholders and
their mutual fund shares.
Furthermore, contracts described in Situation 1, 2, 3, and 4 are not
annuity contracts described in section 403(a) or (b) or section 408(b) of
the Code.
In Situation 5, the shares of XY Fund are not separate investment assets;
XY Fund is nothing more than the alter ego of IC. The sole function of XY
Fund is to provide an investment vehicle to allow IC to meet its
obligations under its annuity contracts. This situation is equivalent for
federal income tax purposes to the direct purchase by IC of the underlying
portfolio of assets of XY Fund. IC possesses sufficient incidents of
ownership to be considered the owner of these underlying assets for federal
income tax purposes.
HOLDING
In Situations 1, 2, 3, and 4, prior to the annuity starting date, A, and
not IC, is the owner of the mutual fund shares for federal income tax
purposes and the earnings and/or gains from the shares are thus includible
in the policyholder's gross income under section 61(a) of the Code.
In Situation 5, IC, and not A, is the owner of the shares of XY Fund for
federal income tax purposes.
EFFECT ON OTHER REVENUE RULINGS
Rev. Rul. 76-281, 1976-2 C.B. 206, is hereby amplified.
PROSPECTIVE APPLICATION
In light of the holding in Rev. Rul. 80-274 and pursuant to the authority
contained in section 7805(b) of the Code, payments made into separate
accounts, such as Variable Account 1 (other than in Situation 5) on or
before December 31, 1980, will be treated as though they are paid into a
segregated asset account within the meaning of section 801(g)(1). After
December 31, 1980, except as set forth below with regard to section 403(a)
or (b) or section 408(b) payments made into separate accounts such as
Variable Account 1 (other than in Situation 5) will be treated as payments
to the mutual fund and the policyholder will be treated as the owner of the
mutual fund shares for federal tax purposes.
For gross dividends and other distributions on stock received on account
of shares purchased with payments made by A after December 31, 1980, IC is
a nominee of A in Situations 1, 2, 3, and 4 for purposes of section 6042 of
the Code unless and until IC distributes to A the evidences of ownership of
interests in the mutual fund purchased with payments received after
December 31, 1980. IC must file Forms 1096 and 1087 with the Internal
Revenue Service to report the dividends received from XY as a nominee of A
and furnish A a statement showing those amounts.
Because Rev. Rul. 80-274 did not address section 403(a) or (b) or section
408(b) of the Code, any contract described in
Situations 1, 2, 3, and 4 entered into on or before September 25, 1981,
will be treated as an annuity contract described in those sections if:
(1) the contract was entered into under an arrangement that, without
taking into account the holding or rationale of this revenue ruling, would
have been determined to meet the requirements of section 403(a) or (b) or
section 408(b) of the Code, and
(2) no contributions are made on behalf of any individual who was not
included under the contract on or before September 25, 1981.
Rev. Rul. 81-225, 1981-2 C.B. 12, 1981-41 I.R.B. 5.
