Transcript Changes in Taxation of Annuities and Life Insurance George K. Chamberlin, JD Vice President – Financial Strategies FINANCEWARE ® Building Taxation of Annuities and Life Insurance A Look.

Changes in Taxation of Annuities
and Life Insurance
George K. Chamberlin, JD
Vice President – Financial Strategies
FINANCEWARE
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Taxation of Annuities and Life Insurance
A Look at Annuities and Life Insurance
Income earned within annuities and life insurance contracts traditionally is not taxed to
the contract owners at the time it is earned. This treatment is one of the major attractions
of these contracts and why billions of dollars are invested in contracts today.
Insurance and annuity contracts are available in a plethora of types and features,
appealing to investors on all levels. However, these contracts are also subject to a bevy
of legal requirements and constraints and these are often subject to change.
Today, we will discuss how changes in the law applicable to annuities and life insurance
may impact your clients and your advice to them. We will also look at other arguments
and issues related to annuities and life insurance.
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Taxation of Annuities and Life Insurance
Diversification and Investor Control
Section 817 of the Internal Revenue Code provides the basis for the tax-free treatment of
growth within the contract. It provides that the separate account held by the insurance
company for each insurance or annuity contract must be adequately diversified at all
times.
Adequate diversification exists where the underlying assets held by the insurance
company are not assets open to the public. Without public access to the assets, there is
little danger of the public controlling the assets and their performance.
A related consideration – and concern for our clients – is that the investor NOT have
significant control over the investments in the contract. If an investor is deemed to have
control over the investments, the growth in the contract will be taxed each year, losing
the tax deferral that is such an important facet of these contracts.
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Taxation of Annuities and Life Insurance
Requirements for Diversification - 1986
When originally enacted, the regulations applicable to the diversification requirement
provided a look through rule to ownership of assets by a registered investment company
partnership or trust.
»All beneficial interests must be held by insurance companies in segregated accounts
»Interests must be more available only by purchase of a variable contract from an
insurer
Where assets were owned by an unregistered partnership interest:
»The same look through rules applied.
»Except, the regulations did NOT limit beneficial interest to persons purchasing a
variable contract from an insurer, unlike the case with the registered owners.
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Taxation of Annuities and Life Insurance
Proposed New Regulations – July 2003
IRS proposed regulations in response to changing market conditions and new products
»- Public offering of investments in hedge fund wrappers with insurance/annuities
»- Use of these investments to avoid taxes was denominated an abuse
The proposed regulations eliminate qualification of unregistered partnerships as
adequately diversified where the investments are open to the public
In addition, in Revenue Rulings 2003-91 and 2003-92 the IRS:
»Held that the owner of a contract will be considered the owner of the underlying
interests in an unregistered partnership where the investments are open to the public
»The contract owner’s gross income will include any interest, dividends or other
income derived from those partnership interests.
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Taxation of Annuities and Life Insurance
Potential Impact of these Changes
There will be little or no impact on clients who
»- participate in an insurance company hedge fund that is not open to the public.
»- participate in an insurance company hedge fund or other product that is
registered.
»- own contracts with insurers who do NOT offer investments in publicly
available non-registered partnerships.
Where clients are invested in non-qualifying contracts, there are a number of
approaches to take in order to avoid income taxation.
»Withdraw from non-complying arrangements and enter into new, qualifying
contracts.
»Avoid contracts which allow investor control of the underlying investments.
»Cure unqualified investments by achieving adequate diversification.
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Taxation of Annuities and Life Insurance
Exchanges of Insurance and Annuity Contracts
Another attractive option with ownership and tax treatment of life insurance and annuity
contracts is the ability to exchange such contracts without suffering adverse income tax
consequences. This is a provision with which all advisors are familiar.
Section 1035 of the Internal Revenue Code provides that no gain or loss is recognized
when a contract owner exchanges one contract for another. This exchange treatment is
deemed appropriate for “individuals who have merely exchanged one insurance policy for
another better suited to their needs….”
The basis in the contract acquired in the exchange remains the same as the basis held in
the previous contract, decreased by any money received by the taxpayer. If any gain or
loss is in fact recognized, the basis will be adjusted accordingly.
This is a powerful and positive feature for taxpayers since it is extremely flexible in
practice and may be leveraged to the benefit of the taxpayer/owner of these contracts.
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Taxation of Annuities and Life Insurance
Developments – Recent Rulings on Exchanges
The breadth and flexibility available under section 1035 is illustrated by several rulings.
For example, the IRS allowed a taxpayer to complete a tax-free exchange of an existing
annuity for two new annuities in Private Letter Ruling 200243047. The taxpayer acquired
an annuity that provided guaranteed retirement income as well as another, variable
annuity for investment purposes.
The consolidation of two separate annuities, issued by two different insurance companies
but owned by one taxpayer was a qualified Section 1035 exchange in Revenue Ruling
2002-75. In this case, the IRS allowed the taxpayer to assign one annuity to another
insurance company which company deposited the cash surrender value of the first
annuity into a pre-existing annuity contract owned by the same taxpayer.
Similarly, a taxpayer may transfer a portion of the cash surrender value of an existing
annuity for a new, different annuity issued by another insurer. This partial exchange was
approved in Revenue Ruling 2003-76. (But see Notice 2003-51, above).
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Taxation of Annuities and Life Insurance
Recent Changes Affecting Section 1035
In Notice 2003-51, the IRS addressed “the taxation of certain tax-free exchanges of
annuity contracts under” sections 72(e) and 1035 of the Code. The focus of the notice
was on partial exchanges, about which the IRS expressed concern with the potential for
abuse and explored the possibility of promulgating new regulations.
Specifically, the IRS is concerned that the assignment of a portion of the cash surrender
value of an annuity contract to a new contract might be performed to avoid the taxation of
gain in either of the two annuity contracts under section 72(e)(2). The IRS suggests that if
a partial exchange of an annuity contract is followed, within two years, with the surrender
of or distributions from either annuity contract, the transaction is presumed to have been
entered into for purposes of tax avoidance.
Pending new regulations, the IRS will consider each such transaction to determine
whether it is an integrated transaction and therefore subject to taxation as a single
contract. If the taxpayer can establish the intervention of a life event or that the surrender
or distribution was not contemplated at the time of the partial exchange, then the
transaction will not be treated as entered into for purposes of tax avoidance.
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Taxation of Annuities and Life Insurance
Potential Impact of Notice 2003-51
Clients who are considering partial exchanges
»Should be made aware of the heightened IRS scrutiny
»Should consider complete exchanges instead of a partial exchange
»Should plan to avoid surrender or distribution of any annuity involved in a partial
exchange within two years of the exchange
Clients who recently have engaged in partial exchanges
»Should defer surrender or distribution unless required by some life event
»Should prepare to establish that there was no contemplation of surrender or
distribution at time of exchange
Clients who have engaged in partial exchanges AND recent surrender or distribution
»Should prepare to establish that there was no contemplation of surrender or
distribution at time of exchange
»Should support their action by evidence of the occurrence of some life event.
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Taxation of Annuities and Life Insurance
Annuities as an Investment in Qualified Plans
Though the tax deferral associated with annuities is a major reason for their purchase,
should an investor purchase an annuity INSIDE a qualified retirement plan – which
already has the benefit of tax deferral?
»The primary argument is that the additional charges associated with an annuity –
presumably charged in part because of the tax deferral – aren’t justified when the
annuity is held in an already tax-deferred account.
»There are a number of considerations supporting investment in an annuity inside a
qualified plan
»One argument is that the ability to select and use a particular money manager
when an annuity is chosen justifies both the investment within a qualified plan and
the additional charges.
»Another approach is that a particular investment policy for an annuity – with the
money manager staying fully invested – reduces turnover as compared with
mutual funds.
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Taxation of Annuities and Life Insurance
More about Annuities within Qualified Plans
Here are some stronger reasons for including an annuity within a qualified retirement
plan – but these considerations may work only for some clients and only after discussion
with an advisor:
»A guaranteed death benefit associated with an annuity may be substantial and
provide flexibility on the death of the annuitant.
»The down market in recent years makes guaranteed minimum returns in some
annuity contracts seem quite attractive to some investors.
»Payment options, as well as timing of annuitization or liquidation, may be flexible
and appealing to investors.
»Professional management of the assets within the annuity allows the investor to
avoid both the burden and necessity of rebalancing and otherwise handling allocation
issues.
»The costs associated with some annuities may not be greater than those for some
mutual funds, leading investors to accept the costs associated with the annuities.
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Taxation of Annuities and Life Insurance
A note on Split Dollar Insurance
As many of you know, the IRS has issued significant new guidance on the treatment of
split dollar insurance. Final regulations were issued in September, 2003. It is important to
note:
»Clients who are participating in split dollar insurance plans – equity arrangements –
should be aware AND ACT before the December 31, 2003 cutoff date. If they do not
act, they are likely to face taxation of the equity build up if they terminate the
arrangement during their lifetimes.
»Further, clients who are participating in plans granting them rights in the cash value
of the insurance could face immediate taxation on the amount of cash value,
assuming there is no substantial risk of forfeiture.
»On the other hand, clients who participate in arrangements under the loan regime
will probably be in a better situation than those with equity based arrangements.
»This is another planning and advice opportunity for advisors to benefit clients.
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Taxation of Annuities and Life Insurance
Excise Taxes on Foreign Life Insurance
To the extent that foreign insurers cover US citizens, there is an excise tax imposed on
payments made to them under Section 4371 of the Internal Revenue Code. This tax –
currently 1% for life insurance - applies to premiums as well as other payments.
Why is this relevant?
»First, with the popularity of foreign life insurance, and the purchase of very high
coverage, premiums may be in seven figures.
»Second, in order to hold foreign insurance, a US citizen must form an offshore
company or trust to own the policy, even though the citizen is the insured.
»One percent of a million dollars is a significant tax. The added cost may reduce
the attraction of foreign insurance structures.
»The one percent is attracting IRS attention as well, leading to new regulations.
»If the tax is NOT paid, the insured and potentially his or her advisors may be at risk
for not only the excise tax deficiency but a penalty tax.
»Caution is required if any clients own foreign life insurance.
»Note the potential of a conflict of interest between the client and the advisor.
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Taxation of Annuities and Life Insurance
Summary
Life insurance and annuity contracts are very common – and very desirable –
investments. Most of our clients are invested to some extent in these contracts.
Understanding the potential issues involved with these contracts and the changes in the
law and perception of these contracts is important to our ability to provide accurate and
timely advice.
One thing is certain…this area of investment will remain in flux and is not static. There
are new products developed each year and at the same time the IRS moves to address
what it considers to be abuses.
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Taxation of Annuities and Life Insurance
We’ve looked at some of the changes and issues with
the treatment of annuities and life insurance.
Are there any questions?
Thank you,
George Chamberlin
[email protected]
(804) 644-4711 ext. 138
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