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Session B-4, Thursday November 1, 2012, 4:30pm-5:30pm
New Generation Products and Tax Logic –
Burning Witches or Predicable Guidance?
Tom Ronce (Moderator), Pacific Life Insurance Company
Bryan Keene, Davis & Harman LLP
Kim Lunn, Allstate Insurance Company
Overview
Trends in Products & Guidance
Guidance on Newer Multi-Purpose Products
Recent Guidance on “Investor Control”
Logic of Guidance on Trust-Held Annuities
New Uncertainty for Life Policy Loan Defaults
Insurance Tax Conference 2012, Session B-4
2
Trends in
Products & Guidance
Insurance Tax Conference 2012, Session B-4
3
Trends …
Managing investment risk
Index annuities & guarantees in general
Managing longevity risk (and investment risk)
GLWBs, CDAs, longevity insurance
Multi-purpose products
LTC combo products, life & annuity riders addressing plethora of risks
IRS guidance
Statutory changes that drive product trends & vice versa (e.g., §§ 72(s), 7702B)
Fewer published rulings in recent years
Regulations even harder to come by
More PLRs … predicable guidance or burning witches?
Insurance Tax Conference 2012, Session B-4
4
Guidance on Newer
Multi-Purpose Products
Insurance Tax Conference 2012, Session B-4
5
Multi-Purpose Products
Types of products
GLWBs & other guaranteed benefits on VAs & life insurance
CDAs or “unbundled” VAs
Longevity insurance
LTC combinations (life & annuity)
Various other riders for life & annuity products:
Nursing home benefits
Critical illness
Unemployment
Future innovations?
Insurance Tax Conference 2012, Session B-4
6
Multi-Purpose Products (cont.)
Guidance
Some statutory (LTC combinations, chronic illness ADBs)
Some regulatory (longevity insurance in qualified plans)
Otherwise, mainly PLRs
The problem w/ PLRs (other than ones you get yourself):
Redactions can make facts hard to discern
Don’t get as much review / scrutiny within IRS
Can be inconsistent or use questionable logic
Generally can’t rely on them (except “substantial authority”)
Insurance Tax Conference 2012, Session B-4
7
Multi-Purpose Products (cont.)
Is there a common analytical framework?
State law treatment as starting point?
Is the additional benefit a separate contract for state law purposes?
Does the state law answer also control for tax purposes?
When does Congress need to weigh in to say “separate contract?”
Negative inference if Congress has weighed in for X, but not Y?
Do you want separate contract treatment or integrated treatment?
Insurance Tax Conference 2012, Session B-4
8
Multi-Purpose Products (cont.)
Resources:
GLWBs/GMWBs/CDAs/Longevity
PLRs 201117013, 201117012, 201105005, 201105004, 201046008, 201001016,
200949036, 200949007, 200939018
QLACs: Prop Reg. 1.401(a)(9)-5 and 1.401(a)(9)-6 (REG-115809-11, 2/2/12)
LTC combinations (life & annuity)
PLRs 201213016, 201105001, 200919011
Various others:
Wellness Riders: PLRs 201105027, 201105026, 200906001
Critical illness/Disability: PLRs 200903001, 200339016 200339015
Unemployment : PLRs 201117013, 201117012
Insurance Tax Conference 2012, Session B-4
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Recent Guidance
on “Investor Control”
Insurance Tax Conference 2012, Session B-4
10
PLR 201235001
Two types of group annuities involved:
Pension plan contracts (qualified)
Non-pension plan contracts (non-qualified)
Based on same separate account
Direct & indirect holdings in real estate
Some held through disregarded entities
Proposed restructuring of separate account
Get more $ into portfolio via general public investing
Insurance Tax Conference 2012, Session B-4
11
PLR 201235001 (cont.)
Current Structure New Structure
Pension Non-Pension Pension Non-Pension General
Contracts Contracts Contracts Contracts Public
Separate Account Separate Account 1 Separate Account 2**
Disregard 1 Disregard 1 NewCo
* The Separate Account will transfer
Disregard 2 Disregard 2 "substantially all" of its Direct Holdings to
Disregard 1, which will then transfer them to
Disregard 2.
** Separate Account 2 will be established
only if any Non-Pension Contracts remain in
Some*
Direct Real estate Real estate force as of the restructuring date. NewCo will
Direct
Holdings assets assets be established and offer interests to the
Holdings
general public irrespective of whether
Separate Account 2 is established.
Insurance Tax Conference 2012, Session B-4
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PLR 201235001 (cont.)
Other key facts:
Non-Pension Contracts amended:
SA-2 became the only investment option under the contracts
Manager must invest all SA-2 $$ in NewCo (i.e., Disregard 1)
Pension contracts not amended in this manner
LICO “not required to invest future money … in Disregard 1 or any other particular asset, and
has not promised the Pension Contract owners that it will do so.”
“Good” reps made for Pension Contracts only
Policyholders have no legal / equitable / direct / indirect ownership
LICO / manager cannot solicit input from policyholders
Access to SA-1 available exclusively through variable contracts
These reps not made for Non-Pension Contracts post-restructuring
Insurance Tax Conference 2012, Session B-4
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PLR 201235001 (cont.)
Conclusions:
Pension contracts respected under investor control doctrine
LICO owns separate account assets supporting contracts
Reason: manager retained discretion
Non-pension contracts disregarded
Policyholders own separate account assets supporting contracts
Reason: “Through Separate Account 2 the Non-Pension Contract owners
hold interests only in NewCo, the interests of which are available for
purchase by the general public.”
Insurance Tax Conference 2012, Session B-4
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PLR 201235001 (cont.)
Questions:
Rev. Proc. 99-44?
Does the investor control doctrine apply to pension contracts or not?
Why would tax-exempt pension contract owners care? UBIT?
Death to the clone issue?
Is “discretion” all you need to avoid being deemed publicly available?
Taxable annuities?
Is intentionally “failing” investor control to get ownership treatment OK?
Does investor control always trump 817(h)? Where’s the line?
Are the “failed” contracts like CDAs, without the contingency?
Why would non-pension contract owners want their contracts taxable?
Insurance Tax Conference 2012, Session B-4
15
PLR 201240018
Deferred, non-qualified annuities
Variable & “New” Investment Options
The variable investment options
Meet requirements of § 817(d) (definition of variable contract)
Assets held in a separate account (SA-1)
Returns directly reflect investment return & market value of SA-1
Insurance Tax Conference 2012, Session B-4
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PLR 201240018 (cont.)
The New Investment Options (NIOs)
Linked to specified indexes
Returns formula-based; reflect index changes over stated duration
“SIV” formula:
Calculated daily, available for surrender, etc. before certain date
May reflect loss even if referenced index has gain at time of early withdrawal
Loss determined using formula applied to early withdrawals
“SMV” formula:
Return as of specified date if no early withdrawal, surrender, etc.
Reflects return on referenced index, subject to certain adjustments
Examples in PLR suggest adjustments limit potential for gain & risk of loss
Insurance Tax Conference 2012, Session B-4
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PLR 201240018 (cont.)
The NIOs (cont.)
Insurer holds assets in general account & separate account (SA-2)
But returns always formulaic
If investments outperform formula, insurer keeps excess
If investments underperform formula, insurer makes up difference
Types of assets supporting obligations
Insurer not obligated to invest in any specific assets
Contract owner has no input
Insurance Tax Conference 2012, Session B-4
18
PLR 201240018 (cont.)
IRS Statement of Law
Focuses more on legal underpinnings of investor control doctrine
“Benefits and burdens” or “incidence” of ownership
Discussion of criteria identified in general tax authorities:
Legal title; rights of possession; burden of taxes & other costs; risk of loss;
benefit of profits; accounting treatment
Sums up published rulings as finding problem where:
Holder exercises sufficient control over assets to be deemed the owner, OR
Assets are not available exclusively through purchase of insurance product
Insurance Tax Conference 2012, Session B-4
19
PLR 201240018 (cont.)
IRS Conclusion
Insurer = owner of assets supporting NIOs
IRS Analysis
All six of the cited “benefits & burdens” line up for insurer
Contract owners have no control over the assets
Contract owners not investing directly in the linked indexes
Returns available only through the contract & not outside it
Returns formula-based & independent of insurer’s actual returns
Insurance Tax Conference 2012, Session B-4
20
PLR 201240018 (cont.)
No ruling requested / opinion expressed …
Whether NIOs are fixed or variable contracts under § 817(d)
Whether SA-2 is a “segregated” account under § 817(d)(1)
Regarding treatment of NIOs under any other Sub-L provisions
Questions / observations
Investor control applies to index annuities?
Helpful way to think of investor control:
Control is key b/c variable products already have “two strikes” under general
tax ownership principles – risk of loss & benefit of gain
Insurance Tax Conference 2012, Session B-4
21
Logic of Guidance
on Trust-Held Annuities
Insurance Tax Conference 2012, Session B-4
22
Trust-Held Annuities
Background
Sec. 72(u)
Annuity held by non-natural person is taxable
Exception if held as “agent” for natural person
Sec. 72(e)(4)(C)
If “individual” transfers annuity w/out full consideration, it is taxable
Sec. 72(s)
Certain distributions required upon death of any “holder”
If non-natural holder, rules apply upon death or change in “primary annuitant”
Insurance Tax Conference 2012, Session B-4
23
Trust-Held Annuities (cont.)
PLR 201124008
Facts
Non-grantor-trust with 6 natural-person beneficiaries
Trust purchases 6 NQ annuities, trust benes = annuitants
At termination, trust transfers contracts to benes w/out consideration
Each bene will receive the annuity for which he/she is the annuitant
Don’t know what trust required if bene predeceased trust termination
Insurance Tax Conference 2012, Session B-4
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Trust-Held Annuities (cont.)
NON-GRANTOR TRUST*
Deferred Annuity A Deferred Annuity C
Annuitant = Bene A Annuitant = Bene C
Deferred Annuity B
Annuitant = Bene B
Bene A Bene B Bene C
Insurance Tax Conference 2012, Session B-4
Trust-Held Annuities (cont.)
Prior rulings
Non-grantor trust owns annuity(ies) that satisfy 72(s)
All trust beneficiaries (including contingent) are natural persons
72(u)(1):
Trust ownership interest is nominal cf. to benes’ ownership interests
Therefore, annuity held by natural person for purposes of 72(u)(1)
72(e)(4)(C):
Distributing contract to bene ≠ transfer w/out consideration
“because the trust is not an individual for purposes of section 72(e)(4)(C).”
PLR200626034, PLR200449017, PLR199933033, PLR199905015,
PLR9810015, PLR9752035, PLR9204014, PLR9204010
Insurance Tax Conference 2012, Session B-4
26
Trust-Held Annuities (cont.)
PLR 201124008: Ruling #1 re: 72(u)(1)
All the beneficial interests of the trust are owned by natural
persons “in a non-employment context”
Therefore, the contracts will be treated as owned by a natural
person for purposes of 72(u)(1)
Insurance Tax Conference 2012, Session B-4
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Trust-Held Annuities (cont.)
PLR 201124008: Ruling #2 re: 72(e)(4)(C)
“The Transfer of the contracts from the trust to the Beneficiary does not have
the effect of avoiding the required distribution rules of §72(s): the annuitant is
not changed. Accordingly, the distribution of the contracts from Trust to
Beneficiaries will not be treated as an assignment of an annuity contract
without full and adequate consideration under §72(e)(4)(C).”
“Without the clarification treating gratuitous transfers of annuity contracts as
assignments, the required distribution rules adopted in the 1984 Act could be
avoided easily because they would allow taxpayers to continue tax deferral
beyond the life of an individual taxpayer.” S. Rep. No. 99-313, at 994.
Insurance Tax Conference 2012, Session B-4
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Trust-Held Annuities (cont.)
Sound result for these facts, but what about the logic?
72(e)(4)(C) applies to “individual who holds an annuity” and transfers it
Earlier PLRs said 72(e)(4)(C) n/a if holder is not “individual”
Contract “held” by “individual” for 72(e)(4)(C) if “held” by natural
person for 72(u)?
But this is illogical & inconsistent, right?
Mixing up rules for natural & non-natural holders
Ruling wants to treat contract as held by natural person for 72(e)(4)(C)
but then justifies result by referencing 72(s) rule for non-natural holders
Seems unnecessary -- 72(e)(4)(C) and 72(s)(6) address concern re: 72(s)
avoidance by natural and non-natural holders, respectively
Insurance Tax Conference 2012, Session B-4
29
Trust-Held Annuities (cont.)
So what’s the big deal if the end result was right?
Questionable logic can leak through to other contexts
For example:
Sec. 72(e)(4)(A)
Loans, assignments & pledges received by “individual” are taxable
For non-natural persons, too, if § 72(u) exception applies?
Sec. 72(s)
Non-grantor-trust where § 72(u) exception applies: does 72(s) apply upon the death
of the trust beneficiary or upon the death / change of the primary annuitant?
Makes a difference if they are different people
Trust taxation and administration
Insurance Tax Conference 2012, Session B-4
30
Trust-Held Annuities (cont.)
GRANDPARENT’S NON-GRANTOR TRUST
Def. Annuity B
Def. Annuity A Annuitant = Grandchild B Def. Annuity C
Annuitant = Grandchild A Value = $100k Annuitant = Grandchild C
Value = $100k IVC = $25k Value = $100k
IVC = $25k IVC = $25k
Child A Child B Child C
• Trust Provision: Trustee can make distributions of income or principal to Child
A, B, or C, per an ascertainable standard. Deceased beneficiary’s share will be
held for benefit of grandchildren, per stirpes.
Insurance Tax Conference 2012, Session B-4
31
New Uncertainty for
Life Policy Loan Defaults?
Insurance Tax Conference 2012, Session B-4
32
Moore v. Commissioner
Taxpayer bought policy in 1975
Participating whole life w/ $20K face
Elected auto-loan provision to pay any late premiums
Paid about 2 years of premiums ($472) before stopping
Carrier kept policy in force for 30+ years w/ policy loans
Court said “unclear from the record” how this could have been
In 2008, carrier informed owner that policy in default
$253 cash value applied to purchase extended term coverage
Told owner $17,941 was taxable for prior policy loans offset in default
Seems to have added at least some of the loaned premiums and subtracted
dividends earned when calculating investment in the contract
Insurance Tax Conference 2012, Session B-4
33
Moore v. Commissioner (cont.)
IRS argument
Policy lapsed in 2008 when cash value insufficient to support
more policy loans under auto-loan provision
Deemed distribution of cash value (including loan value), which
taxpayer was then deemed to use to repay the loan
Taxpayer argument
Nonforfeiture provision trumped auto-loan provision
Abandoned policy in 1977 after stopped paying premiums
Policy terminated well before 2008
Insurance Tax Conference 2012, Session B-4
34
Moore v. Commissioner (cont.)
Court analysis
Normally, loan offset is taxable as IRS argues, but …
Record did not support policy continuing in force for 30+ years
If premium not paid w/in grace period, policy terminates (nonforfeiture)
Loans processed after grace periods, so policy should have terminated
Once policy terminates, owner must take affirmative action to reinstate
Owner didn’t take any such action
Court refused to “construct a multitude of inferences” in IRS favor &
“simultaneously turn a blind eye” to “unexplained discrepancies” in record
Concluded that policy should have terminated prior to 2008
Presumably in a tax year that is now closed by the statute of limitations
Insurance Tax Conference 2012, Session B-4
35
Moore v. Commissioner (cont.)
Observations
Policy terminated even though carrier said it didn’t
Presumably carrier would have felt obligated to pay death benefit, even if it
was a mistake to keep in force for so long
Presumably carrier felt obligated to tax report the gain it calculated in 2008
Policy terminated even though owner received statements
Carrier sent letters at least between 2005-2010
Letters described policy as in force via policy loans & gave lapse notice
Owner thought letters were advertisements
Dividends subtracted from investment in the contract
Distributed to owner? If so, still ignorant of policy being in force?
Insurance Tax Conference 2012, Session B-4
36
Questions?
ABA Joint Fall CLE Meeting 2012
37
