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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
  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
                        Trends in
                   Products & Guidance

Insurance Tax Conference 2012, Session B-4
   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
                Guidance on Newer
               Multi-Purpose Products

Insurance Tax Conference 2012, Session B-4
   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
   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
   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
   Multi-Purpose Products (cont.)
      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
                    Recent Guidance
                  on “Investor Control”

Insurance Tax Conference 2012, Session B-4
   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
                          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
 Direct           Real estate                                   Real estate       force as of the restructuring date. NewCo will
Holdings            assets                                        assets          be established and offer interests to the
                                                                                  general public irrespective of whether
                                                                                  Separate Account 2 is established.

Insurance Tax Conference 2012, Session B-4
   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
   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
   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
   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
   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
   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
   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
   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
   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
                  Logic of Guidance
               on Trust-Held Annuities

Insurance Tax Conference 2012, Session B-4
   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
   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
   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
   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
   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
   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
   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
    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
             New Uncertainty for
          Life Policy Loan Defaults?

Insurance Tax Conference 2012, Session B-4
   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
   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
   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
   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

ABA Joint Fall CLE Meeting 2012

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