Internal Revenue Service
Revenue Ruling
Rev. Rul. 77-85
1977-1 C.B. 12
Section 61
Section 72
Section 801
Section 809
Section 7805
IRS Headnote
Investment annuity policy; ownership of assets; income from custodial
accounts. A policyholder of an investment annuity contract issued by a life
insurance company must include in gross income, under section 61 of the
Code, interest and dividends or other income received by the custodian of
the investment account created in conjunction with the contract and over
which the policyholder has investment control. An investment account
created under contracts entered into after March 9, 1977, will not be
treated as a segregated asset account of the insurance company under
section 801(g)(1); investment accounts created under contracts entered into
before March 10, 1977, will be treated as segregated asset accounts subject
to certain conditions.
Full Text
Rev. Rul. 77-85 [fn1]
Advice has been requested regarding the Federal income tax consequences of
an annuity arrangement involving a custodial account, as described below.
Specifically, advice has been requested whether the subject custodial
account is a segregated asset account for purposes of section 801(g)(1)(B)
of the Internal Revenue Code of 1954. The use of the terms "annuity",
"policy" and "purchase" in this ruling is for descriptive convenience only
and is not intended to have any substantive legal effect.
The custodial account is created by agreement among a policyholder, an
insurance company and a custodian in conjunction with the purchase of an
investment annuity policy by the policyholder from the insurance company.
Upon purchase of the investment annuity policy, the policyholder deposits
an initial amount of at least a specified minimum with the custodian. At
any time before the annuity starting date, the policyholder may make
additional payments into the account in amounts equal to a specified
minimum. These additional payments permit the purchase of increased
benefits under the investment annuity policy. The initial and subsequent
payments may be made either in cash or by transfer of securities or other
assets that are on an approved list as modified from time to time by the
insurance company.
The custodian acts on behalf of the policyholder and the insurance company
in accordance with the terms of the agreement and performs certain limited
administrative functions (such as payment of scheduled premiums). The
amounts in the account are invested by the custodian in accordance with the
directions of the policyholder, but with the limitation that the
investments selected by the policyholder must be selected from the approved
list. In some cases the list includes publicly traded securities, while in
other cases the list is restricted to Federally insured bank deposit
instruments. The policyholder may direct the custodian in writing at any
time, and from time to time, to sell, purchase or exchange securities or
other assets held in the custodial account, and to invest and reinvest
principal and income. The policyholder may direct the custodian as to what
action to take with respect to the voting of securities held in the account
or the exercise of any other right or option relating to assets of the type
held in the account.
The policyholder may not receive any amount directly from the account and
may not receive a distribution of assets in kind. At any time prior to the
annuity starting date, however, the policyholder may make a full or partial
surrender of the policy to the insurance company. If such a surrender is
made, the custodian is directed by the agreement to sell all or part of the
assets as appropriate and to pay over the necessary proceeds to the
insurance company. The insurance company in turn will make the full or
partial cash surrender payment to the policyholder in an amount equal to
the proceeds received by the insurance company from the account, less the
amount of any cash surrender charges. If the policyholder dies prior to the
annuity starting date, the balance of the account is liquidated by the
custodian and paid over to the insurance company. The insurance company
will then pay these proceeds, less applicable charges, to the
policyholder's designated beneficiary in a lump sum or such other
settlement option as may be selected.
Once the policyholder has attained a specified age, or at an earlier or
later age as elected by the policyholder, monthly payments will begin under
the terms of the settlement option selected. The monthly payments will
commence upon the first day of the first month following the attainment of
such age or the making of such an election. The commencement of these
payments is denominated the annuity starting date. The monthly payments for
each one year period ending on the anniversary of the annuity starting date
are funded by an annual premium paid from the account to the insurance
company, from terminal premiums on other similar accounts and, if
necessary, from the general assets of the insurance company. During the
payment period, the custodial account remains subject to the investment
direction of the policyholder. After the annuity starting date, the
policyholder may no longer surrender the policy.
The annual premium is determined as a percentage of the value of the
custodial account on the anniversary of the annuity starting date. The
amount of the monthly payments to the policyholder will reflect the
fluctuating value of the assets in the custodial account because the
monthly payments are determined by reference to the annual premium in
accordance with rates specified in the policy. Upon the policyholder's
death after the annuity starting date, the insurance company will receive
the remaining balance in the account as the terminal premium and the
monthly payments will cease unless the payout option selected by the
policyholder had a guaranteed period or a survivorship feature.
The custodian receives a monthly fee and receives additional fees for each
transaction executed. In addition, the custodian is reimbursed for all
expenses incurred with respect to the account.
The insurance company receives a charge each time a payment is made by the
policyholder to the custodial account. During the period prior to the
annuity starting date, the insurance company also receives an annual market
value premium equal to a specified percentage of the year-end value of the
account. The market value premium compensates the insurance company for its
cost and for its risk assumed in guaranteeing to the policyholder an
annuity rate under the contract. The insurance company is also entitled to
reimbursement for any taxes or charges imposed with respect to the assets
held in the custodial account.
Section 801(g)(1)(B) of the Code defines a "contract with reserves based on
a segregated asset account" as a contract (i) which provides for the
allocation of all or part of the amounts received under the contract to an
account which, pursuant to State law or regulation, is segregated from the
general asset accounts of the company, (ii) which is described in section
805(d)(1) (other than a life, health or accident, property, casualty or
liability insurance contract) or which provides for the payment of
annuities, and (iii) under which the amounts paid in, or the amount paid
out, reflect the investment return and the market value of the segregated
asset account. If a contract ceases to reflect current market value, such
contract shall not be considered as meeting the requirements of clause
(iii) after such cessation.
Section 809(c)(1) of the Code provides, in pertinent part, that the gross
amount of premiums and other consideration on insurance and annuity
contracts shall be taken into account in determining gain or loss from
operations under section 809(b).
Since section 801(g)(1)(B) of the Code defines a contract with reserves
based on a segregated asset account for purposes of determining what
amounts in such accounts are includable in, or excludable from, a life
insurance company's taxable income, the insurance company must be the owner
of the assets in the segregated accounts. Section 801(g)(1)(B) does not
apply to income from assets owned by another person simply because those
assets are set aside by such person to be used eventually to purchase an
annuity from the insurance company.
The facts of the subject annuity arrangement indicate that the individual
policyholder is the owner of the assets in the custodial account for
purposes of taxing the income therefrom. As in the case of a pledge
arrangement, the policyholder possesses significant incidents of ownership
over the assets in the account at all times. The policyholder retains the
power to direct the custodian to sell, purchase or exchange securities, or
other assets held in the custodial account, thereby retaining investment
control over the account. The policyholder is also able to exercise an
owner's right to vote account securities either through the custodian or
personally.
In addition, although the policyholder cannot receive distributions from
the custodial account according to the provisions of the custodian
agreement, through the interaction of that agreement and the annuity
policy, he effectively enjoys the benefit of any income produced by, and
any increase in the value of, the assets in the custodial account, and
bears any loss in the value of such assets. For example, under the annuity
policy in combination with the custodian agreement, the policyholder can in
fact make withdrawals from the custodial account, even to the extent of
closing out the entire account, any time prior to the annuity starting date
chosen in the policy. Also, because on the annuity starting date and
annually thereafter the value of the assets accumulated and retained in the
custodial account will determine the value of the policyholder's annuity,
the policyholder will enjoy any increase or suffer any decrease in the
value of such assets (including the income derived therefrom), which
results from the policyholder's investment efforts through a proportional
increase or decrease in the value of the policyholder's annuity each year.
For example, if, through the policyholder's own investment efforts during
the first year following the annuity starting date, the policyholder
increases the value of the assets in the custodial account on the first
anniversary of the annuity starting date to double the "assumed value" for
that date (the value that would have been produced had the assets in the
account grown at the rate of growth assumed in the premium tables), the
amount of the policyholder's annuity payments for the second year will be
double the "expected amount" (the amount that the policyholder would have
received had the account grown only at the assumed rate of
growth--generally a level amount under the rates of purchase and the
premium charges specified in the contract). In addition, the policyholder's
annuity payments for all of the later years will continue to be double the
"expected amount" so long as the assets in the account on the first
anniversary date (when their value was double the "assumed value") continue
to grow at the assumed rate of growth. If, on the other hand, there is any
decrease in the value of the assets in the account during the year as a
result of the policyholder's investment decisions, the policyholder will
receive a correspondingly smaller annuity the next year (and thereafter, to
the extent such loss is not recouped). Although the insurance company
guarantees the purchase rates for the one-year term annuity at the issuance
of the policy, it does not guarantee the size of the annuity (in either
units or dollars) that the policyholder will receive for any year. That
amount depends solely on the investment results of the individual
policyholder as they are reflected in the value (if any) of the assets in
the custodial account on the annuity starting date and on each anniversary
thereof.
In view of the fact that the policyholder possesses such substantial
incidents of ownership in the assets in the custodial account, such assets
are owned by the policyholder, rather than by the insurance company, for
purposes of section 801(g)(1)(B) of the Code. While section 801(g)(1)(B)
contemplates that particular classes of policyholders will bear the
investment risk with respect to segregated asset accounts of the insurance
company, it does not extend to assets in an investment account over which
an individual policyholder has direct investment control and can exercise
other incidents of ownership that make such person, rather than the
insurance company, the owner of such assets. Under the subject custodial
arrangement, the bundle of rights that the individual policyholder has with
respect to the assets in the custodial account makes such individual the
owner of such assets for Federal income tax purposes. The fact that under
state law such individual does not formally have legal title to such
assets, or that for certain state insurance law purposes such assets are
treated as assets in a separate asset account of an insurance company, is
not controlling for Federal income tax purposes.
In addition, the fact that a custodian is used to hold such assets until
they are transferred to the insurance company does not change the
conclusion that, for Federal income tax purposes, the individual
policyholder, not the insurance company, is the owner of such assets (until
they are transferred to the insurance company). The setting aside of the
assets in the custodial account for the purchase of term annuities is
basically a pledge arrangement. When property is held in escrow or trust
and the income therefrom benefits, or is to be used to satisfy the legal
obligations of, a person who has caused such property, either by action or
inaction, to be held in escrow or trust, such person is deemed to be the
owner thereof, and such income is includible in that person's gross income,
even though that person may never actually receive it. See for example
sections 1.61-13(b), 1.677(a)-1(d), and 1.678(a)-1(b) of the Income Tax
Regulations; and Northern Trust Co. v. United States, 193 F.2d 127 (7th
Cir. 1951), cert. denied, 343 U.S. 956 (1952).
Since the assets in the custodial account are owned by the individual
policyholder, not the insurance company, any interest, dividends and other
income received by the custodian on securities and other assets held in the
custodial accounts are includible in the gross income of the policyholder
under section 61 of the Code for the year in which they are received by the
custodian. No part of such income is subject to exclusion or inclusion
under section 801(g), because the conclusion that such assets are not owned
by the insurance company precludes the custodial account from being treated
as a segregated account under section 801(g)(1)(B).
Furthermore, because the insurance company receives nothing until a portion
of the custodial account is liquidated and remitted to it by the custodian
as either charges or premiums due under the contract, the insurance company
should only include the premiums and charges paid each year in its premium
income for that year under section 809(c)(1) of the Code.
Under the authority of section 7805(b) of the Code, custodial accounts
created pursuant to investment annuity policies entered into between the
insurance company and the policyholder on or before March 9, 1977, will be
treated as though they were segregated asset accounts within the meaning of
section 801(g)(1), if:
(1) there are no contributions to such accounts after March 9, 1977 (other
than employer contributions to qualified employee annuity or other
qualified retirement plans or employer contributions to purchase an annuity
contract under section 403(b), provided such contributions are not
currently taxable to the employee under subchapter D of the Code), and
(2) the account assets are consistently treated as the property of the
insurance company for all purposes under subchapter L of the Code.
[fn1] Also released as News Release IR-1774, dated March 9, 1977.
