Revenue Ruling 77-263 and Annuity Tax Implications

An Internal Revenue Service (IRS) Revenue Ruling is a public interpretation of tax law as it applies to a particular set of facts. Revenue Ruling 77-263 is an interpretation that addresses the tax treatment of specific annuity contracts. These arrangements are often referred to as “wrap-around annuities” because of how the assets are held. This ruling clarifies who is considered the owner of the assets within these structures for federal income tax purposes, which has significant consequences for the policyholder.

Factual Scenario in Revenue Ruling 77-263

The situation described in Revenue Ruling 77-263 involved an individual who purchased a contract labeled as an “annuity” from a life insurance company. The funds paid by the policyholder were not held by the insurance company directly. Instead, the money was deposited with a third-party custodian. This custodian held the assets in a separate account that was nominally linked to the insurance company.

This arrangement was distinct from a standard annuity because of the level of control the policyholder retained. The policyholder had the explicit power to direct the custodian to invest the funds in specific assets. In the scenario presented, the policyholder directed the investment into a certificate of deposit (CD) issued by the custodian. Furthermore, the policyholder retained all rights to vote on any shares that might be purchased with the account’s funds, a right typically held by the owner of the asset.

The IRS’s Analysis and Holding

The IRS’s analysis in Revenue Ruling 77-263 centered on the concept of ownership. For an annuity to receive tax-deferred status under the Internal Revenue Code, the insurance company must be the owner of the assets backing the contract. The IRS examined the “incidents of ownership,” which are the rights and powers associated with property, to determine who truly controlled the assets in the custodial account.

The ruling concluded that the policyholder’s ability to direct the investment of the funds into specific financial instruments was a significant incident of ownership. By telling the custodian exactly where to place the money, the policyholder was exercising a level of control inconsistent with the idea that the insurance company owned the assets. The policyholder, not the insurer, was making the substantive investment decisions that would determine the account’s growth.

Because the policyholder retained these substantial rights, the IRS determined that the policyholder had never fully transferred ownership of the funds to the insurance company. The insurance company was viewed as a mere conduit, a pass-through entity for the policyholder’s investment activities. The formal holding of the ruling was clear: for federal income tax purposes, the policyholder, and not the insurance company, is considered the owner of the assets held in the custodial account. The principles established in this ruling laid the groundwork for what is known as the “investor control doctrine,” which the IRS later expanded to address more complex investment arrangements.

Tax Implications for the Policyholder

The direct consequence of the IRS’s holding is the loss of the primary tax advantage of an annuity: tax deferral. Normally, the earnings and gains within an annuity contract are not taxed until the owner begins receiving payments or makes withdrawals. This allows the investment to grow on a tax-deferred basis, which can significantly enhance returns over time.

Under the investor control doctrine, because the policyholder is deemed the owner of the underlying assets, this tax deferral is eliminated. Any interest, dividends, or other income generated by the assets in the account must be included in the policyholder’s gross income for the tax year in which it is earned. For example, the interest earned on the certificate of deposit in the ruling’s scenario would be taxable to the policyholder annually, just as if they owned the CD directly.

The IRS later extended this doctrine to variable annuities. A subsequent ruling determined that if an annuity allows a policyholder to select from publicly available mutual funds, the policyholder is treated as the owner of the fund shares for tax purposes, and tax deferral is lost.

However, the IRS also clarified that not all choice constitutes excessive control. A later ruling established that an annuity allowing a policyholder to allocate funds among several non-publicly available investment options offered by the insurance company does not violate the investor control doctrine. This provides a “safe harbor” for the structure of most modern variable annuities, which offer a menu of proprietary funds. To qualify for tax deferral, these annuity accounts must also meet certain diversification requirements set by the tax code.