Revenue Ruling 84-74: Investor Control Rules for Annuities
Understand how your level of control over an annuity's investments determines whether the contract retains its tax-deferred growth status.
The investor control doctrine is an Internal Revenue Service (IRS) principle for the tax treatment of annuity contracts. It addresses variable annuity contracts where the policyholder retains significant control over the investment decisions of the assets funding the contract. The doctrine establishes a boundary where the policyholder’s influence is so substantial that they are considered the direct owner of the underlying assets for tax purposes.
The Concept of Investor Control
The doctrine’s purpose is to determine the true owner of assets in a variable annuity. If a policyholder has excessive influence over the investment portfolio, the annuity is viewed as a “wrapper” for direct investments, and its favorable tax treatment is disregarded. The main issue is the degree of command the policyholder has over specific assets in the account.
For example, consider an annuity where the holder can direct an investment manager to buy shares of a specific company or sell a particular mutual fund. In this scenario, the policyholder is making day-to-day investment decisions, not just selecting a general strategy. The IRS views this micro-management as equivalent to owning the securities in a brokerage account, crossing the line into direct control.
The doctrine was established through a series of IRS rulings, with Revenue Ruling 81-225 being a key development. It examined arrangements where annuity assets were invested in mutual funds also available for direct purchase by the general public. The IRS determined that if the funds underlying the annuity are publicly available, the policyholder is considered the owner of the assets, and the contract loses its tax-deferred status. For the annuity to be respected for tax purposes, control over individual investment decisions must remain with the insurance company.
Tax Implications of Investor Control
When the IRS determines a policyholder has exercised investor control, the annuity’s tax-deferred growth is lost. All income generated by the underlying assets becomes currently taxable to the policyholder. This includes any dividends, interest, and realized capital gains earned within the account during that tax year.
This tax liability arises regardless of whether the policyholder withdraws money from the annuity. The income is “imputed” to the policyholder, meaning it is treated as if they received it directly. For example, if the assets generate $10,000 in gains and dividends in a year, the policyholder must report that amount on their tax return, even if the funds remain in the annuity.
A variable annuity must also satisfy diversification requirements under Internal Revenue Code Section 817 to maintain its tax-deferred status. These rules support the investor control doctrine by preventing annuities from being used as wrappers for a few public investments. These tests are distinct, and satisfying the diversification rules does not automatically protect a contract from the investor control doctrine.
Permissible Investment Options
In response to the investor control doctrine, the insurance industry developed “insurance-dedicated funds” (IDFs), or variable insurance trusts (VITs). These are investment funds, similar to mutual funds, but are available exclusively through insurance company separate accounts that fund variable annuity and life insurance products. They cannot be purchased directly by the general public.
This structure limits the policyholder’s influence over the investments. The policyholder can allocate premiums among various IDFs offered within the annuity, choosing between a growth-oriented fund, a bond fund, or a balanced fund. However, they cannot influence the specific securities that the IDF manager buys or sells, as investment decisions are left to the fund manager.
The distinction is the separation between choosing a broad investment strategy and directing individual transactions. By limiting the policyholder’s choice to a menu of non-publicly traded funds, the insurance company retains control over the underlying assets. This arrangement allows the annuity to maintain its tax-deferred status and provides policyholders with investment flexibility while adhering to the doctrine.