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Tax Facts Q: 3522. How are the payments under a variable annuity taxed?

* PLR 201120011

The IRS recently released a letter ruling concerning the treatment of payments as annuities from an insurance company, based on annual percentage increases.

The taxpayers, insurance companies, plan to issue nonqualified single premium immediate annuity contracts (the "Contracts"). The Contracts are available in several different forms, including a straight life annuity, a life annuity with a guarantee period, and a life annuity with various types of refund features. In addition, the Contracts can be payable for a single life or for joint lives, and include a cash withdrawal feature and an acceleration feature.

The payments made under the Contracts are generally fixed, level periodic payments, unless a Contract owner selects Option X at the time a Contract is issued. Under the Option, a Contract owner can elect to have the fixed annuity payments increase annually for the life of the Contract by a constant percentage equal to 1, 2, 3, or 4 percent.

The taxpayers requested a ruling from the IRS that the payments made under the Contracts pursuant to Option X are "substantially equal periodic payments" within the meaning of IRC Section 72(q)(2)(D), and could be taxed as such.

The IRS noted that the annual payments under the Contracts with Option X would automatically increase by a fixed percentage over the prior year's payments, rather than increase or decrease based on the account balance and the remaining life expectancy from the chosen table. Thus, the payments under the Contracts with Option X would not be determined using the required minimum distribution method described in Rev. Rul. 2002-62, and Notice 89-25.

The taxpayers argued that the legislative history of the Tax Reform Act of 1986 (H.R. 3838, P.L. 99-514) suggests that a stream of payments under a defined contribution or defined benefit plan will not fail to be substantially equal solely because the payments vary on account of certain cost of living adjustments. See, e.g., S. Rep. No. 99-313, at 615 (1986).

However, the annual increase in payment amounts provided under Option X is at a fixed rate chosen by a Contract owner. Therefore, the IRS held, the series of payments provided under Option X do not vary on account of cost of living adjustments, and thus, payments made under the Contracts pursuant to Option X are not "substantially equal periodic payments" within the meaning of Section 72(q)(2)(D).

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Title Annotation:Monthly Round-up
Publication:Tax Facts Intelligence
Date:Sep 1, 2011
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