Rev. Rul. 79-335

ISSUE

The Internal Revenue Service has reconsidered its position in Rev. Rul. 70-143, 1970-1 C.B. 167, regarding a beneficiary's basis in the right to the accumulated value under a deferred variable annuity contract.

FACTS

An individual purchased from an insurance company a contract that provides for a variable annuity. The contract was a customary deferred variable annuity contract, which permitted the contract owner to elect for the designated annuitant one of several typical variable annuity installment options, including a simple variable life annuity, a variable life annuity with a specified number of guaranteed installments, and a joint and survivor variable life annuity.

The owner is credited at the date of purchase of the variable annuity contract with accumulation units that represent the owner's proportionate interest in an accumulation fund on the basis of the value of accumulation units as of the valuation date applicable to the owner's payment. The accumulation units fluctuate in value as the accumulation fund fluctuates in value.

The accumulation fund, which is managed by the insurance company, consists of assets purchased by the insurance company and held for the exclusive benefit of the owners (and their beneficiaries) of variable annuity contracts issued by the insurance company. The fund is registered with the Securities and Exchange Commission as a diversified open-end investment company.

Under the terms of the annuity contract, upon surrender of the contract, a cash redemption value is payable to an owner-annuitant upon proper application at any time prior to the annuity starting date. The cash redemption value payable is determined by multiplying the number of accumulation units held to the credit of the contract by the current value of each accumulation unit at the time of redemption.

In the event of the contract owner's death prior to the first annuity payment under the contract, the named beneficiary (or the owner's estate if the beneficiary predeceases the owner) has the right to surrender the contract for the then value of the owner's interest in the insurance company's accumulation fund (in a lump-sum), unless one of the beneficiary settlement options has been selected by the owner-annuitant in accordance with the terms of the contract. If no such beneficiary settlement option has been selected, the beneficiary may elect, in lieu of that one lump-sum payment, to receive the accumulated value of the contract either in the form of a simple variable life annuity or a variable life annuity with a specified number of guaranteed payments.

LAW AND ANALYSIS

Section 1014(a) of the Internal Revenue Code provides that the basis of property in the hands of a person acquiring the property from a decedent is the fair market value of the property at the date of the decedent's death or, if the decedent's executor so elects, at the alternate valuation date prescribed in section 2032.

Section 1014(b)(9) of the Code provides, in the case of persons dying after December 31, 1953, that property acquired from the decedent by reason of death, form of ownership, or other conditions (if by reason thereof the property is required to be included in determining the value of the decedent's gross estate) shall, for purposes of section 1014(a), be considered to have been acquired from or to have passed from the decedent. However, section 1014(b)(9)(A) provides that the foregoing provisions shall not apply to annuities described in section 72.

In general, section 72 of the Code deals with the tax treatment of annuities. Section 72(e) determines the amounts or portions of amounts to be included in gross income when such amounts are not paid as an annuity, but are nevertheless received under or in discharge of a contract involving amounts payable as annuities.

Section 1.72-1(a) of the Income Tax Regulations provides that section 72 of the Code prescribes rules relating to the inclusion in gross income of amounts received under a life insurance, endowment, or annuity contract unless such amounts are specifically excluded from gross income under other provisions of chapter 1 of the Code. In general, these rules provide that amounts subject to the provisions of section 72 are includible in the gross income of the recipient except to the extent that they are considered to represent a reduction or return of premiums or other consideration paid.

Section 1.72-1(b) of the regulations provides that, for the purpose of determining the extent to which amounts received represent a reduction or return of premiums or other consideration paid, the provisions of section 72 of the Code distinguish between "amounts received as an annuity" and "amounts not received as an annuity." In general, "amounts received as an annuity" are amounts that are payable at regular intervals over a period of more than one full year from the date on which they are deemed to begin, provided the total of the amount so payable or the period for which they are to be paid can be determined as of that date. See section 1.72-2(b)(2) and (3). Any other amounts to which the provisions of section 72 apply are considered to be "amounts not received as an annuity." See section 1.72-11.

Section 1.72-2(a)(1) of the regulations provides that the contracts under which amounts paid will be subject to the provisions of section 72 of the Code include contracts that are considered to be life insurance, endowment, and annuity contracts in accordance with the customary practice of life insurance companies. For purposes of section 72, however, it is immaterial whether such contracts are entered into with an insurance company.

Section 1.72-2(b)(1)(i) of the regulations provides that, in general, the amounts to which section 72 of the Code applies are any amounts received under the contracts described in section 1.72-2(a)(1). However, if such amounts are specifically excluded from gross income under other provisions of chapter 1 of the Code, section 72 shall not apply for the purpose of including such amounts in gross income. For example, section 72 does not apply to amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured and are excludable from gross income under section 101(a). See also sections 101(d), relating to proceeds of life insurance paid at a date later than death, and 104(a)(4), relating to compensation for injuries or sickness.

Since the contract in question is considered to be an annuity contract in accordance with the customary practice of life insurance companies, any amount received under any of the available options in the contract (and not specifically excluded from gross income under other provisions of chapter 1 of the Code) is an amount to which section 72 of the Code applies.

Rev. Rul. 70-143 holds, under similar facts, that the right to the accumulated value under the annuity contract is not an annuity described in section 72 of the Code, because it would not be received on or after the annuity starting date.

This conclusion was reached on the basis of section 1.72-2(b)(2) of the regulations, which provides, in part, that amounts subject to section 72 of the Code are considered to be amounts received as an annuity only in the event they are received on or after the "annuity starting date." However, section 72 also applies to amounts not received as an annuity. See section 72(e) and section 1.72-11.

Rev. Rul. 55-313, 1955-1 C.B. 219, concerns a deferred annuity contract that provides that, upon the death of the contract owner prior to the date of the first annuity payment, the issuing insurance company will pay to the beneficiary an amount equal to the consideration paid for the contract or the cash surrender value of the contract upon the death of the owner, whichever is greater. The revenue ruling holds that the excess of the amount of the payment to the beneficiary over the amount of the consideration paid for the contract is includible in the gross income of the beneficiary.

The basis rule prescribed in section 1014(b)(9) of the Code, fair market value at death, pertains to property acquired from the decedent.

In the instant case, the property that will be acquired by the beneficiary is an interest in the benefits provided under the annuity contract. Those benefits accord to the contract owner, or in the event of the owner's death, the named beneficiary, the right to surrender the contract at any time before the annuity starting date and to receive in return an amount equal to the accumulated value under the contract. This right is an option. Upon the death of the owner, several other options under the contract, such as the right to select a variable life annuity, also pass to the beneficiary. The fact that the beneficiary may, after the death of the contract owner, elect to receive a lump-sum payment in return for the accumulated value does not render the property acquired from the decedent an interest in something other than an annuity contract. In general, section 72 of the Code provides extensive rules for determining the extent, if any, to which payments under the various settlement options provided by variable annuity contracts are includible in gross income. Since this variable annuity contract is subject to the provisions of section 72, the exclusion of section 1014(b)(9)(A) applies.

HOLDINGS For purposes of section 1014 of the Code, the deferred variable annuity contract is an annuity described in section 72.

If the beneficiary of the variable annuity contract in this case elects to receive the lump-sum payment under the contract, the excess of the amount received over the amount of the consideration paid for the contract is, as in the case of a straight deferred annuity, includible in the gross income of the beneficiary. See section 72(e) of the Code; and Rev. Rul. 55-313.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 70-143 is revoked.

PROSPECTIVE APPLICATION

Under the authority contained in section 7805(b) of the Code, the conclusion in this revenue ruling will not be applied to deferred variable annuity contracts purchased prior to October 21, 1979, including any contributions applied to such contracts pursuant to a binding commitment entered into before that date. This revenue ruling will apply to all other amounts contributed to deferred variable annuity contracts on or after October 21, 1979.

¹ Also published as News Release IR-2164, dated September 21, 1979.