Session 3: Annuity Products Tax Update Session Chair: Bryan Keene Davis & Harman LLP Presenters: Rebecca Baxter IRS Shannon Gamache MassMutual Bryan Keene Davis & Harman LLP
2016 Product Tax Seminar Annuity Product Tax Update September 8, 2016 Bryan Keene (Davis & Harman) Shannon Gamache (MassMutual) Rebecca Baxter (IRS)
Agenda Deferred Income Annuities (DIAs) & Similar Products General tax issues for DIAs Partial annuitization using a DIA rider QLAC update Required Minimum Distributions Partial Annuitizations in QPs v. NQ Taxable Variable Annuity with GLWB Reporting Penalties 2
Disclaimers These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting or tax advice. The views and opinions expressed are solely those of the presenters and not those of Davis & Harman LLP, MassMutual or the Internal Revenue Service.
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Annuity Product Tax Update DIAs & Similar Products 5
DIAs & Similar Products Trend towards retirement products without cash values Deferred income annuities (DIAs) Longevity insurance, including qualifying longevity annuity contracts (QLACs) Idea is that agreeing to forgo access to cash value now increases benefits payable later Cost-effective way for individual to insure against longevity risk DIA & QLAC marketplaces are growing as a result 6
DIAs & Similar Products (cont.) DIAs provide life-contingent annuity payments starting at a specified future date Typically no cash surrender value, which is intended to help increase future benefit amounts Often have return of premium (ROP) death benefit before the annuity starting date Issued in qualified and non-qualified markets The former typically provide payments that start by age 70½ to be RMD compliant, unless satisfy QLAC definition 7
DIAs Aggregation Issues 72(e)(12) aggregation rule All NQ annuity contracts issued in same calendar year by same company (or affiliates) to the same policyholder are treated as a single contract for 72(e) purposes 8
DIAs Aggregation Issues (cont.) 72(e) says if an amount is not received as an annuity before the annuity starting date, it is included in gross income to the extent it does not exceed the excess (if any) of: the cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received, over the investment in the contract at such time. Does the aggregation rule apply to DIAs? If so, how? 9
DIAs Aggregation Example In 2014, an individual purchased the following two annuity contracts from Company X: (1) DIA for single premium of $50,000 (2) Cash Value (CV) Contract for single premium of $50,000 In 2016, the cash value of the CV Contract without regard to surrender charges has grown to $55,000 and the individual takes a $5,000 withdrawal If 72(e)(12) does not apply, the full $5,000 is taxable because the cash value of the CV Contract ($55,000) exceeds the investment in that contract ($50,000) by $5,000 If 72(e)(12) applies, the contracts are treated as a single contract for 72(e): Combined cash value is $55,000 because the DIA has no cash value Combined investment in the contract is $100,000 The aggregate cash value does not exceed the aggregate investment in the contract, so there is no taxable amount for purposes of 72(e) 10
DIAs Aggregation Issues (cont.) Result in example seems contrary to intent of 72(e)(12) Possible alternatives? 1989 legislative history of changes to 72(e)(12) says that aggregation was not intended to apply to immediate annuities (H.R. Conf. Rep. No. 101-386, at 665.) Is a DIA sufficiently like an immediate annuity? It has no cash value and will provide only for annuity payments taxable under section 72(b), except possibly in the case of a lump sum or commutation, features that are common under immediate annuities also Deem a cash value to exist for the DIA? Seems like a difficult argument to sustain In form and substance, there is no cash value; the lack of such a value is critical to the pricing and economics of the product 11
DIAs in a Partial Exchange Partial exchange rules (Rev. Proc. 2011-38) Applies to a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract IRS will not challenge nonrecognition treatment under 1035 if no amount, other than an amount received as an annuity for a period of 10 years or more or during one or more lives, is received under either the original contract or the new contract during the 180 days beginning on the date of the transfer In other cases, IRS warns it may recharacterize the transaction according to its substance, based on general tax principles and all the facts and circumstances 12
DIAs in a Partial Exchange (cont.) DIAs issued in a partial exchange Can a DIA qualify for the life / 10-year payout exception? Does that exception apply if a withdrawal is taken from the original contract w/in 180 days after a partial exchange into a DIA? This latter question seems to exist for any partial exchange into a life annuity, e.g., does the exception apply to a withdrawal taken from the original contract within 180 days of a partial exchange into a life-contingent SPIA? It seems it should, but it s unclear because the guidance says 1035 will apply if no amount, other than an amount received as an annuity for a period of 10 years or more or during one or more lives, is received under either contract within 180 days 13
Annuity Product Tax Update Partial Annuitization w/ DIA Rider 14
PLR 201632004 NQ deferred VA issued with DIA rider Contract: Variable investment options Accumulation Value (AV) and death benefit Can surrender, take withdrawals, apply AV to payout option DIA rider: Works like a typical DIA Life-contingent fixed annuity payments ( DIA Payments ) Start date delayed, potentially many years No withdrawal value or surrender right 15
PLR 201632004 (cont.) Owner transfers AV from Contract to Rider Transfers irrevocable Amount transferred no longer part of the Contract s AV Cannot be accessed via withdrawal, surrender, etc. Each transfer secures future DIA Payments Calculated on transfer date using then-current purchase rates If multiple transfers, all DIA Payments under a Rider will: commence on same date, be paid over the same duration, and have the same annuitant, payment frequency, and period certain 16
PLR 201632004 - Conclusions At the time of each partial transfer of AV to the Rider: A separate contract will be treated as arising for purposes of 72, (see 72(a)(2)(A)) For purposes of 72(b), 72(c) & 72(e) a pro rata portion of the investment in the contract will be apportioned between the Contract and the separate contract that is treated as having arisen by virtue of the transfer (see 72(a)(2)(A)) The pro rata allocation determined as of the transfer date based on the percentage of the AV transferred, and 17
PLR 201632004 Conclusions (cont.) At the time of each partial transfer of AV to the Rider: A separate annuity starting date will be determined with respect to each separate contract that is treated as having arisen by virtue of a transfer from the Contract to the Rider (see 72(a)(2)(C)) 18
PLR 201632004 Additional Conclusions If transfer a portion of the AV to the Rider & then take withdrawal from the remaining AV in the Contract: the withdrawal will be taxable under [ ] 72(e) without regard to the investment in the contract that was allocated to the Rider, i.e., to the separate contract that [ ] 72(a)(2)(A) treated as arising when such transfer was made. If owner makes multiple transfers to the Rider: each subsequent transfer will give rise to a new, separate contract for purposes of 72, and the conclusions listed above will apply to each of the separate contracts that is treated as arising from each partial transfer. 19
PLR 201632004 Observations Resolves circularity in the statute How can you have an amount received as an annuity before you have an amount received as an annuity? Proper treatment of withdrawals If separate contract rule n/a until DIA Payments commence, basis recovery accelerated Aggregation rule does not apply Transfers to Rider not taxable and not partial exchanges Multiple exclusion ratios, but shortcut possible? 20
Annuity Product Tax Update QLAC Update 21
QLAC Update - Background Treas. Reg. 1.401(a)(9)-17 No cash surrender value or continuation benefit allowed Annuity starting date by age 85 Premium limits Limited death benefits allowed, based on complicated rules Allow only a lump sum ROP or life-contingent survivor annuity Subject to significant limits for non-spouses OK to offer lump sum ROP and/or J&S if spouse = sole beneficiary If spouse is not the sole beneficiary: Cannot offer a lump sum ROP with a J&S benefit for the non-spouse Non-spouse beneficiary must be irrevocably elected if J&S benefit is available in the case of the owner s death before the annuity start date Two different MDIB tables apply to impose a percentage cap on the J&S survivor benefits that can be provided to a non-spouse depending on the situation 22
QLAC Update Divorce Issues Divorce & inability to switch to non-spouse death benefit Severe restrictions on types of survivor benefits for non-spouses Post-issuance divorce changes beneficiary s status from spouse to non-spouse Regulations suggest spousal status is re-determined annually for deferred annuities or determined at annuity starting date for annuitizations Payout structure and death benefit are typically established at contract issuance A benefit that complied at contract issuance may not comply following a divorce 23
QLAC Update Rollover Issues Premium limits apply to IRA QLACs based on prior year-end account balance For QPs, rules say to adjust account balance for subsequent contributions, distributions No similar rule for IRA account balances, which might suggest no adjustment allowed Result is that individuals may need to wait until year following rollover to IRA to buy QLAC Plans typically do not offer QLACs directly, so need to roll to IRA to get one 24
Annuity Product Tax Update Required Minimum Distributions 25
RMDs Increasing Payments RMD rules say annuity payments may increase only if certain requirements are met (limit backloading) For commercial annuities, an increasing annuity must pass the minimum income threshold test when payments begin Treas. Reg. 1.401(a)(9)-6, Q&A-14(c) The MITT applies to annuity payments that increase by a constant %, annuities with a cash refund death benefit, participating annuities, and contracts that allow commutations 26
RMDs Increasing Payments (cont.) To pass the MITT, the total future expected payments must exceed total value being annuitized, determined at the annuity start date Total future expected payments must be calculated by ignoring future increases in payments and by using IRS mortality tables Total value being annuitized generally means the premium or the value of the individual s interest in the plan that is being annuitized, determined when annuity payments commence The required assumptions regarding the total future expected payments are creating irrational results due to low interest rates and improved mortality: 27
RMDs Increasing Payments (cont.) Problems under the MITT: Low interest rates drive down the initial payment, which the test assumes will continue as a level payment during the entire annuity term IRS mortality tables reflect shorter life expectancies than insurers actually assume in pricing, and this reduces the sum of the future payments for purposes of the test These problems exist for any increasing annuity and are affecting even fixed level payouts if they have a commutation feature Interest and mortality problems are compounded for QLACs because they start at late ages 28
RMDs Increasing Payments (cont.) Problems for QLACs and other DIAs under the MITT: How do you calculate the total value being annuitized? Regulations say it is determined when annuity payments commence The premium for a QLAC or DIA is paid well in advance of the annuity start date, so using the premium presents a mismatch. Also, a QLAC or DIA has no cash value, so there is no specified value that is being annuitized as of the annuity start date. Death of one of the joint annuitants before the start date also presents questions. 29
RMDs Short-Term Advances Insurers often allow contract owners to request an advance on a limited number of future payments, e.g., the payments to be made in the next 6 months Payments then resume as scheduled; discounting may or may not apply These features are intended to address liquidity concerns that otherwise may discourage annuitization 30
RMDs Short-Term Advances (cont.) Potential issue: RMD regulations state that the interval between payments must be uniform and not exceed one year, and that an acceleration must shorten the annuity period or reduce the annuity payments If these requirements apply to short-term advances, they may not be allowed Compare individual accounts, where the individual has total control over the timing of payments throughout a year and can change from year-to-year For example, take monthly withdrawals in one year, a single withdrawal in the next year, and two withdrawals in the following year 31
Annuity Product Tax Update Partial Annuitization: QP vs. NQ 32
Notice 2016-39 Phased retirement under defined benefit plan Receive part of benefits while working part-time Similar to partial annuitization under deferred annuity Civil Service and Federal Employees Retirement Systems? Specific Facts: Employee begins part-time employment, receives portion of benefits, won t get full benefits until full retirement at future date that is indeterminate because the date could change Plan s obligations based in part on employee s continued part-time employment, affecting duration of phased benefits & future accruals Employee cannot elect form of phased benefit but elects a distribution option at full retirement that applies to entire benefit, including phased benefit 33
Notice 2016-39 (cont.) Payments are amounts not received as an annuity Pro rata recovery rules of 72(e)(8) apply Simplified exclusion ratio under 72(d) does not apply Plan s obligations not fixed under 1.72-4(b)(1) because: Unknown duration (within employee s control) Accrual of additional benefits before the full benefits begin Indeterminate form of the phased retirement benefit 34
Rev. Proc. 2016-36 Notice 2016-39 does not apply to NQ annuities Notice potentially inconsistent w/ 72(a)(2)? Describes two product features that will not affect exclusion ratio treatment for payments from NQ annuity: the possibility of further contributions to the contract or a subsequent election under the contract to receive the benefit payable under the contract in a different manner generally will not affect the determination of whether payments are amounts received as an annuity. 35
Rev. Proc. 2016-36 (cont.) Expands circumstances in which exclusion ratio applies? What needs to be fixed? Payout option compare Treas. Reg. 1.72-11(e) New exclusion ratio applies if the terms of the contract are modified or the annuity obligations are exchanged to provide a different payment term Premiums exclusion ratio calculated using investment in the contract as of the annuity starting date What happens if subsequent premium paid? 36
Annuity Product Tax Update Taxable Annuity with GLWB 37
Taxable Annuity w/ GLWB PLR 201515001 & PLR 201519001 Typical VA structure but with public mutual funds Investment options correspond to public mutual funds Insurer holds the shares in state law separate account Premiums paid in cash or in kind Cash only to fixed account Withdrawals pro rata between fixed & separate account Separate account distributions in cash or in kind 38
Taxable Annuity w/ GLWB (cont.) GLWB feature seems to be typical design Guaranteed annual withdrawal amount for life If contract value (including fixed & separate account) exhausted other than via excess withdrawals, benefit starts Traditional annuitization benefit Separate account value liquidated; fixed annuity payments 39
Taxable Annuity w/ GLWB (cont.) Rulings requested and granted: Policyholder owns separate account assets for tax purposes (Rev. Rul. 81-225) In-kind premiums or distributions not taxable events Contract is an annuity under 72, except for portion of separate account treated as owned by policyholder IRC 72 cash value excludes separate account value Fixed account withdrawals taxed under 72(e) Charges against fixed account not treated as distributions 40
Taxable Annuity w/ GLWB (cont.) Rulings requested and granted (continued): Investment in the contract includes premiums and charges paid into general account, whether directly by policyholder or by debiting separate account GLWB and annuity payments get exclusion ratio Mutual fund dividends can be QDI Contract does not form part of a straddle GLWB payments don t affect policyholder s ability to deduct investment losses from the mutual funds 41
Taxable Annuity w/ GLWB (cont.) Observation: The tax treatment of the product appears identical to a contingent deferred annuity Policyholder owns the underlying mutual fund shares But still has an annuity that provides benefits linked to those mutual fund shares And the presence of the annuity feature does not affect the tax treatment that normally applies to a mutual fund shareholder 42
Annuity Product Tax Update Reporting Penalties 43
Penalties Increased & Indexed Trade Preferences Extension Act of 2015, Pub. L. No. 114-27 806 Increased penalties under 6721 & 6722 for information returns due after 2015: $250 per return (up from $100) with annual cap of $3 million If timely corrected, $50 per return (up from $30) with annual cap of $500,000 (up from $250,000) Intentional Disregard: no cap and per-return penalty is the greater of (1) $500 (up from $250) or (2) 10% of the underreported amount 44
Penalties Increased & Indexed (cont.) Inflation adjustments Stephen Beck, Jr., ABLE Act of 2014, Pub. L. No. 113-295 208 of Division B Requires inflation adjustments to the penalty amounts for information returns / payee statements required to be filed in a calendar year beginning after 2014 2015 Form 1099-R: see sections 3.48 and 3.49 of Rev. Proc. 2015-53, as amended by section 4 of Rev. Proc. 2016-11 2016 Form 1099-R, see sections 3.06 and 3.07 of Rev. Proc. 2016-11 Basically, increased the base penalty amount to $260 and increased the dollar caps 45
New De Minimis Exception New exception to 6721 & 6722 for certain de minimis errors involving incorrect dollar amounts Consolidated Approp. Act, 2016, Pub. L. No. 114-113 208 of Division Q Current regulations say an error involving a monetary amount is never inconsequential for purposes of the rules saying inconsequential errors do not trigger penalties Treas. Reg. 301.6721-1(c)(1) and (c)(2)(iii); Treas. Reg. 301.6722-1(b)(1) and (b)(2)(i) Errors cannot exceed $100 per information return or payee statement ($25 if reporting amount withheld) Exception n/a if fail to file or if payee requests a correction Applies for returns / statements required to be filed after 2016 46
Questions? 47