PAYMENTS ON INSURANCE CONTRACTS ARE 'NONPERIODIC DISTRIBUTIONS' SUBJECT TO REPORTING AND WITHHOLDING.

Rev. Rul. 91-17

ISSUE

What, if any, are an insurance company's recordkeeping, reporting, and withholding obligations with regard to amounts that section 7702(g) and (h) of the Internal Revenue Code treats as ordinary income received or accrued by the policyholder during the taxable year if a contract is a life insurance contract under applicable law but fails to meet the definition of a life insurance contract under section 7702(a), or is a variable contract but fails to satisfy the diversification requirements set forth in section 817(h) and the regulations thereunder?

FACTS

X, an insurance company subject to tax under subchapter L of chapter 1 of the Code, issued various contracts that qualified as "life insurance," "endowment," and "annuity" contracts under applicable law. During the tax year at issue, some of X's nonvariable "life" and "endowment" contracts satisfied neither (1) the cash value accumulation test of section 7702(b) of the Code, nor (2) the guideline premium requirements of section 7702(c) and the cash value corridor requirement of section 7702(d). In addition, some of X's variable "life" and variable "annuity" contracts failed to satisfy the diversification requirements set forth in the regulations under section 817(h). See section 1.817-5 of the Income Tax Regulations.

X did not file any information returns or withhold and pay over to the United States any amount of tax with regard to the ordinary income that section 7702(g) and (h) of the Code treated as received or accrued during the taxable year by the policyholders of the contracts described above. X also did not send the policyholders any payee statements or notices of the right to elect not to have the withholding provisions of section 3405 apply.

LAW AND ANALYSIS

Section 7702 of the Code defines the term "life insurance contract" for purposes of the Code. Section 7702(a) provides that a "life insurance contract" is any contract that is a life insurance contract under the applicable law, but only if such contract meets either (1) the cash value accumulation test of section 7702(b), or (2) the guideline premium requirements of section 7702(c) and falls within the cash value corridor of section 7702(d).

Section 7702(g)(1)(A) of the Code provides that if at any time a contract that is a life insurance contract under the applicable law does not meet the definition of a life insurance contract under section 7702(a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year. Further, section 7702(g)(1)(C) provides that if, during any taxable year of the policyholder, a contract that is a life insurance contract under the applicable law ceases to meet the definition of a life insurance contract under section 7702(a), the income on the contract for all prior taxable years shall be treated as received or accrued during the taxable year in which such cessation occurs.

Section 7702(g)(1)(B) of the Code provides that, for purposes of section 7702(g)(1), the term "income on the contract" means, with respect to any taxable year of the policyholder, the excess of the sum of (1) the increase in the net surrender value of the contract during the taxable year, and (2) the cost of life insurance protection provided under the contract during the taxable year, over the premiums paid under the contract during the taxable year. Section 7702(g)(1)(D) provides that, for purposes of section 7702(g)(1), the cost of life insurance protection provided under the contract shall be the lesser of -- (1) the cost of individual insurance on the life of the insured as determined on the basis of uniform premiums (computed on the basis of 5-year age brackets) prescribed by the Secretary by regulations, or (2) the mortality charge (if any) stated in the contract.

Section 7702(h) of the Code provides that references in section 7702(a) and (g) to a life insurance contract shall be treated as including references to a contract that is an endowment contract under applicable law.

Section 817(d) of the Code defines the term "variable contract" to mean a contract that (1) provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to state law or regulation, is segregated from the general asset accounts of the company, and (2) provides for the payment of annuities or is a life insurance contract. In the case of an annuity contract, the amounts paid out, are required to reflect the investment return and the market value of the segregated asset account. In the case of a life insurance contract, the amount of the death benefit (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account.

Under section 817(h) of the Code, a variable contract (other than a pension plan contract) that is otherwise described in section 817 and that is based on a segregated asset account, does not qualify as an annuity, endowment, or life insurance contract for any period (and any period subsequent to a period) for which the investments made by such account are not adequately diversified. Section 817(h) applies for purposes of subchapter L, section 72, (relating to annuities), and section 7702(a) (relating to the definition of a life insurance contract). Section 1.817-5(a) of the regulations provides that, if a variable contract that is a life insurance contract under applicable law is not treated as a life insurance or endowment contract under section 7702(a), the income on the contract for any taxable year of the policyholder is treated as ordinary income received or accrued by the policyholder during such year in accordance with section 7702(g) and (h). If a variable contract is not treated as an annuity contract under section 72, the regulation provides that the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year in the same manner as a life insurance or endowment contract under section 7702(g) and (h).

Section 3405 of the Code provides that, in general, the payor of a "designated distribution" shall withhold and be liable for the payment of the tax required to be withheld under that provision. A "designated distribution" includes, subject to certain exceptions not relevant to this ruling, "any distribution or payment from or under . . . (iii) a commercial annuity." Section 3405(d)(6) defines the term "commercial annuity" to mean "an annuity, endowment, or life insurance contract issued by an insurance company licensed to do business under the laws of any State." See also section 35.3405-1 A-1 and A-4 of the Temporary Employment Taxes and Collection of Income Tax at Source Regulations Under the Tax Equity and Fiscal Responsibility Act of 1982.

Section 7702(g) and (h) of the Code treat income on a life insurance or endowment contract that fails to satisfy the definition of such a contract under that provision as received or accrued by the policyholder. Consequently, the income deemed received or accrued by X's policyholders under section 7702(g) and (h) is a designated distribution within the meaning of section 3405, and X is subject to the recordkeeping, reporting, and withholding requirements applicable to designated distributions. See H.R. Cong. Rep. 861, 98th Cong., 2d Sess. 1076 (1984), 1984-3 (Vol. 2) C.B. 330 (House bill followed with respect to the consequences of failing to meet the definition of a life insurance contract under section 7702); 1 H.R. Rep. 432, 98th Cong., 1st Sess. 149 (1983) ("Because the income on the contract [that fails to meet the section 7702(a) definition of a life insurance contract] is treated as received by the policyholder, the income would be a distribution subject to the recordkeeping, reporting, and withholding rules under present law relating to commercial annuities (including life insurance).")

Under section 3405(b)(1) of the Code, if a designated distribution is a "nonperiodic distribution," the payor must withhold the amount determined under section 3405(b)(2). Section 3405 defines the term "nonperiodic distribution" as "any designated distribution which is not a periodic payment." Section 3504(d)(3). A "periodic payment" is "a designated distribution which is an annuity or similar periodic payment." Section 3504(d)(2). The Code provides that payments of interest only on a principal amount shall not be treated as annuity-type payments. See section 72(j). The amounts treated as received pursuant to section 7702(g) and (h), which are deemed distributions under section 3405, consist of "income on the contract" and thus do not represent annuity-type payments. See section 7702(g)(1)(B). Because the deemed distribution is not an annuity-type payment, the distribution is a "nonperiodic distribution" as defined in section 3405(d)(3) and not a "periodic payment" as defined in section 3405(d)(2). (Treatment of the deemed distribution as nonperiodic carries no inference with respect to sections 871, 881, 1441, and 1442.)

Section 3405(b)(2) of the Code provides that, in the case of any nonperiodic distribution that is not a "qualified total distribution" (as defined in section 3405(d)(4)), the amount withheld under section 3405(b)(1) shall be the amount determined by multiplying such distribution by 10 percent. However, a payor is required to withhold tax only if the amount of the deemed distribution is at least $200. All amounts received during a single taxable year of the payee from the payor under the same arrangement must be aggregated for purposes of determining whether the $200 threshold is met. See section 35.3405-1 F-6 of the temporary regulations.

Section 3405(e) of the Code provides that, for purposes of chapter 24 (relating to the collection of income tax at source) and so much of subtitle F (pertaining to procedure and administration) as relates to chapter 24, any designated distribution shall be treated as if it were wages paid by an employer to an employee with respect to which there has been withholding under section 3402. (If the designated distribution is not subject to withholding by reason of an election by the payee under section 3405(b)(3), as described below, the amount withheld is treated as zero.) In the case of designated distributions subject to withholding, the amount withheld is treated as a special fund in trust for the United States. Section 7501. The payor must deposit the amount withheld under section 3405 with a federal reserve bank or an authorized financial institution in accordance with the provisions of section 6302 and section 31.6302(c)-1(a)(1)(i) of the Employment Taxes and Collection of Income Tax at Source Regulations. See also section 35.3405-1 E-10 of the temporary regulations.

With respect to any nonperiodic distribution, an individual may elect not to have withholding apply. Section 3405(b)(3) of the Code. At the time of any nonperiodic distribution (or at such earlier time as may be provided in regulations), the payor of the distribution is required to transmit to the payee notice of the right to make an election provided in section 3405(b). Section 3405(d)(10)(B)(ii). See also section 35.3405-1 D-9 of the temporary regulations. The notice must be in the form, and contain the information prescribed in the temporary regulations. See section 35.3405-1 D-26 of the temporary regulations. Notice to the payee of the right to elect not to have withholding apply to a nonperiodic distribution may not be given earlier than six months prior to the distribution and not later than the time that gives the payee reasonable time to elect not to have withholding apply and to reply to the payor with the election information. Section 35.3405-1 D-9 of the temporary regulations.

Section 6047(d) of the Code provides that the Secretary of the Treasury or his delegate shall by forms or regulations require that any person issuing any contract under which designated distributions may be made make returns and reports regarding such contract (1) to the Secretary, (2) to the participants of such contract, and (3) to such other persons as the Secretary may be regulations prescribe. The reports are required to be in such form, made at such time, and contain such information as may be prescribed by forms or regulations.

Section 35.3405-1 E-8 of the temporary regulations provides that the reporting requirements of section 6047(e) (redesignated section 6047(d) by the Tax Reform Act of 1984, section 491(d)(47), 1984-3 (Vol. 1) C.B. 360) are triggered any time there is a designated distribution to which section 3405 applies. In the absence of other forms or regulations, the reporting requirement is satisfied if Form W-2P or Form 1099R is filed with respect to each payee. See 35.3405-1 E-9 of the temporary regulations.

Because some of X's contracts failed to satisfy the requirements of section 7702(a) or section 817(h) of the Code, the income on such contracts is a nonperiodic designated distribution. As a result, X has recordkeeping, reporting, withholding, and deposit obligations under sections 3402, 3403, 3405, 6047, 6302, and 7501. Specifically, X has a duty to withhold (and pay over to the United States as a tax creditable against the income tax liability of the policyholder) an amount equal to 10 percent of such distribution, provided the amount of the distribution is at least $200 per year. Section 3405(b) and (c); section 35.3401-1 F-6 of the temporary regulations. Under section 3405(c), X is liable for the tax that it failed to withhold and pay over to the United States. X also must notify the policyholder of the right to elect under section 3405(b)(3) not to have withholding apply. In addition, under section 6047(d), returns and reports regarding such designated distributions must be made by X to the Internal Revenue Service and to the participants of such contract.

If X's failure to meet its recordkeeping, reporting, withholding, and deposit obligations is not due to reasonable case, X may be subject to the penalties described in sections 6651, 6652(e), 6652(h), 6656(a), and 6704 of the Code.

HOLDING

If a contract fails to meet the definition of a life insurance or endowment contract under section 7702(a) of the Code or a variable contract does not satisfy the diversification requirements set forth in regulations under section 817(h), then the income on such a contract is a nonperiodic distribution within the meaning of section 3405(d)(3). The income deemed received by X's policyholders under section 7702(g) and (h) is subject to the recordkeeping, reporting, withholding, and deposit requirements applicable to nonperiodic distributions.

WAIVER OF CIVIL PENALTIES

The Service will waive civil penalties for failure to satisfy the reporting, withholding, and deposit requirements for income deemed received under section 7702(g) and (h) of the Code if the insurance company:

1) requests and receives a waiver of the failure to meet the definition of a life insurance contract pursuant to section 7702(f)(8); or

2) satisfies the conditions of section 1.817-5(a)(2)(i)- (iii) of the regulations applicable to an inadvertent failure to diversify the investments of a segregated account underlying a variable contract.

In addition, the Service will waive civil penalties for failure to satisfy the reporting, withholding, and deposit requirements for income treated as received or accrued under section 7702(g) and (h) of the Code if, prior to June 3, 1991, the insurance company requests, and, in a timely manner, executes a closing agreement under which the company agrees to pay an amount based on (i) the amount of tax that would have been owed by the policyholders if they were treated as receiving the income on the contracts, and (ii) any interest with regard to such tax. Applications to enter into a closing agreement should be addressed to Assistant Chief Counsel, Financial Institutions and Products, FI&P:4, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.

DRAFTING INFORMATION

The principal author of this revenue ruling is Frederick S. Campbell-Mohn of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Manny Burstein on (202) 566-3603 (not a toll-free call).