Rev. Rul. 77-85

Advice has been requested regarding the Federal income tax consequences of an annuity arrangement involving a custodial account, as described below. Specifically, advice has been requested whether the subject custodial account is a segregated asset account for purposes of section 801(g)(1)(B) of the Internal Revenue Code of 1954. The use of the terms "annuity", "policy" and "purchase" in this ruling is for descriptive convenience only and is not intended to have any substantive legal effect.

The custodial account is created by agreement among a policyholder, an insurance company and a custodian in conjunction with the purchase of an investment annuity policy by the policyholder from the insurance company. Upon purchase of the investment annuity policy, the policyholder deposits an initial amount of at least a specified minimum with the custodian. At any time before the annuity starting date, the policyholder may make additional payments into the account in amounts equal to a specified minimum. These additional payments permit the purchase of increased benefits under the investment annuity policy. The initial and subsequent payments may be made either in cash or by transfer of securities or other assets that are on an approved list as modified from time to time by the insurance company.

The custodian acts on behalf of the policyholder and the insurance company in accordance with the terms of the agreement and performs certain limited administrative functions (such as payment of scheduled premiums). The amounts in the account are invested by the custodian in accordance with the directions of the policyholder, but with the limitation that the investments selected by the policyholder must be selected from the approved list. In some cases the list includes publicly traded securities, while in other cases the list is restricted to Federally insured bank deposit instruments. The policyholder may direct the custodian in writing at any time, and from time to time, to sell, purchase or exchange securities or other assets held in the custodial account, and to invest and reinvest principal and income. The policyholder may direct the custodian as to what action to take with respect to the voting of securities held in the account or the exercise of any other right or option relating to assets of the type held in the account.

The policyholder may not receive any amount directly from the account and may not receive a distribution of assets in kind. At any time prior to the annuity starting date, however, the policyholder may make a full or partial surrender of the policy to the insurance company. If such a surrender is made, the custodian is directed by the agreement to sell all or part of the assets as appropriate and to pay over the necessary proceeds to the insurance company. The insurance company in turn will make the full or partial cash surrender payment to the policyholder in an amount equal to the proceeds received by the insurance company from the account, less the amount of any cash surrender charges. If the policyholder dies prior to the annuity starting date, the balance of the account is liquidated by the custodian and paid over to the insurance company. The insurance company will then pay these proceeds, less applicable charges, to the policyholder's designated beneficiary in a lump sum or such other settlement option as may be selected.

Once the policyholder has attained a specified age, or at an earlier or later age as elected by the policyholder, monthly payments will begin under the terms of the settlement option selected. The monthly payments will commence upon the first day of the first month following the attainment of such age or the making of such an election. The commencement of these payments is denominated the annuity starting date. The monthly payments for each one year period ending on the anniversary of the annuity starting date are funded by an annual premium paid from the account to the insurance company, from terminal premiums on other similar accounts and, if necessary, from the general assets of the insurance company. During the payment period, the custodial account remains subject to the investment direction of the policyholder. After the annuity starting date, the policyholder may no longer surrender the policy.

The annual premium is determined as a percentage of the value of the custodial account on the anniversary of the annuity starting date. The amount of the monthly payments to the policyholder will reflect the fluctuating value of the assets in the custodial account because the monthly payments are determined by reference to the annual premium in accordance with rates specified in the policy. Upon the policyholder's death after the annuity starting date, the insurance company will receive the remaining balance in the account as the terminal premium and the monthly payments will cease unless the payout option selected by the policyholder had a guaranteed period or a survivorship feature.

The custodian receives a monthly fee and receives additional fees for each transaction executed. In addition, the custodian is reimbursed for all expenses incurred with respect to the account.

The insurance company receives a charge each time a payment is made by the policyholder to the custodial account. During the period prior to the annuity starting date, the insurance company also receives an annual market value premium equal to a specified percentage of the year-end value of the account. The market value premium compensates the insurance company for its cost and for its risk assumed in guaranteeing to the policyholder an annuity rate under the contract. The insurance company is also entitled to reimbursement for any taxes or charges imposed with respect to the assets held in the custodial account.

Section 801(g)(1)(B) of the Code defines a "contract with reserves based on a segregated asset account" as a contract (i) which provides for the allocation of all or part of the amounts received under the contract to an account which, pursuant to State law or regulation, is segregated from the general asset accounts of the company, (ii) which is described in section 805(d)(1) (other than a life, health or accident, property, casualty or liability insurance contract) or which provides for the payment of annuities, and (iii) under which the amounts paid in, or the amount paid out, reflect the investment return and the market value of the segregated asset account. If a contract ceases to reflect current market value, such contract shall not be considered as meeting the requirements of clause (iii) after such cessation.

Section 809(c)(1) of the Code provides, in pertinent part, that the gross amount of premiums and other consideration on insurance and annuity contracts shall be taken into account in determining gain or loss from operations under section 809(b).

Since section 801(g)(1)(B) of the Code defines a contract with reserves based on a segregated asset account for purposes of determining what amounts in such accounts are includable in, or excludable from, a life insurance company's taxable income, the insurance company must be the owner of the assets in the segregated accounts. Section 801(g)(1)(B) does not apply to income from assets owned by another person simply because those assets are set aside by such person to be used eventually to purchase an annuity from the insurance company.

The facts of the subject annuity arrangement indicate that the individual policyholder is the owner of the assets in the custodial account for purposes of taxing the income therefrom. As in the case of a pledge arrangement, the policyholder possesses significant incidents of ownership over the assets in the account at all times. The policyholder retains the power to direct the custodian to sell, purchase or exchange securities, or other assets held in the custodial account, thereby retaining investment control over the account. The policyholder is also able to exercise an owner's right to vote account securities either through the custodian or personally.

In addition, although the policyholder cannot receive distributions from the custodial account according to the provisions of the custodian agreement, through the interaction of that agreement and the annuity policy, he effectively enjoys the benefit of any income produced by, and any increase in the value of, the assets in the custodial account, and bears any loss in the value of such assets. For example, under the annuity policy in combination with the custodian agreement, the policyholder can in fact make withdrawals from the custodial account, even to the extent of closing out the entire account, any time prior to the annuity starting date chosen in the policy. Also, because on the annuity starting date and annually thereafter the value of the assets accumulated and retained in the custodial account will determine the value of the policyholder's annuity, the policyholder will enjoy any increase or suffer any decrease in the value of such assets (including the income derived therefrom), which results from the policyholder's investment efforts through a proportional increase or decrease in the value of the policyholder's annuity each year.

For example, if, through the policyholder's own investment efforts during the first year following the annuity starting date, the policyholder increases the value of the assets in the custodial account on the first anniversary of the annuity starting date to double the "assumed value" for that date (the value that would have been produced had the assets in the account grown at the rate of growth assumed in the premium tables), the amount of the policyholder's annuity payments for the second year will be double the "expected amount" (the amount that the policyholder would have received had the account grown only at the assumed rate of growth--generally a level amount under the rates of purchase and the premium charges specified in the contract). In addition, the policyholder's annuity payments for all of the later years will continue to be double the "expected amount" so long as the assets in the account on the first anniversary date (when their value was double the "assumed value") continue to grow at the assumed rate of growth. If, on the other hand, there is any decrease in the value of the assets in the account during the year as a result of the policyholder's investment decisions, the policyholder will receive a correspondingly smaller annuity the next year (and thereafter, to the extent such loss is not recouped). Although the insurance company guarantees the purchase rates for the one-year term annuity at the issuance of the policy, it does not guarantee the size of the annuity (in either units or dollars) that the policyholder will receive for any year. That amount depends solely on the investment results of the individual policyholder as they are reflected in the value (if any) of the assets in the custodial account on the annuity starting date and on each anniversary thereof.

In view of the fact that the policyholder possesses such substantial incidents of ownership in the assets in the custodial account, such assets are owned by the policyholder, rather than by the insurance company, for purposes of section 801(g)(1)(B) of the Code. While section 801(g)(1)(B) contemplates that particular classes of policyholders will bear the investment risk with respect to segregated asset accounts of the insurance company, it does not extend to assets in an investment account over which an individual policyholder has direct investment control and can exercise other incidents of ownership that make such person, rather than the insurance company, the owner of such assets. Under the subject custodial arrangement, the bundle of rights that the individual policyholder has with respect to the assets in the custodial account makes such individual the owner of such assets for Federal income tax purposes. The fact that under state law such individual does not formally have legal title to such assets, or that for certain state insurance law purposes such assets are treated as assets in a separate asset account of an insurance company, is not controlling for Federal income tax purposes.

In addition, the fact that a custodian is used to hold such assets until they are transferred to the insurance company does not change the conclusion that, for Federal income tax purposes, the individual policyholder, not the insurance company, is the owner of such assets (until they are transferred to the insurance company). The setting aside of the assets in the custodial account for the purchase of term annuities is basically a pledge arrangement. When property is held in escrow or trust and the income therefrom benefits, or is to be used to satisfy the legal obligations of, a person who has caused such property, either by action or inaction, to be held in escrow or trust, such person is deemed to be the owner thereof, and such income is includible in that person's gross income, even though that person may never actually receive it. See for example sections 1.61-13(b), 1.677(a)-1(d), and 1.678(a)-1(b) of the Income Tax Regulations; and Northern Trust Co. v. United States, 193 F.2d 127 (7th Cir. 1951), cert. denied, 343 U.S. 956 (1952).

Since the assets in the custodial account are owned by the individual policyholder, not the insurance company, any interest, dividends and other income received by the custodian on securities and other assets held in the custodial accounts are includible in the gross income of the policyholder under section 61 of the Code for the year in which they are received by the custodian. No part of such income is subject to exclusion or inclusion under section 801(g), because the conclusion that such assets are not owned by the insurance company precludes the custodial account from being treated as a segregated account under section 801(g)(1)(B).

Furthermore, because the insurance company receives nothing until a portion of the custodial account is liquidated and remitted to it by the custodian as either charges or premiums due under the contract, the insurance company should only include the premiums and charges paid each year in its premium income for that year under section 809(c)(1) of the Code.

Under the authority of section 7805(b) of the Code, custodial accounts created pursuant to investment annuity policies entered into between the insurance company and the policyholder on or before March 9, 1977, will be treated as though they were segregated asset accounts within the meaning of section 801(g)(1), if:

(1) there are no contributions to such accounts after March 9, 1977 (other than employer contributions to qualified employee annuity or other qualified retirement plans or employer contributions to purchase an annuity contract under section 403(b), provided such contributions are not currently taxable to the employee under subchapter D of the Code), and

(2) the account assets are consistently treated as the property of the insurance company for all purposes under subchapter L of the Code.

¹ Also released as News Release IR-1774, dated March 9, 1977.