SECTION 2. BACKGROUND

Rev. Rul. 77–85, 1977–1 C.B. 12, concludes that if a contract holder retains control over the assets in a custodial account associated with a purported “annuity” contract, then the contract holder is the owner of those assets for federal income tax purposes. The contract holder’s gross income, therefore, includes any interest, dividends, and other income generated by those assets. In the ruling, the contract holder’s control over the assets in the custodial account is manifested by the ability to direct the custodian: (1) to invest amounts in the account in any of an approved list of investments, and (2) to sell, purchase, or exchange securities or other assets held in the account. Through the interaction of the custodial agreement and the annuity contract, the contract holder enjoys any increase or suffers any decrease in the value of the assets in the account as well as any income from the assets. The contract holder also has the right to vote account securities either through the custodian or personally. Rev. Rul. 77–85 generally applies to contracts entered into after March 9, 1977.

In Rev. Rul. 80–274, 1980–2 C.B. 27, an insurance company and a savings and loan association enter into a group annuity contract under which the association’s depositors are issued annuity certificates. The certificate holders’ premiums (net of sales and other expenses) are invested in certificates of deposit issued by the savings and loan association, with maturity dates designated by the certificate hold

ers. When a certificate of deposit matures, the proceeds generally are invested in another certificate of deposit with the savings and loan association. Prior to the annuity starting date, a holder of an annuity certificate can withdraw part or all of his or her investment (including the investment income thereon) by partially or completely surrendering the certificate. Due to fees imposed by the insurance company, annuity certificate holders receive a lower rate of return than if they were to invest directly in the certificates of deposit. The ruling concludes, however, that, prior to the annuity starting date, the position of holders of the annuity certificates is substantially identical to what their position would have been if investments were directly maintained or established with the savings and loan association, with the insurance company acting merely as a conduit.

Rev. Rul. 81–225, 1981–2 C.B. 12, analyzes five situations involving purported variable “annuity” contracts. In four of the situations, the ruling concludes that the contracts are not annuity contracts described in §§ 403(a), 403(b), or 408(b) and that prior to the annuity starting date the contract holders are the owners of the assets held by the insurance company with regard to the contracts. In these situations, the insurance company holds shares of mutual funds that are directly or indirectly available to the public. In the fifth situation, the contract holder can invest only in a non-publicly-available mutual fund managed by the insurance company or one of its affiliates. The shares in that mutual fund are available only through the purchase of an annuity contract. In this situation, the ruling concludes that the insurance company is treated as the owner of the mutual fund shares held by the company for the contracts. Rev. Rul. 80–274 did not address the treatment of contracts described in §§ 403(a), 403(b) or 408(b). For that reason, Rev. Rul. 81–225 contains a special transition rule for such contracts. This rule provides that any contract entered into on or before September 25, 1981, is treated as an annuity contract if the arrangement would have met the requirements imposed by those sections without

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cluded that the contract holder was the owner of the mutual fund shares for tax purposes. As the contract holder could surrender the contract for cash prior to annuitization, the possibility that the mutual fund shares could be converted into an immediate annuity at rates guaranteed in the contract did not cause the contract holder to lack ownership or control.

Section 817(h) of the Internal Revenue Code was added by §211(a) of the Tax Reform Act of 1984, 1984–3 (Vol. 1) C.B. 259–60, effective for taxable years beginning after December 31, 1983. Section 817(h) provides that a variable contract (other than a pension plan contract described in § 818(a)) is not treated as a life insurance, endowment, or annuity contract if the investments of a segregated asset account upon which the contract is based are not adequately diversified in accordance with regulations prescribed by the Secretary. Pension plan contracts described in § 818(a) are subject to a variety of statutory limits, including limits on annual contributions, that do not apply to other variable contracts.

The legislative history explains the purpose underlying the § 817(h) diversification requirement as follows:

In authorizing Treasury to prescribe diversification standards, the conferees intend that standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors and investments that are made, in effect, at the direction of the investor. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 1055, 1984–3 (Vol. 2) C.B. 309.

Section 1.817–5 of the Income Tax Regulations provides guidance related to the minimum level of diversification applicable to the investments underlying variable annuity and life insurance contracts. Satisfying the diversification requirements, however, does not prevent a contract holder’s control of the investments of a segregated asset account from causing the contract holder, rather than the insurance company, to be treated as the owner of the assets in the account.