Subchapter L: Can You Believe It? Reserves for Annuity Contractions that Flunk I.R.C. Section 72(s) Can Be Deductible

In two of my TAXING TIMES columns last year, I dealt with the policyholder and company tax treatment of contracts that fail to qualify as life insurance contracts under I.R.C. § 7702.1 In the October 2015 TAXING TIMES column, I pointed out that a life insurance company is entitled to a tax reserve deduction for a contract that flunks I.R.C. § 7702. After writing that piece, I have been asked: What about the tax treatment of contracts that do not qualify as annuity contracts for tax purposes because they lack the requisite distribution-after-death provisions of I.R.C. § 72(s)? As it turns out, the same result applies as for failed life insurance contracts—the life insurance company should obtain a tax reserve deduction for a contract that fails to qualify as an annuity contract under I.R.C. § 72(s) provided the contract has a lifetime annuity payout option.

Let’s explore how this is the likely result. I.R.C. § 72(s) provides, with certain exceptions, that a contract is not treated as an annuity contract “for purposes of this title” unless it provides that annuity benefits will be distributed within five years of the holder’s death or, if annuitization had commenced before death, at least as rapidly as under the method of distribution being used at the time of death. The phrase “for purposes of this title” refers to all provisions of the Internal Revenue Code, that is, Title 26 of the United States Code. This means that when determining the issuing company’s tax treatment of a contract that flunks I.R.C. § 72(s) the contract cannot be considered an annuity contract. This broad application of I.R.C. § 72(s) has significant potential ramifications.

The company tax issues that need to be addressed when a contract fails to qualify as an annuity contract under I.R.C. § 72(s) are: (1) whether the premium is includible in income; (2) if so, the type of insurance reserve deduction that is applicable; and (3) whether the policy acquisition expenses (DAC) provisions apply. The DAC issue is the easiest to answer. Under I.R.C. § 848(c)(1), only specified insurance contracts are subject to the so-called “DAC tax” whereby expenses equal to a designated percentage of net premiums (1.75 percent in the case of annuity contracts) are required to be capitalized and amortized as a deduction ratably over a 120-month period. Specified insurance contracts are limited to life insurance, annuity and non-cancellable (or guaranteed renewable) accident and health insurance contracts. Because a failed annuity is not an annuity contract for tax purposes by reason of I.R.C. § 72(s), it is not a specified insurance contract and the DAC tax does not apply. As a result, the recurring expenses incurred to sell the contracts are currently deductible. Regulations under I.R.C. § 162 provide that “advertising and other selling expenses” are currently deductible on an accrual basis as ordinary and necessary business expenses.