Debt Instruments With Original Issue Discount; Annuity Contracts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8754]

RIN 1545-AS76

Debt Instruments With Original Issue Discount; Annuity Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

federal income tax treatment of certain annuity contracts. The

regulations determine which of these contracts are taxed as debt

instruments for purposes of the original issue discount provisions of

the Internal Revenue Code. The regulations provide needed guidance to

owners and issuers of these contracts.

DATES: Effective date: The regulations are effective February 9, 1998.

Applicability dates: For dates of applicability, see Sec. 1.1275-

1(j)(8).

FOR FURTHER INFORMATION CONTACT: Jonathan R. Zelnik, (202) 622-3930

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Sections 163(e) and 1271 through 1275 of the Internal Revenue Code

(Code) provide rules for the treatment of debt instruments that have

original issue discount (OID).

On February 2, 1994, the IRS and Treasury published in the Federal

Register (59 FR 4799) final regulations under the OID provisions. On

April 7, 1995, the IRS published in the Federal Register (60 FR 17731)

a notice of proposed rulemaking relating to the federal income tax

treatment of annuity contracts that are not issued by insurance

companies subject to tax under subchapter L of the Code. The proposed

regulations treat certain of these annuity contracts as debt

instruments for purposes of the OID provisions.

The IRS received a number of written comments on the proposed

regulations. In addition, on August 8, 1995, the IRS held a public

hearing on the proposed regulations. The proposed regulations, with

certain changes in response to comments, are adopted as final

regulations. The comments and changes are discussed below.

Explanation of Provisions

Certain Annuity Contracts

The OID provisions generally apply to issuers and holders of debt

instruments. The term debt instrument means any instrument or

contractual arrangement that constitutes indebtedness under general

principles of federal income tax law. See section 1275(a)(1) and

Sec. 1.1275-1(d).

Section 1275(a)(1)(B) excepts two types of annuity contracts from

the definition of debt instrument (and, therefore, from the OID

provisions). First, section 1275(a)(1)(B)(i) excepts an annuity

contract to which section 72 applies if the contract ``depends (in

whole or in substantial part) on the life expectancy of 1 or more

individuals.'' Second, section 1275(a)(1)(B)(ii) excepts an annuity

contract to which section 72 applies if the contract is issued by ``an

insurance company subject to tax under subchapter L'' and the

circumstances of the contract's issuance meet certain criteria.

The proposed regulations address only the first exception, which is

contained in section 1275(a)(1)(B)(i). Under the proposed regulations,

an annuity contract qualifies for the exception in section

1275(a)(1)(B)(i) only if all payments under the contract are periodic

payments that: (1) are made at least annually for the life (or lives)

of one or more individuals; (2) do not increase at any time during the

life of the contract; and (3) are part of a series of payments that

begins within one year of the date of the initial investment in the

contract. An annuity contract that is otherwise described in the

preceding sentence, however, does not fail to qualify for the exception

in section 1275(a)(1)(B)(i) merely because it also provides for a

payment (or payments) made by reason of the death of one or more

individuals. Thus, under the proposed regulations, the exception in

section 1275(a)(1)(B)(i) applies only to an immediate annuity contract

with level (or decreasing) payments for the life (or lives) of one or

more individuals. No deferred annuity contract qualifies for the

exception.

Several commentators questioned the approach of the proposed

regulations. In particular, they contended that the exception in

section 1275(a)(1)(B)(i) should not be limited to those annuity

contracts that require periodic payments to begin within one year of

the date of the initial investment in the contract. That is, deferred

annuities, if dependent in whole or substantial part on an individual's

(or several individuals') survival, should also qualify for the

exception in section 1275(a)(1)(B)(i).

[[Page 1055]]

Other commentators took issue with this point of view and contended

that the proposed regulations should be finalized without substantial

change.

After a careful review of this issue, the IRS and the Treasury have

modified the regulations to eliminate the requirement that annuity

distributions begin within one year of the date of the initial

investment in the contract. Instead, as suggested by the legislative

history, the final regulations interpret section 1275(a)(1)(B)(i) as

excepting from the definition of debt instrument only those annuity

contracts that contain terms ensuring that the life contingency under

the contract is both ``real and significant.'' H.R. Conf. Rep. No. 861,

98th Cong., 2d Sess. 887 (1984), 1984-3 (Vol. 2) C.B. 141. The Treasury

and the IRS have determined that the life contingency under an annuity

contract is ``real and significant'' within the meaning of the

legislative history only if, on the day the contract is purchased,

there is a high probability that total distributions under the contract

will increase commensurately with the longevity of the individual (or

individuals) over whose life (or lives) the distributions are to be

made. (These individuals are hereinafter referred to as annuitants.)

The final regulations, therefore, provide a two-pronged general rule:

An annuity contract qualifies for the exception in section

1275(a)(1)(B)(i) only if it both: (1) provides for periodic

distributions made at least annually for the life (or joint lives) of

an individual (or a reasonable number of individuals); and (2) contains

no terms or provisions that can significantly reduce the probability

that total distributions will increase commensurately with longevity.

The final regulations identify several types of terms and

provisions that can significantly reduce the probability that total

distributions under the contract will increase commensurately with

longevity. These terms and provisions include the availability of a

cash surrender option, the availability of a loan secured by the

contract, minimum payout provisions, maximum payout provisions, and

provisions that allow decreasing payouts. Subject to limited

exceptions, the presence of any of these terms or provisions causes an

annuity contract to fail to qualify for the exception in section

1275(a)(1)(B)(i). The list of identified terms and provisions in the

final regulations is not exclusive. A contract fails to qualify for the

exception in section 1275(a)(1)(B)(i) if the contract contains any

other term or provision that can significantly reduce the probability

that total distributions under the contract will increase

commensurately with longevity.

Cash Surrender Options and Loans Secured by the Contract

If the holder of an annuity contract can exchange or surrender all

or part of the contract for a distribution or for distributions that

are not contingent on life, the holder's decision whether, and when, to

exchange or surrender the contract can render the life contingency

insignificant. Similarly, if the holder of an annuity contract can

borrow against the contract, the holder's decision whether, and when,

to borrow can have a comparable effect. The final regulations,

therefore, provide that, if either the issuer or a person acting in

concert with the issuer explicitly or implicitly makes available either

a cash surrender option or a loan secured by the contract, then the

contract contains a term that can significantly reduce the probability

that total distributions on the contract will increase commensurately

with longevity. That availability, therefore, causes the contract to

fail to qualify for the exception in section 1275(a)(1)(B)(i).

Minimum Payout Provisions

If an annuity contract guarantees that a minimum amount will be

distributed regardless of the death of the individual (or individuals)

over whose life (or lives) payments are to be made, the minimum amount

is not subject to the life contingency. In addition, the larger the

minimum amount relative to aggregate expected distributions over the

remaining (joint) life expectancy of the annuitant (or annuitants), the

less likely it is that total distributions under the contract will

increase commensurately with the longevity of the annuitant (or

annuitants). A sufficiently large minimum amount renders the life

contingency virtually meaningless. For example, consider a contract

that provides for monthly distributions to begin on the annuity

starting date and to extend for the longer of the life of the annuitant

or 20 years, regardless of the annuitant's age. If the annuitant has a

life expectancy as of the annuity starting date of 5 years, it is

likely that distributions will be made for exactly 20 years, regardless

of when the annuitant dies. In this case, although the form of the

contract indicates that it depends on life, the existence of the

minimum payout provision significantly reduces the probability that

total distributions under the contract will depend on longevity.

Because the existence of a minimum payout provision can

significantly reduce the probability that total distributions under the

contract will increase commensurately with longevity, the existence of

any such provision generally causes the contract to fail to qualify for

the exception in section 1275(a)(1)(B)(i). The final regulations

provide only two exceptions to this general rule. First, an annuity

contract does not fail to be described in section 1275(a)(1)(B)(i)

merely because it contains a minimum payout provision that guarantees a

death benefit no greater than the unrecovered consideration paid for

the contract. Second, an annuity contract does not fail to be described

in section 1275(a)(1)(B)(i) merely because the contract provides that,

after annuitization, distributions may be guaranteed to continue for a

term certain that is no longer than one-half of the period of time from

the annuity starting date to the expected date of the ``terminating

death.''

The terminating death is the annuitant death that, in general,

causes annuity payments to cease under the contract. The expected date

of the terminating death is determined as of the annuity starting date

with respect to all then-surviving annuitants by reference to the

applicable mortality table prescribed under section

417(e)(3)(A)(ii)(I). See Rev. Rul. 95-6, 1995-1 C.B. 80, for the

applicable mortality table that is prescribed for this purpose as of

January 8, 1998.

Maximum Payout Provisions

If an annuity contract provides that distributions will cease if an

annuitant lives beyond a specified date, total distributions under the

contract may fail to increase commensurately with longevity. If the

specified date is relatively early (when compared to the annuitant's

life expectancy as of the annuity starting date), its existence

significantly reduces the probability that total distributions under

the contract will increase commensurately with longevity. Conversely,

if the specified date is very late (when compared to the annuitant's

life expectancy as of the annuity starting date), its existence does

not significantly reduce the probability that total distributions under

the contract will increase commensurately with longevity. For example,

consider an annuity contract that provides that distributions will be

made for the life of the annuitant but in no event for more than 30

years. If the annuitant is a relatively young person, this maximum

payout provision significantly attenuates the life contingency. On the

other hand, if the annuitant has a life expectancy of 10 years on the

annuity starting date, this maximum payout

[[Page 1056]]

provision is unlikely to determine the total distributions.

Because the existence of a maximum payout provision can

significantly reduce the probability that total distributions under the

contract will increase commensurately with longevity, the final

regulations provide that the existence of any maximum payout provision

generally causes the contract to fail to qualify for the exception in

section 1275(a)(1)(B)(i). There is a single exception to this general

rule in cases where the period of time between the annuity starting

date and the date after which (under the maximum payout provision) no

distributions will be made is at least twice as long as the period of

time from the annuity starting date to the expected date of the

terminating death.

Decreasing Payout Provisions

The connection between longevity and distributions under an annuity

contract is apparent in the case of a contract that provides for equal

annual distributions for life. For each year the annuitant lives,

another equal distribution is made. If distributions decrease over

time, this connection can become attenuated. Consider an annuity

contract that provides for a distribution upon annuitization of

$100,000 followed by annual distributions of $10 per year for life.

Although this contract provides for periodic distributions for life,

the pattern of the distributions causes the amount distributed to fail

to adequately reflect longevity.

If the amount of distributions under an annuity contract during any

contract year may be less than the amount of distributions during the

preceding year, the final regulations provide that this possibility can

significantly reduce the probability that total distributions under the

contract will increase commensurately with longevity. Thus, the

existence of this possibility generally causes the contract to fail to

qualify for the exception in section 1275(a)(1)(B)(i). There is a

single exception to this general rule for certain variable

distributions that are closely tied to investment experience,

inflation, or similar fluctuating criteria. In these cases, because the

provision can result in comparable increases in the amount of

distributions, the possibility that the distributions may decline from

year to year does not significantly reduce the probability that total

distributions under the contract will increase commensurately with

longevity.

Private and Charitable Gift Annuity Contracts

Several commentators expressed concerns that the proposed

regulations, if finalized, would alter the tax treatment traditionally

afforded private and charitable gift annuity contracts. Private annuity

contracts are typically issued as consideration in intra-family

transfers of property. Charitable gift annuity contracts are typically

issued by charitable institutions in exchange for a transfer of cash or

property greater in value than the annuity. Because these contracts may

call for periodic distributions to begin more than one year after they

are issued, there was concern that, under the proposed regulations,

they might fail to qualify for the exception in section

1275(a)(1)(B)(i).

In many cases, distributions under private and charitable gift

annuity contracts are entirely contingent on the survival of one

individual (or a small number of individuals). These contracts are not

indebtedness under general principles of federal income tax law and,

therefore, are not within the definition of debt instrument in section

1275(a)(1)(A). For almost all other private and charitable gift

annuities, the final regulations address the concern by removing the

requirement that the distributions begin within one year of the date of

the initial investment in the contract.

Annuity Contracts Issued by Foreign Insurance Companies

One commentator asked the IRS to clarify the treatment of annuity

contracts issued by a foreign insurance company that does not engage in

a trade or business within the United States. In particular, the

commentator asked for guidance on whether such an annuity contract

qualifies under section 1275(a)(1)(B)(ii), which provides a broad

exception from the definition of debt instrument for certain annuity

contracts issued by ``an insurance company subject to tax under

subchapter L.'' These regulations do not address the exception in

section 1275(a)(1)(B)(ii). The Treasury and the IRS, however, welcome

comments on the proper scope of that provision.

Certain Compensation Arrangements

Several commentators questioned whether the proposed regulations

apply to certain compensation arrangements whose distributions are

taxed under section 72. The timing rules of the OID provisions do not

apply to compensation arrangements that are subject to other specific

Code or regulations provisions. For example, if an arrangement is

described in the first sentence of section 404(a) or in section 404(b)

or if amounts under the arrangement are includible under sections 83,

403, or 457, or under Sec. 1.61-2, the arrangement is not subject to

the OID timing provisions. See also Secs. 1.1273-2(d) and 1.1274-1(a),

under which a nonpublicly traded debt instrument issued for services

has an issue price equal to its stated redemption price at maturity

and, therefore, has no OID.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It has also been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations. Because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29,

1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Code, the notice of proposed

rulemaking was submitted to the Small Business Administration for

comment on its impact on small business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendment to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entries for ``Sections 1.1271-1 through 1.1274-5'' and

``Sections 1.1275-1 through 1.1275-5'' and adding the following entries

in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.1271-1 also issued under 26 U.S.C. 1275(d).

Section 1.1272-1 also issued under 26 U.S.C. 1275(d).

Section 1.1272-2 also issued under 26 U.S.C. 1275(d).

Section 1.1272-3 also issued under 26 U.S.C. 1275(d).

Section 1.1273-1 also issued under 26 U.S.C. 1275(d).

Section 1.1273-2 also issued under 26 U.S.C. 1275(d).

[[Page 1057]]

Section 1.1274-1 also issued under 26 U.S.C. 1275(d).

Section 1.1274-2 also issued under 26 U.S.C. 1275(d).

Section 1.1274-3 also issued under 26 U.S.C. 1275(d).

Section 1.1274-4 also issued under 26 U.S.C. 1275(d).

Section 1.1274-5 also issued under 26 U.S.C. 1275(d). * * *

Section 1.1275-1 also issued under 26 U.S.C. 1275(d).

Section 1.1275-2 also issued under 26 U.S.C. 1275(d).

Section 1.1275-3 also issued under 26 U.S.C. 1275(d).

Section 1.1275-4 also issued under 26 U.S.C. 1275(d).

Section 1.1275-5 also issued under 26 U.S.C. 1275(d). * * *

Par. 2. Section 1.1271-0 is amended by adding entries for

paragraphs (i) through (j)(8) to Sec. 1.1275-1 to read as follows:

Sec. 1.1271-0 Original issue discount; effective dates; table of

contents.

* * * * *

Sec. 1.1275-1 Definitions.

* * * * *

(i) [Reserved]

(j) Life annuity exception under section 1275(a)(1)(B)(i).

(1) Purpose.

(2) General rule.

(3) Availability of a cash surrender option.

(4) Availability of a loan secured by the contract.

(5) Minimum payout provision.

(6) Maximum payout provision.

(7) Decreasing payout provision.

(8) Effective dates.

* * * * *

Par. 3. Section 1.1275-1 is amended by:

1. Revising the first sentence of paragraph (d).

2. Adding and reserving paragraph (i).

3. Adding paragraph (j).

The revision and additions read as follows:

Sec. 1.1275-1 Definitions.

* * * * *

(d) Debt instrument. Except as provided in section 1275(a)(1)(B)

(relating to certain annuity contracts; see paragraph (j) of this

section), debt instrument means any instrument or contractual

arrangement that constitutes indebtedness under general principles of

Federal income tax law (including, for example, a certificate of

deposit or a loan). * * *

* * * * *

(i) [Reserved]

(j) Life annuity exception under section 1275(a)(1)(B)(i)--(1)

Purpose. Section 1275(a)(1)(B)(i) excepts an annuity contract from the

definition of debt instrument if section 72 applies to the contract and

the contract depends (in whole or in substantial part) on the life

expectancy of one or more individuals. This paragraph (j) provides

rules to ensure that an annuity contract qualifies for the exception in

section 1275(a)(1)(B)(i) only in cases where the life contingency under

the contract is real and significant.

(2) General rule--(i) Rule. For purposes of section

1275(a)(1)(B)(i), an annuity contract depends (in whole or in

substantial part) on the life expectancy of one or more individuals

only if--

(A) The contract provides for periodic distributions made not less

frequently than annually for the life (or joint lives) of an individual

(or a reasonable number of individuals); and

(B) The contract does not contain any terms or provisions that can

significantly reduce the probability that total distributions under the

contract will increase commensurately with the longevity of the

annuitant (or annuitants).

(ii) Terminology. For purposes of this paragraph (j):

(A) Contract. The term contract includes all written or unwritten

understandings among the parties as well as any person or persons

acting in concert with one or more of the parties.

(B) Annuitant. The term annuitant refers to the individual (or

reasonable number of individuals) referred to in paragraph (j)(2)(i)(A)

of this section.

(C) Terminating death. The phrase terminating death refers to the

annuitant death that can terminate periodic distributions under the

contract. (See paragraph (j)(2)(i)(A) of this section.) For example, if

a contract provides for periodic distributions until the later of the

death of the last-surviving annuitant or the end of a term certain, the

terminating death is the death of the last-surviving annuitant.

(iii) Coordination with specific rules. Paragraphs (j) (3) through

(7) of this section describe certain terms and conditions that can

significantly reduce the probability that total distributions under the

contract will increase commensurately with the longevity of the

annuitant (or annuitants). If a term or provision is not specifically

described in paragraphs (j) (3) through (7) of this section, the

annuity contract must be tested under the general rule of paragraph

(j)(2)(i) of this section to determine whether it depends (in whole or

in substantial part) on the life expectancy of one or more individuals.

(3) Availability of a cash surrender option--(i) Impact on life

contingency. The availability of a cash surrender option can

significantly reduce the probability that total distributions under the

contract will increase commensurately with the longevity of the

annuitant (or annuitants). Thus, the availability of any cash surrender

option causes the contract to fail to be described in section

1275(a)(1)(B)(i). A cash surrender option is available if there is

reason to believe that the issuer (or a person acting in concert with

the issuer) will be willing to terminate or purchase all or a part of

the annuity contract by making one or more payments of cash or property

(other than an annuity contract described in this paragraph (j)).

(ii) Examples. The following examples illustrate the rules of this

paragraph (j)(3):

Example 1. (i) Facts. On March 1, 1998, X issues a contract to A

for cash. The contract provides that, effective on any date chosen

by A (the annuity starting date), X will begin equal monthly

distributions for A's life. The amount of each monthly distribution

will be no less than an amount based on the contract's account value

as of the annuity starting date, A's age on that date, and permanent

purchase rate guarantees contained in the contract. The contract

also provides that, at any time before the annuity starting date, A

may surrender the contract to X for the account value less a

surrender charge equal to a declining percentage of the account

value. For this purpose, the initial account value is equal to the

cash invested. Thereafter, the account value increases annually by

at least a minimum guaranteed rate.

(ii) Analysis. The ability to obtain the account value less the

surrender charge, if any, is a cash surrender option. This ability

can significantly reduce the probability that total distributions

under the contract will increase commensurately with A's longevity.

Thus, the contract fails to be described in section

1275(a)(1)(B)(i).

Example 2. (i) Facts. On March 1, 1998, X issues a contract to B

for cash. The contract provides that beginning on March 1, 1999, X

will distribute to B a fixed amount of cash each month for B's life.

Based on X's advertisements, marketing literature, or illustrations

or on oral representations by X's sales personnel, there is reason

to believe that an affiliate of X stands ready to purchase B's

contract for its commuted value.

(ii) Analysis. Because there is reason to believe that an

affiliate of X stands ready to purchase B's contract for its

commuted value, a cash surrender option is available within the

meaning of paragraph (j)(3)(i) of this section. This availability

can significantly reduce the probability that total distributions

under the contract will increase commensurately with B's longevity.

Thus, the contract fails to be described in section

1275(a)(1)(B)(i).

(4) Availability of a loan secured by the contract--(i) Impact on

life contingency. The availability of a loan secured by the contract

can significantly reduce the probability that total

[[Page 1058]]

distributions under the contract will increase commensurately with the

longevity of the annuitant (or annuitants). Thus, the availability of

any such loan causes the contract to fail to be described in section

1275(a)(1)(B)(i). A loan secured by the contract is available if there

is reason to believe that the issuer (or a person acting in concert

with the issuer) will be willing to make a loan that is directly or

indirectly secured by the annuity contract.

(ii) Example. The following example illustrates the rules of this

paragraph (j)(4):

Example. (i) Facts. On March 1, 1998, X issues a contract to C

for $100,000. The contract provides that, effective on any date

chosen by C (the annuity starting date), X will begin equal monthly

distributions for C's life. The amount of each monthly distribution

will be no less than an amount based on the contract's account value

as of the annuity starting date, C's age on that date, and permanent

purchase rate guarantees contained in the contract. From marketing

literature circulated by Y, there is reason to believe that, at any

time before the annuity starting date, C may pledge the contract to

borrow up to $75,000 from Y. Y is acting in concert with X.

(ii) Analysis. Because there is reason to believe that Y, a

person acting in concert with X, is willing to lend money against

C's contract, a loan secured by the contract is available within the

meaning of paragraph (j)(4)(i) of this section. This availability

can significantly reduce the probability that total distributions

under the contract will increase commensurately with C's longevity.

Thus, the contract fails to be described in section

1275(a)(1)(B)(i).

(5) Minimum payout provision--(i) Impact on life contingency. The

existence of a minimum payout provision can significantly reduce the

probability that total distributions under the contract will increase

commensurately with the longevity of the annuitant (or annuitants).

Thus, the existence of any minimum payout provision causes the contract

to fail to be described in section 1275(a)(1)(B)(i).

(ii) Definition of minimum payout provision. A minimum payout

provision is a contractual provision (for example, an agreement to make

distributions over a term certain) that provides for one or more

distributions made--

(A) After the terminating death under the contract; or

(B) By reason of the death of any individual (including

distributions triggered by or increased by terminal or chronic illness,

as defined in section 101(g)(1) (A) and (B)).

(iii) Exceptions for certain minimum payouts--(A) Recovery of

consideration paid for the contract. Notwithstanding paragraphs

(j)(2)(i)(A) and (j)(5)(i) of this section, a contract does not fail to

be described in section 1275(a)(1)(B)(i) merely because it provides

that, after the terminating death, there will be one or more

distributions that, in the aggregate, do not exceed the consideration

paid for the contract less total distributions previously made under

the contract.

(B) Payout for one-half of life expectancy. Notwithstanding

paragraphs (j)(2)(i)(A) and (j)(5)(i) of this section, a contract does

not fail to be described in section 1275(a)(1)(B)(i) merely because it

provides that, if the terminating death occurs after the annuity

starting date, distributions under the contract will continue to be

made after the terminating death until a date that is no later than the

halfway date. This exception does not apply unless the amounts

distributed in each contract year will not exceed the amounts that

would have been distributed in that year if the terminating death had

not occurred until the expected date of the terminating death,

determined under paragraph (j)(5)(iii)(C) of this section.

(C) Definition of halfway date. For purposes of this paragraph

(j)(5)(iii), the halfway date is the date halfway between the annuity

starting date and the expected date of the terminating death,

determined as of the annuity starting date, with respect to all then-

surviving annuitants. The expected date of the terminating death must

be determined by reference to the applicable mortality table prescribed

under section 417(e)(3)(A)(ii)(I).

(iv) Examples. The following examples illustrate the rules of this

paragraph (j)(5):

Example 1. (i) Facts. On March 1, 1998, X issues a contract to D

for cash. The contract provides that, effective on any date D

chooses (the annuity starting date), X will begin equal monthly

distributions for the greater of D's life or 10 years, regardless of

D's age as of the annuity starting date. The amount of each monthly

distribution will be no less than an amount based on the contract's

account value as of the annuity starting date, D's age on that date,

and permanent purchase rate guarantees contained in the contract.

(ii) Analysis. A minimum payout provision exists because, if D

dies within 10 years of the annuity starting date, one or more

distributions will be made after D's death. The minimum payout

provision does not qualify for the exception in paragraph

(j)(5)(iii)(B) of this section because D may defer the annuity

starting date until his remaining life expectancy is less than 20

years. If, on the annuity starting date, D's life expectancy is less

than 20 years, the minimum payout period (10 years) will last beyond

the halfway date. The minimum payout provision, therefore, can

significantly reduce the probability that total distributions under

the contract will increase commensurately with D's longevity. Thus,

the contract fails to be described in section 1275(a)(1)(B)(i).

Example 2. (i) Facts. The facts are the same as in Example 1 of

this paragraph (j)(5)(iv) except that the monthly distributions will

last for the greater of D's life or a term certain. D may choose the

length of the term certain subject to the restriction that, on the

annuity starting date, the term certain must not exceed one-half of

D's life expectancy as of the annuity starting date. The contract

also does not provide for any adjustment in the amount of

distributions by reason of the death of D or any other individual,

except for a refund of D's aggregate premium payments less the sum

of all prior distributions under the contract.

(ii) Analysis. The minimum payout provision qualifies for the

exception in paragraph (j)(5)(iii)(B) of this section because

distributions under the minimum payout provision will not continue

past the halfway date and the contract does not provide for any

adjustments in the amount of distributions by reason of the death of

D or any other individual, other than a guaranteed death benefit

described in paragraph (j)(5)(iii)(A) of this section. Accordingly,

the existence of this minimum payout provision does not prevent the

contract from being described in section 1275(a)(1)(B)(i).

(6) Maximum payout provision--(i) Impact on life contingency. The

existence of a maximum payout provision can significantly reduce the

probability that total distributions under the contract will increase

commensurately with the longevity of the annuitant (or annuitants).

Thus, the existence of any maximum payout provision causes the contract

to fail to be described in section 1275(a)(1)(B)(i).

(ii) Definition of maximum payout provision. A maximum payout

provision is a contractual provision that provides that no

distributions under the contract may be made after some date (the

termination date), even if the terminating death has not yet occurred.

(iii) Exception. Notwithstanding paragraphs (j)(2)(i)(A) and

(j)(6)(i) of this section, an annuity contract does not fail to be

described in section 1275(a)(1)(B)(i) merely because the contract

contains a maximum payout provision, provided that the period of time

from the annuity starting date to the termination date is at least

twice as long as the period of time from the annuity starting date to

the expected date of the terminating death, determined as of the

annuity starting date, with respect to all then-surviving annuitants.

The expected date of the terminating death must be determined by

reference to the applicable mortality table prescribed under section

417(e)(3)(A)(ii)(I).

(iv) Example. The following example illustrates the rules of this

paragraph (j)(6):

[[Page 1059]]

Example. (i) Facts. On March 1, 1998, X issues a contract to E

for cash. The contract provides that beginning on April 1, 1998, X

will distribute to E a fixed amount of cash each month for E's life

but that no distributions will be made after April 1, 2018. On April

1, 1998, E's life expectancy is 9 years.

(ii) Analysis. A maximum payout provision exists because if E

survives beyond April 1, 2018, E will receive no further

distributions under the contract. The period of time from the

annuity starting date (April 1, 1998) to the termination date (April

1, 2018) is 20 years. Because this 20-year period is more than twice

as long as E's life expectancy on April 1, 1998, the maximum payout

provision qualifies for the exception in paragraph (j)(6)(iii) of

this section. Accordingly, the existence of this maximum payout

provision does not prevent the contract from being described in

section 1275(a)(1)(B)(i).

(7) Decreasing payout provision--(i) General rule. If the amount of

distributions during any contract year (other than the last year during

which distributions are made) may be less than the amount of

distributions during the preceding year, this possibility can

significantly reduce the probability that total distributions under the

contract will increase commensurately with the longevity of the

annuitant (or annuitants). Thus, the existence of this possibility

causes the contract to fail to be described in section

1275(a)(1)(B)(i).

(ii) Exception for certain variable distributions. Notwithstanding

paragraph (j)(7)(i) of this section, if an annuity contract provides

that the amount of each distribution must increase and decrease in

accordance with investment experience, cost of living indices, or

similar fluctuating criteria, then the possibility that the amount of a

distribution may decrease for this reason does not significantly reduce

the probability that the distributions under the contract will increase

commensurately with the longevity of the annuitant (or annuitants).

(iii) Examples. The following examples illustrate the rules of this

paragraph (j)(7):

Example 1. (i) Facts. On March 1, 1998, X issues a contract to F

for $100,000. The contract provides that beginning on March 1, 1999,

X will make distributions to F each year until F's death. Prior to

March 1, 2009, distributions are to be made at a rate of $12,000 per

year. Beginning on March 1, 2009, distributions are to be made at a

rate of $3,000 per year.

(ii) Analysis. If F is alive in 2009, the amount distributed in

2009 ($3,000) will be less than the amount distributed in 2008

($12,000). The exception in paragraph (j)(7)(ii) of this section

does not apply. The decrease in the amount of any distributions made

on or after March 1, 2009, can significantly reduce the probability

that total distributions under the contract will increase

commensurately with F's longevity. Thus, the contract fails to be

described in section 1275(a)(1)(B)(i).

Example 2. (i) Facts. On March 1, 1998, X issues a contract to G

for cash. The contract provides that, effective on any date G

chooses (the annuity starting date), X will begin monthly

distributions to G for G's life. Prior to the annuity starting date,

the account value of the contract reflects the investment return,

including changes in the market value, of an identifiable pool of

assets. When G chooses the annuity starting date, G must also choose

whether the distributions are to be fixed or variable. If fixed, the

amount of each monthly distribution will remain constant at an

amount that is no less than an amount based on the contract's

account value as of the annuity starting date, G's age on that date,

and permanent purchase rate guarantees contained in the contract. If

variable, the monthly distributions will fluctuate to reflect the

investment return, including changes in the market value, of the

pool of assets. The monthly distributions under the contract will

not otherwise decline from year to year.

(ii) Analysis. Because the only possible year-to-year declines

in annuity distributions are described in paragraph (j)(7)(ii) of

this section, the possibility that the amount of distributions may

decline from the previous year does not reduce the probability that

total distributions under the contract will increase commensurately

with G's longevity. Thus, the potential fluctuation in the annuity

distributions does not cause the contract to fail to be described in

section 1275(a)(1)(B)(i).

(8) Effective dates--(i) In general. Except as provided in

paragraph (j)(8) (ii) and (iii) of this section, this paragraph (j) is

applicable for interest accruals on or after February 9, 1998 on

annuity contracts held on or after February 9, 1998.

(ii) Grandfathered contracts. This paragraph (j) does not apply to

an annuity contract that was purchased before April 7, 1995. For

purposes of this paragraph (j)(8), if any additional investment in such

a contract is made on or after April 7, 1995, and the additional

investment is not required to be made under a binding contractual

obligation that was entered into before April 7, 1995, then the

additional investment is treated as the purchase of a contract after

April 7, 1995.

(iii) Contracts consistent with the provisions of FI-33-94,

published at 1995-1 C.B. 920. See Sec. 601.601(d)(2)(ii)(b) of this

chapter. This paragraph (j) does not apply to a contract purchased on

or after April 7, 1995, and before February 9, 1998, if all payments

under the contract are periodic payments that are made at least

annually for the life (or lives) of one or more individuals, do not

increase at any time during the term of the contract, and are part of a

series of distributions that begins within one year of the date of the

initial investment in the contract. An annuity contract that is

otherwise described in the preceding sentence does not fail to be

described therein merely because it also provides for a payment (or

payments) made by reason of the death of one or more individuals.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: December 19, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98-20 Filed 1-7-98; 8:45 am]

BILLING CODE 4830-01-U