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The Impact of Federal Income Tax Laws on Life Insurance and Annuities

The federal government wants to make sure that the tax advantages of insurance products are directed toward an 'insurance purpose.'

Judith A. Hasenauer, 09/06/2012

We are all aware that life insurance and annuities are heavily regulated financial products. Virtually all financial-services professionals are knowledgeable about the licenses that are necessary in order to transact a life insurance or annuity business. However, fewer people are aware of the other elements of insurance regulation--particularly those imposed under federal income tax law.

The regulation of the business of insurance, except for variable annuities and variable life insurance, has been delegated to the various states. For over a century, state insurance regulators have been almost exclusively involved in the regulation of insurance companies, the products they sell, and the people who sell such products. It was not until 1959 that the federal government got involved in the regulation of insurance with the decision that variable annuities are investment company securities and therefore subject to the full panoply of federal securities regulation. As variable life insurance came on the scene, it too became subject to federal securities regulation. The end result was a form of dual regulation where both the state insurance regulators and the Securities and Exchange Commission regulated variable products.

Until the late 1970s, the federal taxing authorities were but little involved in any definitional or regulatory oversight of the business of insurance or of the products sold by insurers. Until 1977, the interpretation of Treasury Regulations stated that an annuity or life insurance product was whatever was customarily treated as such by insurers in compliance with state insurance regulatory requirements.

Then, in 1977, the Internal Revenue Service, for the first time, undertook in a Revenue Ruling to define an insurance product by the nature of the investments that were held by the insurer to be the reserves for such a product. Then, in 1984, Congress made extensive changes to the life insurance company tax laws that imposed significant limitations on the type of assets that could be held under a variable annuity or variable life insurance products.

There followed even more changes to the tax laws that redefined what features a life insurance policy or annuity contract had to contain if these products were to be treated as such for purposes of the federal income tax. These definitions were directed toward not only variable annuities and variable life insurance policies, but created new definitions for all life insurance and annuity contracts. These requirements, in effect, created a form of regulation of life insurance and annuities by the federal taxing authorities. However, unlike regulation by state insurance regulators or the SEC, the regulatory functions of the Internal Revenue Service are applied more retroactively than they are proactivel.

Variable insurance products come in for more extensive requirements under federal tax laws than is the case with non-variable products. Variable insurance products must comply with requirements regarding the assets that underlie the products if they are to be treated as life insurance or annuities for federal income tax purposes. Thus, an owner of a variable insurance product must not exercise "policy owner control" over the assets that underlie the product. This means that the policy owner can select an investment strategy from among a number of such strategies offered by the insurer; however, the policy owner cannot select specific assets (other than insurance company dedicated mutual funds) to underlie the life insurance policy or annuity contract. The policy owner must not be able to control any element of the investment process aside from the selection of the investment strategy.

Variable insurance products must also have investments that meet certain diversification standards as indicated in the Internal Revenue Code and the Treasury Regulations. Failure to comply with these diversification requirements can cause the variable annuity or variable life insurance product to cease to be treated as "insurance products" for federal income tax purposes, and all investment gains will be taxable to the policy owner in the tax year where the failure occurs--all at ordinary income tax rates! If the diversification failure is inadvertent, the insurer can petition the Secretary of the Treasury for relief, but generally only to shift the tax burden from all the affected policy owners to the insurer.

The waning years of the 20thcentury also saw changes in the definition of life insurance for purposes of the federal tax laws. The main thrust of these changes was to require minimum amounts of "net amount at risk" under a policy with respect to the cash values of a policy or the premiums paid for the policy. There were also changes in the definition of life insurance for purposes of withdrawals of cash values and the imposition of tax penalties on withdrawals from life insurance policies that were deemed to fail tests relating to the payment mode of premiums under the policies. Thus, single premium life insurance contracts or even multiple premium life insurance contracts that do not have premiums that would qualify the policies as at least a seven-year annual premium policy are treated as annuities if cash values are withdrawn prior to the death of the insured.

The purpose of all these requirements for life insurance and annuities is basically the same. Life insurance and annuities provide significant tax advantages to policy owners. The federal government wants to make sure that these tax advantages are directed toward an "insurance purpose," not merely to provide tax advantages to investments. The taxing authorities do not want, as a policy matter, for a taxpayer to be able to elect to defer taxes on investment income merely through the subterfuge of wrapping the investment with an insurance contract. The objective of insurance should be insurance--not investment.

It is obvious that any insurance transaction involves an investment element. This is fundamental to the insurance transaction. However, for federal tax purposes, the primary objective should not be investment, but the insurance element. Otherwise the transaction will be taxed as investment rather than enjoy the advantages afforded to life insurance products. This means that the IRS now performs a quasi-regulatory function in addition to the direct regulatory functions already performed by state insurance regulators and the SEC.

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Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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