Annuity Payments Weren't Substantially Equal Periodic Payments That Escaped 10% Penalty

PLR 201120011

IRS has privately ruled that payments made under nonqualified single premium immediate annuity contracts offered by two life insurance companies weren't “substantially equal periodic payments” under Code Sec. 72(t)(2)(A)(iv). Under the annuity, fixed payments increased annually for the life of the contract by a constant percentage chosen by the contract owner. Accordingly, the payments weren't excepted from the Code Sec. 72(t)(1) 10% penalty on early distributions.

Background. The rules for the taxation of amounts received under an annuity contract are set out in Code Sec. 72. Under Code Sec. 72(q)(1), a penalty tax is imposed on certain premature or early distributions under annuity contracts equal to 10% of the amount that is includible in gross income. The Code Sec. 72(q)(1) penalty tax isn't imposed if the distribution satisfies one of the exceptions set out in Code Sec. 72(q)(2). For example, under Code Sec. 72(q)(2)(D), a distribution will not be subject to the penalty tax if it is “part of a series of substantially equal periodic payments (not less frequent than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and his designated beneficiary.”

Similarly, distributions from qualified retirement plans and IRAs before age 59 1/2 are generally hit with a 10% penalty tax under Code Sec. 72(t)(1). There are a number of exceptions to the penalty, including one under Code Sec. 72(t)(2)(A)(iv) for distributions that are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary.

In Notice 2004-15, 2004-1 CB 526, IRS stated that because Code Sec. 72(q)(2)(D) and Code Sec. 72(t)(2)(A)(iv) were enacted for the same purpose, it was appropriate to apply the same methods to determine whether a distribution was part of a series of substantially equal periodic payments. Accordingly, IRS says taxpayers may use one of the methods set out in Notice 89-25, 1989-1 CB 662, as modified by Rev Rul 2002-62, 2002-2 CB 710, to determine whether a distribution from a non-qualified annuity contract is part of a series of substantially equal periodic payments under Code Sec. 72(q)(2)(D).

Notice 89-25, Q&A-12, provided three methods under which payments will be considered to be substantially equal periodic payments under Code Sec. 72(t)(2)(A)(iv) : (1) the required minimum distribution method; (2) the fixed amortization method; or (3) the fixed annuitization method. Under the first method, payments qualify if the annual payment is determined using a method that would be acceptable for purposes of calculating the minimum distribution required under Code Sec. 401(a)(9). For this purpose, the payment may be determined based on the life expectancy of the employee or the joint life and last survivor expectancy of the employee and beneficiary.

Notice 89-25, Q&A-12, was modified by Rev Rul 2002-62, for any series of payments beginning on or after Jan. 1, 2003. Rev Rul 2002-62 describes the required minimum distribution method as follows:

The annual payment for each year is determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. Under this method, the account balance, the number from the chosen life expectancy table and the resulting annual payments are redetermined for each year. If this method is chosen, there will not be deemed to be a modification in the series of substantially equal periodic payments, even if the amount of payments changes from year to year, provided there is not a change to another method of determining the payments.

Facts. Two life insurance companies (Taxpayers) plan to issue non-qualified single premium immediate annuity contracts in several different forms, including a straight life annuity, a life annuity with a guarantee period, and a life annuity with various types of refund features. These contracts can be payable for a single life or for joint lives, and, for a contract owner age 59 1/2 or older, can include both a cash withdrawal feature and an acceleration feature. The payments made under the contracts are generally fixed, level periodic payments, unless a contract owner selects Option U at the time a contract is issued.

Under Option U, a contract owner can elect to have the fixed annuity payments increase annually for the life of the contract by a constant percentage equal to 1%, 2%, 3%, or 4%. The percentage can't be changed after the contract is issued. If the contract owner elects Option U, the amount of the single premium paid for the contract is unaffected, but the initial payments made under the contract will be lower.

Taxpayers represented that the annuity payments made under the contracts in cases where Option U isn't elected would be substantially equal periodic payments under Code Sec. 72(q)(2)(D). Taxpayers also represented that when Option U is elected, payments made under the contracts would satisfy the minimum distribution requirement of Code Sec. 401(a)(9) and Reg. §1.401(a)(9)-6. Taxpayers requested a ruling that payments made under the contracts with Option U were substantially equal periodic payments.

Taxpayers' position. Taxpayers argued that under Notice 89-25, Q&A-12, payments which are determined using a method that would be acceptable for purposes of calculating the minimum distribution required under Code Sec. 401(a)(9) are substantially equal periodic payments. Taxpayers then relied on the Code Sec. 401(a)(9) regs that provide that certain annually increasing annuity payments to people over age 70 1/2 will satisfy the Code Sec. 401(a)(9) requirements.

Taxpayers also raised an alternative argument based on the legislative history of the Tax Reform Act of '86 (P.L. 99-514), which suggests that a stream of payments under a defined contribution or defined benefit plan will not fail to be substantially equal solely because the payments vary on account of certain cost of living adjustments. (S. Rep. No. 99-313, p. 615 (1986))

PLR's conclusion. In the private letter ruling (PLR), IRS ruled that the payments made under the contracts with Option U weren't substantially equal periodic payments under Code Sec. 72(q)(2)(D).

The PLR found that the Taxpayers' argument disregarded Rev Rul 2002-62, which replaced the guidance provided in Notice 89-25, Q&A-12, with a more detailed description of the three methods. In particular, Rev Rul 2002-62 clarified that the required minimum distribution method involves an annual recalculation of the payments determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. Under this method, the annual payments may increase or decrease based on the account balance and the remaining life expectancy from the chosen table.

In contrast, the annual payments under the contracts with Option U would automatically increase by a fixed percentage over the prior year's payments, rather than increase or decrease based on the account balance and the remaining life expectancy from the chosen table. Thus, the payments under the contracts with Option U wouldn't be determined using the required minimum distribution method described in Rev Rul 2002-62 and Notice 89-25.

In the PLR, IRS indicated that it believed that Rev Rul 2002-62 merely provides further explanation of the required minimum distribution method in Notice 89-25. However, to the extent that the two vary, the PLR concluded that Rev Rul 2002-62 controls.

In dismissing Taxpayers' alternate argument based on legislative history, IRS noted that, unlike payments that vary on account of cost of living adjustments, the annual increase in payment amounts provided under Option U were at a fixed rate chosen by a contract owner.

References: For the substantially equal payment exception to the 10% penalty, see FTC 2d/FIN ¶H-11107; United States Tax Reporter ¶724.21; TaxDesk ¶144,011; TG ¶8324.