[Federal Register Volume 63, Number 5 (Thursday, January 8, 1998)]
[Rules and Regulations]
[Pages 1054-1059]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-20]


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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