IRS Blesses Next Big Annuity Trend: Fee-Based Annuities

by Prof. Robert Bloink and Prof. William H. Byrnes

Even following the demise of the DOL fiduciary rule, the impact of the fiduciary issue continues to color trends in the annuity product marketplace as uncertainty looms over whether the rule will be revived and as states continue to enact their own fiduciary regimes. One significant trend that has survived the rocky fiduciary ride is the fee-based annuity trend that would allow clients and advisors alike to escape the potential conflicts generated by commission-based sales. Despite the potential popularity of fee-based annuities even in a post-fiduciary rule world, questions surrounding the tax treatment of the fee prevented the trend from truly taking hold. Fortunately, the IRS has provided some degree of favorable guidance that could finally allow the fee-based annuity trend to take off.

Fee-Based Annuity Appeal

Generally, afee-basedannuity charges an ongoing asset-based fee instead of providing the advisor with a traditional commission. Because these fees are typically "level," they became popular after the release of the DOL fiduciary rule because firms that sell them were not required to deal with all of the onerous requirements of the DOL's best interests contract exemption.

The availability of a streamlined version of the exemption for level fee advisors under the fiduciary rule also made sellingfee-based products more attractive for advisory firms, which can potentially be held liable for advisors who, as fiduciaries (at least under the DOL rule), sell products that are not in the client's best interests.

Historically, advisors have been compensated for the sale of variable annuity products on a commission basis, which is believed to motivate advisors to recommend products because of their high commission value, rather than because they are in the client's best interests. This structure generates concern both that the advisor's compensation may not be reasonable and also creates a potential conflict of interest between advisor and client.

Despite the potential benefits, issues surrounding the tax treatment of the fee when pulled from a non-qualified fee-based annuity product deterred many clients from jumping in because of concerns about their potential tax liability. Further, the potential 10 percent penalty that could apply if the client was under age 59 ½ provide a significant impediment for many clients who are approaching retirement age.

The IRS Private Letter Ruling

Fortunately, the IRS has released company-specific private letter rulings clarifying that when an advisor deducts his or her advisoryfeedirectly from the cash value of a non-qualified annuity product, that withdrawal is not treated as a taxable transaction. The annuity in question involvedfee-based annuities, where the advisor was not entitled to receive a commission for the sale in addition to the1.5 percent advisory fee.

The rulings in question apply to fee-based variable, fixed indexed or hybrid annuities that are non-qualified, meaning that they are sold outside of a retirement plan (although annuities sold within retirement plans already received this favorable tax treatment).

In addition to the 1.5 percent limit, the ruling made clear that the non-taxable transaction rule would only apply if the fee was related to the annuity only. Because of this, advisors who manage multiple accounts for a single client cannot pull fees related to other accounts from the annuity without taxation.

While this ruling is widely viewed as positive forfee-basedadvisors and clients, clients should be reminded that although private letter rulings do give some indication of the IRS' view on the issue at hand, these rulings are technically only applicable to the taxpayer that requested the ruling--meaning that the client cannot rely upon the ruling unless the relevant issuer has obtained a private letter ruling.

Conclusion

While the PLR does not technically apply to all annuity sales as of yet, it does serve to significantly ease the costs associated with fee-based annuity sales and could potentially lead to an industry-wide rule on the issue at some point in the future. Because the rulings were technically issued to several different issuers, however, clients do have options when it comes to selecting a fee-based product if the annuity is otherwise in line with their financial goals.