513 / How are annuity contracts held by corporations and other non-natural persons taxed?

When an annuity contract is no longer treated as an annuity for tax purposes, income on the contract is treated as ordinary income received or accrued by the owner during the taxable year.¹ “Income on the contract” is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (the amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement.²

This rule does not apply to any annuity contract that is:

(1)     acquired by the estate of a decedent by reason of the death of the decedent;

(2)     held under a qualified pension, profit sharing, or stock bonus plan, as an IRC
Section 403(b) tax sheltered annuity, or under an individual retirement plan;

(3)     purchased by an employer upon the termination of a qualified pension, profit sharing, or stock bonus plan or tax sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to the employee’s beneficiary;

(4)     an immediate annuity (i.e., an annuity that is purchased with a single premium or annuity consideration, the annuity starting date of which is no later than one year from the date of purchase, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period); or

(5)     a qualified funding asset (as defined in IRC Section 130(d) but without regard to whether there is a qualified assignment).³ A qualified funding asset is any annuity contract issued by a licensed insurance company that is purchased and held to fund periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness.⁴

These requirements apply “to contributions to annuity contracts after February 28, 1986.”⁵ It is clear that if all contributions to the contract are made after February 28, 1986, the requirements apply to the contract. It seems clear enough that if no contributions are made after February 28, 1986, to an annuity contract, such contract held by a non-natural person is treated for tax purposes as an annuity contract and is taxed under the annuity rules ( Q 512). If contributions to a contract held by a non-natural person have been made both before March 1, 1986, and after February 28, 1986, however, it is not clear whether the income on the contract is allocated to different portions of the contract and whether the portion of the contract allocable to contributions before March 1, 1986, may continue to be treated as an annuity contract for income tax purposes. The IRC makes no specific provision for separate treatment of contributions to the same contract made before March 1, 1986, and those made after February 28, 1986.