Debt Instruments with Original Issue Discount; Annuity Contracts

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8754] RIN 1545 B AS76

TITLE: Debt Instruments with Original Issue Discount; Annuity
Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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 �1.1275 B 1(j)
(8).

FOR FURTHER INFORMATION CONTACT: Jonathan R. Zelnik, (202) 622 B
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
�1.1275 B 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 A 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 A 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). 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 A 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 A 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 A 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 B 6, 1995 B 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 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 A 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
�1.61 B 2, the arrangement is not subject to the OID timing
provisions. See also ��1.1273 B 2(d) and 1.1274 B 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 A Sections 1.1271 B 1 through 1.1274 B 5 @
and A Sections 1.1275 B 1 through 1.1275 B 5 @ and adding the
following entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1271 B 1 also issued under
26 U.S.C. 1275(d).

Section 1.1272 B 1 also issued under 26 U.S.C. 1275(d).

Section 1.1272 B 2 also issued under 26 U.S.C. 1275(d).

Section 1.1272 B 3 also issued under 26 U.S.C. 1275(d).

Section 1.1273 B 1 also issued under 26 U.S.C. 1275(d).

Section 1.1273 B 2 also issued under 26 U.S.C. 1275(d).

Section 1.1274 B 1 also issued under 26 U.S.C. 1275(d).

Section 1.1274 B 2 also issued under 26 U.S.C. 1275(d).

Section 1.1274 B 3 also issued under 26 U.S.C. 1275(d).

Section 1.1274 B 4 also issued under 26 U.S.C. 1275(d).

Section 1.1274 B 5 also issued under 26 U.S.C. 1275(d). * * *
Section 1.1275 B 1 also issued under 26 U.S.C. 1275(d).

Section 1.1275 B 2 also issued under 26 U.S.C. 1275(d).

Section 1.1275 B 3 also issued under 26 U.S.C. 1275(d).

Section 1.1275 B 4 also issued under 26 U.S.C. 1275(d).

Section 1.1275 B 5 also issued under 26 U.S.C. 1275(d). * * * Par.
2. Section 1.1271 B 0 is amended by adding entries for paragraphs
(i) through (j)(8) to �1.1275-1 to read as follows: � 1.1271 B 0
Original issue discount; effective dates; table of contents.

* * * * *

�1.1275 B 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 B 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:

�1.1275 B 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
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):

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 B 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 � 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:
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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