Alert April 01, 2008

IRS Issues Final Regulations Regarding Diversification Requirements for Variable Contracts

The IRS finalized regulations (T.D. 9385) under Section 817 of the Internal Revenue Code (the “Code”) concerning the diversification requirements applicable to variable annuity, endowment, and life insurance contracts.  Section 817 of the Code provides that if a variable contract based upon a segregated asset account is not adequately diversified, then such variable contract will not be treated as an annuity, endowment or life insurance contract.  Additionally, any income earned by that segregated asset account will be treated as ordinary income received or accrued by the policyholders.  A variable contract will be treated as adequately diversified if no one investment constitutes more than 55% of the whole value of the total assets, no two investments constitute more than 70% of the whole value of the total assets, no three investments constitute more than 80% of the whole value of the total assets, and no four investments constitute more than 90% of the whole value of the total assets.  Section 817 provides for a look-through rule under which taxpayers do not treat an investment in a regulated investment company (“RIC”), partnership, or trust as a single asset, but, rather, take into account the underlying assets of the RIC, partnership, or trust.  This look-through rule applies, however, only where all of the interests in the RIC, partnership or trust are owned by one or more segregated assets accounts or certain “permitted investors,” and where public access to the RIC, partnership, or trust is available exclusively through the purchase of a variable contract.

The final regulations expand the list of “permitted investors” to include ownership by qualified section 529 tuition plans, by trustees of foreign pension plans, and by Puerto Rican accounts that are treated as segregated accounts under Puerto Rican law.  Under the former regulations, “permitted investors” included only the general account of a life insurance company, the manager of the RIC, partnership or trust, a qualified pension or retirement plan, or certain members of the public.  Additionally, the final regulations remove a provision from the regulations that provided that the payment required to remedy an inadvertent diversification failure must be based on the tax that would have been owed by the policyholders if they were treated as receiving the income on an insurance contract.  Under the final regulations, the amount required to be paid to remedy an inadvertent failure to diversify remains the amount set forth on Revenue Procedure 92-25, section 4.02.  However, the modification will preserve flexibility should the IRS desire to change this amount in response to future comments requested by Notice 2007-15.

The regulations were finalized in substantially the form of the regulations proposed on July 30, 2007 (REG-118719-07), and became effective on March 7, 2008.