Does an annuity contract mean that a disqualified plan's investment income is zero?

[Peter Gulia]

A practitioner is negotiating the closing of an IRS audit. The IRS describes the settlement range as based on the taxes that could be imposed if the plan is treated as not qualified. The IRS requests that the taxpayer's representative submit a worksheet showing those taxes.

Because the plan's only investment is rights under a group annuity contract, the representative intends to show the plan's investment income as zero for every year, taking the position that the annuity contract still gets the tax treatment of an annuity contract.

In your experience, do IRS people commonly accept or question such a position (in the context of Audit CAP)?

[Bird]

No experience, but that is a novel theory. I doubt it will get much traction.

[Peter Gulia]

Just to be clear: the taxpayer's representative would show taxes on not having a deduction for contributions to the plan, and would treat only the build-up in the annuity contract as not yet income under IRC 72.

[jpod]

What is the effect of Section 72(u)?

[Peter Gulia]

Even if none of the IRC 72(u)(3) exceptions applies, IRC 72(u)(1) applies only if an annuity contract is held by a non-natural person. A fact missing from my beginning description is that the employer isn't a corporation or any kind of business organization, but rather a natural person who operates her business as a sole proprietorship. So not only are all participants and annuitants natural persons but also the holder of the group annuity contract is a natural person.

Based on this, the taxpayer's representative might argue that an estimate of what taxes would result from a disqualified plan includes undoing deductions for contributions, but doesn't include assuming that the plan's trust (which doesn't exist) would be taxed as a complex trust and bear tax on the trust's realized capital gains and dividends. Instead, the income on the annuity contract would be taxed under IRC 72 rules as a participant gets payment.

[jpod]

Ok, so you escape 72(u); good. In that case, what theory could the IRS possibly assert for counting the inside build-up in the CAP computation? Is there one? Doesn't the Rev. Proc. say that the sanction is computed by assuming that the trust loses its tax exemption (as opposed to the income being taxable)? Either you're concerned about nothing or I am not seeing the forest through the trees.

[Peter Gulia]

You're right; I'm hoping that my client (the taxpayer's representative) is right, but seeking to find out whether the IRS has an argument that she hasn't thought of.

[movedon]

No experience, but I think it makes sense. Let us know how it goes.

[Ron Snyder]

The question is not simply whether a natural person OWNS the annuity, but the annuity is covers the life of and individual. A group annuity will never work.

[panther]

See also, Siske, Roger, "IRS Voluntary Compliance Program" ALI-ABA (July 2002) re qualified plan corrections (internal buildup of income in group insurance annuity contracts or individual insurance annuity contracts is not included in the "Maximum Payment Amount" under Audit CAP -- cites IRC 72).

Further thought -- If the sponsor were a tax-exempt corporation and the group annuity is deemed owned by a non-natural person and, per IRC 72(u), the annuity contract income is ordinary income to the policyholder, would there be any tax if the policy-holder is a tax-exempt organization? I would not think so.