SOME INVESTMENT FUNDS will have to find a new structure for tapping into money from pension trusts after an IRS ruling in late July.
The IRS issued two rulings about different forms of variable annuity contracts that an investor might purchase from a life insurance company. The product is called a variable annuity because the eventual annuity paid is linked to the return the insurance company earns from investing the premium paid by the investor. The investor has a choice of different accounts or investments he can direct the insurance company to make. He can also move the money between accounts.
The issue the rulings address is whether the investor should be treated as the direct owner of the investments. They conclude that he should if — among other things — the investments were available for direct purchase by the general public and there is little diversification of investments in the segregated asset accounts set up by the insurance company. For example, Revenue Ruling 2003-92 addresses a case where an insurance company set up various segregated asset accounts each one of which holds an interest in a single partnership. The partnership interests can be purchased by any accredited investor through private placements. The IRS said that, even though the partnerships make diversified investments, that is not enough since the investor is using the insurance company to make an investment in a single partnership in which he could have invested directly.
Investment funds sometimes try to tap into money in pension trusts. Pension trusts are exempted from US income taxes, but must pay taxes on any “unrelated business taxable income.” Dividends, interest, royalties, annuities and some other types of passive income are not considered such income. Therefore, the investment funds sometimes arrange for pension trusts to invest in them through an annuity contract that earns a return tied to the investment results in the fund. Such arrangements will be harder to make work after the latest IRS rulings.