26 CFR § 1.72-7 - Adjustment in investment where a contract contains a refund feature.

§ 1.72-7 Adjustment in investment where a contract contains a refund feature.

(a) Definition of a contract containing a refund feature. A contract to which section 72 applies, contains a refund feature if:

(1) The total amount receivable as an annuity under such contract depends, in whole or in part, on the continuing life of one or more persons,

(2) The contract provides for payments to be made to a beneficiary or the estate of an annuitant on or after the death of the annuitant if a specified amount or a stated number of payments has not been paid to the annuitant or annuitants prior to death, and

(3) Such payments are in the nature of a refund of the consideration paid. See paragraph (c)(1) of § 1.72-11.

(b) Adjustment of investment for the refund feature in the case of a single life annuity. Where a single life annuity contract to which section 72 applies contains a refund feature and the special rule of paragraph (d) of this section does not apply, the investment in the contract shall be adjusted in the following manner:

(1) Determine the number of years necessary for the guaranteed amount to be fully paid by dividing the maximum amount guaranteed as of the annuity starting date by the amount to be received annually under the contract to the extent such amount reduces the guaranteed amount. The number of years should be stated in terms of the nearest whole year, considering for this purpose a fraction of one-half or more as an additional whole year.

(2) Consult Table III or VII (whichever is applicable) of § 1.72-9 for the appropriate percentage under the whole number of years found in subparagraph (1) of this paragraph and the age (as of the annuity starting date) and, if applicable, sex of the annuitant.

(3) Multiply the percentage found in subparagraph (2) of this paragraph by whichever of the following is the smaller: (i) The investment in the contract found in accordance with § 1.72-6 or (ii) the total amount guaranteed as of the annuity starting date.

(4) Subtract the amount found in subparagraph (3) of this paragraph from the investment in the contract found in accordance with § 1.72-6.

The resulting amount is the investment in the contract adjusted for the present value of the refund feature without discount for interest and is to be used in determining the exclusion ratio to be applied to the payments received as an annuity. The percentage found in Tables III or VII shall not be adjusted in a manner described in paragraph (a)(2) of § 1.72-5. These principles may be illustrated by the following examples:
Example 1.
On January 1, 1954, a husband, age 65, purchased for $21,053, an immediate installment refund annuity payable $100 per month for life. The contract provided that in the event the husband did not live long enough to recover the full purchase price, payments were to be made to his wife until the total payments under the contract equaled the purchase price. The investment in the contract adjusted for the purpose of determining the exclusion ratio is computed in the following manner:
Cost of the annuity contract (investment in the contract, unadjusted) $21,053
Amount to be received annually $1,200
Number of years for which payment guaranteed ($21,053 divided by $1,200) 17.5
Rounded to nearest whole number of years 18
Percentage located in Table III for age 65 (age of the annuitant as of the annuity starting date) and 18 (the number of whole years) (percent) 30
Subtract value of the refund feature to the nearest dollar (30 percent of $21,053) $6,316
Investment in the contract adjusted for the present value of the refund feature without discount for interest $14,737
Example 2.
Assume the same facts as in example (1), except that the total investment in the contract was made after June 30, 1986. The investment in the contract adjusted for the purpose of determining the exclusion ratio is computed as follows:
Cost of the annuity contract (investment in the contract, unadjusted) $21,053
Amount to be received annually $1,200
Number of years for which payment guaranteed ($21,053 ÷ $1,200) 17.5
Rounded to nearest whole number of years 18
Percentage in Table VII for age 65 and 18 years (percent) 15
Subtract value of the refund feature to the nearest dollar (15 percent of $21,053) $3,158
Investment in the contract adjusted for the present value of the refund feature without discount for interest $17,895
Example 3.
Assume the same facts as in example (1), except that the pre-July 1986 investment in the contract is $10,000 and the post-June 1986 investment in the contract is $11,053. If the annuitant makes the election described in § 1.72-6(d)(6), separate computations must be performed pursuant to § 1.72-6(d) to determine the adjusted investment in the contract. The pre-July 1986 investment in the contract and the post-June 1986 investment in the contract adjusted for the purpose of determining the exclusion ratios are, respectively, $7,000 and $9,395, determined as follows:
Pre-July 1986 investment in the contract (unadjusted) $10,000
Pre-July 1986 portion of the amount to be received annually ($10,000/$21,053 × $1,200) $570.00
Number of years for which payment guaranteed ($10,000 ÷ $570) 17.50
Rounded to nearest whole number of years 18
Percentage in Table III for age 65 and 18 years (percent) 30
Subtract value of the refund feature to the nearest dollar (30 percent of $10,000) $3,000
Pre-July 1986 investment in the contract adjusted for the present value of the refund feature without discount for interest $7,000
Post-June 1986 investment in the contract (unadjusted) $11,053
Post-June 1986 portion of the amount to be received annually ($11,053/$21,053 × $1,200) $630
Number of years for which payment guaranteed ($11,053 ÷ $630) 17.54
Rounded to nearest whole number of years 18
Percentage in Table VII for age 65 and 18 years (percent) 15
Subtract value of the refund feature to the nearest dollar (15 percent of $11,053) $1,658
Post-June 1986 investment in the contract adjusted for the present value of the refund feature without discount for interest $9,395
If, in the above examples, the guaranteed amount had exceeded the investment in the contract (or applicable portion thereof), the percentage found in Table III or VII (whichever is applicable) should have been applied to the lesser of these amounts since any excess of the guaranteed amount over the investment in the contract (as found under § 1.72-6) would not have constituted a refund of premiums or other consideration paid. In such a case, however, a different multiple might have been obtained from Table III or VII (whichever is applicable) since the number of years for which payments were guaranteed would have been greater.

(c) Adjustment of investment for the refund feature in the case of a joint and survivor annuity.

(1) Except as provided in paragraph (c)(2) of this section, if a joint and survivor annuity contract described in paragraph (b) (1), (2) or (6) of § 1.72-5 contains a refund feature and the special rule of paragraph (d) of this section does not apply, the investment in the contract shall be adjusted in the following manner:

(i) Find the percentage determined under the following formula:

V = t = 0 N 1 d x + t 1 x [ ( N 1 2 t ) P ( T y + t + 1 T y + t + M + 1 1 y ) ] N

In which:
V = The percentage, rounded to the nearest whole percent,
x = The age at the nearest birthday of the primary annuitant,
y = The age at the nearest birthday of the survivor annuitant,
N = The guaranteed amount divided by the annual annuity payable to the primary annuitant, rounded to the nearest integer,
P = The annual annuity continued to the survivor annuitant divided by the annual annuity payable to the primary annuitant,

M = N 1 2 t , P 1 x = The numbers of survivors at age x, d = 1 x 1 x + 1 , and T x = s = 0 1 2 ( 1 x + s + 1 x + s + 1 ) .

(ii) Multiply the percentage found in paragraph (c)(1)(i) of this section by the lesser of (A) the investment in the contract found in accordance with § 1.72-6, or (B) the total amount guaranteed as of the annuity starting date.

(iii) Subtract the amount found in paragraph (c)(1)(ii) of this section from the investment in the contract found in accordance with § 1.72-6.

In the case of a contract providing for payments to be made to two persons in the manner described in paragraph (b)(6) of § 1.72-5, this paragraph (c)(1) is applied as though the older person were the primary annuitant and the younger person were the survivor annuitant. For purposes of this paragraph (c)(1), the number of survivors at agex (lx) is determined under the following table:
x lx
5 1000000.
6 999729.
7 999493.
8 999284.
9 999069.
10 998849.
11 998620.
12 998382.
13 998135.
14 997876.
15 997606.
16 997322.
17 997025.
18 996714.
19 996387.
20 996044.
21 995684.
22 995304.
23 994905.
24 994484.
25 994041.
26 993573.
27 993080.
28 992563.
29 992024.
30 991461.
31 990876.
32 990269.
33 989638.
34 988984.
35 988303.
36 987593.
37 986846.
38 986055.
39 985210.
40 984298.
41 983310.
42 982230.
43 981046.
44 979742.
45 978302.
46 976709.
47 974945.
48 972992.
49 970832.
50 968447.
51 966000.
52 963313.
53 960375.
54 957175.
55 953705.
56 949954.
57 945912.
58 941568.
59 936908.
60 931903.
61 926451.
62 920540.
63 914090.
64 907011.
65 899221.
66 890428.
67 880797.
68 870298.
69 858904.
70 846565.
71 832316.
72 816861.
73 800078.
74 781837.
75 762012.
76 740743.
77 717689.
78 692780.
79 665977.
80 637260.
81 607339.
82 575531.
83 541919.
84 506647.
85 469931.
86 432459.
87 394138.
88 355393.
89 316712.
90 278663.
91 242020.
92 207150.
93 174602.
94 144828.
95 118151.
96 94871.7
97 74863.6
98 58042.2
99 44176.1
100 32956.4
101 24044.8
102 17104.1
103 11815.5
104 7886.75
105 5054.94
106 3086.95
107 1778.82
108 955.465
109 470.955
110 208.668
111 80.7899
112 26.2340
113 6.69620
114 1.19385
115 .111460

(2) If the multiples in Tables I through IV of § 1.72-9 are used to determine any portion of the expected return under a contract described in paragraph (c)(1) of this section, only the post-June 1986 investment in the contract (if any) shall be adjusted in the manner described in paragraph (c)(1) of this section, and the pre-July 1986 investment in the contract shall, in the case of a contract described in paragraph (b) (1) or (6) of § 1.72-5, be adjusted in the following manner:

(i) Determine the number of years necessary for the guaranteed amount to be fully paid by dividing the maximum amount guaranteed as of the annuity starting date by the amount to be received annually under the contract. The number of years should be stated in terms of the nearest whole year, considering for this purpose a fraction of one-half or more as an additional whole year.

(ii) Consult Table III of § 1.72-9 for the appropriate percentages under the whole number of years found in subdivision (i) of this subparagraph and the age (as of the annuity starting date) and sex of each annuitant. If the annuitants are not of the same sex, substitute for the female annuitant a male annuitant 5 years younger, or for the male annuitant a female annuitant 5 years older, so that Table III will be entered in both cases with the ages of annuitants of the same sex.

(iii) Find the sum of the two percentages found in accordance with subdivision (ii) of this subparagraph.

(iv) To the age of the elder of the two annuitants (as determined under subdivision (ii) of this subparagraph), add the number of years (indicated in the table below) opposite the number of years by which such annuitants' ages differ:

Number of years difference in age (2 male annuitants or 2 female annuitants) Addition to older age in years
0 to 1, inclusive 9
2 to 3, inclusive 8
4 to 5, inclusive 7
6 to 8, inclusive 6
9 to 11, inclusive 5
12 to 15, inclusive 4
16 to 20, inclusive 3
21 to 27, inclusive 2
28 to 42, inclusive 1
Over 42 0

(v) Consult Table III for the appropriate percentage under the whole number of years found in subdivision (i) of this subparagraph and the age and sex of the elder annuitant as adjusted under subdivision (iv) of this subparagraph.

(vi) Subtract the percentage obtained in subdivision (v) of this subparagraph from the sum of the percentages found under subdivision (iii) of this subparagraph. If the result is less than one, subdivisions (vii) and (viii) of this subparagraph shall be disregarded and no adjustment made to the investment in the contract.

(vii) Multiply the percentage found in subdivision (vi) of this subparagraph by whichever of the following is the smaller: (A) the investment in the contract found in accordance with § 1.72-6 or (B) the total amount guaranteed as of the annuity starting date.

(viii) Subtract the amount found in subdivision (vii) of this subparagraph from the investment in the contract found in accordance with § 1.72-6.

(3) The principles of this paragraph (c) may be illustrated by the following examples:

Example 1.
Prior to July 1, 1986, Taxpayer A, a 70-year-old male, purchases a joint and last survivor annuity for $33,050. The contract provides for payments of $100 a month to be paid first to himself for life and then to B, his 40-year-old daughter, if she survives him. The contract further provides that in the event both die before ten years' payments have been made, payments will be continued to C, a beneficiary, or to C's estate, until ten years' payments have been made. If there is no post-June 1986 investment in the contract, the investment in the contract adjusted for the purpose of determining the exclusion ratio is computed in the following manner:
Cost of the annuity contract (investment in the contract unadjusted) $33,050
Guaranteed amount ($1,200 × 10) $12,000
Percentage in Table III for male, age 70 (or female, age 75) for duration of the guarantee (10) 21
Percentage in Table III for female, age 40 (or male, age 35) for duration of the guarantee (10) 2
Sum of percentages obtained 23
Difference in years of age between two males, aged 70 and 35 (or 2 females, aged 75 and 40) 35
Addition, in years, to older age 1
Percentage in Table III for male one year older than A 22
Difference between percentages obtained (23 percent less 22 percent) 1
Value of the refund feature to the nearest dollar (1 percent of $12,000) $120
Investment in the contract adjusted for present value of the refund feature $32,930
Example 2.
The facts are the same as in example (1), except that the total investment in the contract was made after June 30, 1986, A is 73 years of age, and B is A's 70 year old spouse. The percentage determined under the formula in paragraph (c)(1)(i) of this section is two percent. Thus, the amount determined under paragraph (c)(1)(ii) of this section is $240 (2 percent of $12,000), and the investment in the contract adjusted for the present value of the refund feature is $32,810 ($33,050 - $240).

(4) If an annuity described in paragraph (b) of § 1.72-5 contains a refund feature and the manner of determining the adjustment to the investment in the contract (or to any part of such investment) is not prescribed or requires use of the formula in paragraph (c)(1)(i) of this section, the Commissioner will determine the amount of the adjustment upon request. The request must contain the date of birth of each annuitant, the guaranteed amount, the annual annuity payable to each annuitant, and the annuity starting date. Send the request to the Commissioner of Internal Revenue, Attention: OP:E:EP:GA, Washington, D.C. 20224.

(d) Adjustment of investment in the contract where paragraph (b)(3) of § 1.72-2 applies to payments.

(1) If paragraph (b)(3) of § 1.72-2 applies to payments to be made under a contract and this section also applies because of the provision for a refund feature, an adjustment shall be made to the investment in the contract in accordance with this paragraph before making the computations required by paragraph (d)(3) of § 1.72-4 and paragraph (d)(7) of § 1.72-5. In the case of the guarantee of a specified amount, the adjustment shall be made by applying the appropriate multiple from Table III or VII (whichever is applicable), as otherwise determined under this section, to the investment in the contract or the guranteed amount, whichever is the lesser. The guarantee period shall be found by dividing the amount guaranteed by the amount determined by placing the payments received during the first taxable year (to guaranteed amount) on an annual basis. Thus, if monthly payments are first received by a taxpayer on a calendar year basis in August, his total payments (to the extent that they reduce the guaranteed amount) for the taxable year would be divided by 5 and multiplied by 12. The guaranteed amount would then be divided by the result of this computation to obtain the guarantee period. If the contract merely guarantees that proceeds from a unit or units of a fund shall be paid for a fixed number of years or the life (or lives) of an annuitant (or annuitants), whichever is the longer, the fixed number of years is the guarantee period. The appropriate percentage in Table III or VII shall be applied to whichever of the following is the smaller: (i) the investment in the contract; or (ii) the product of the payments received in the first taxable year, placed on an annual basis, multiplied by the number of years for which payment of the proceeds of a unit or units is guaranteed.

(2) The principles of this paragraph may be illustrated by the following examples:

Example 1.
Taxpayer A, a 50-year-old male purchases for $25,000 a contract which provides for variable monthly payments to be paid to him for his life. The contract also provides that if he should die before receiving payments for fifteen years, payments shall continue according to the original formula to his estate or beneficiary until payments have been made for that period. Beginning with the month of September, A receives payments which total $450 for the first taxable year of receipt. This amount, placed on an annual basis, is $1,350 ($450 divided by 4, or $112.50; $112.50 multiplied by 12, or $1,350). If there is no post-June 1986 investment in the contract, the guaranteed amount is considered to be $20,250 ($1,350 × 15), and the multiple from Table III (found in the same manner as in paragraph (b) of this section), 9 percent, applied to $20,250 (since this amount is less than the investment in the contract), results in a refund adjustment of $1,822,50. The latter amount, subtracted from the investment in the contract of $25,000, results in an adjusted investment in the contract of $23,177.50. If A dies before receiving payments for 15 years and the remaining payments are made to B, his beneficiary, B shall exclude the entire amount of such payments from his gross income until the amounts so received by B, together with the amount received by A and excludable from A's gross income, equal or exceed $25,000. Any excess and any payments thereafter received by B shall be fully includible in gross income.
Example 2.
Assume the same facts as in example (1), except that the total investment in the contract was made after June 30, 1986. The applicable multiple found in Table VII is 3 percent. When this is applied to the guaranteed amount of $20,250, it results in a refund adjustment of $607.50. The adjusted investment in the contract in $24,392.50 ($25,000 - $607.50).

(e) Adjustment of the investment in the contract where more than one annuity element is provided for a single consideration. In the case of contracts to which paragraph (b) of § 1.72-6 applies for the purpose of allocating the investment in the contract to two or more annuity elements which are provided for a single consideration, if one or more of such elements involves a refund feature, the portion of the investment in the contract properly allocable to each such element shall be adjusted for the refund feature before aggregating all the investments in order to obtain the exclusion ratio which is to apply to the contract as a whole.

Example 1.
If taxpayer A, an insured 70 years of age, upon maturity of an endowment policy which cost him a net amount of $86,000, elected a dual settlement consisting of (1) monthly payments for his life aggregating $4,146 per year with 10 years' payments certain, and (2) monthly payments for his 60-year-old brother, B, aggregating $2,820 per year with 20 years' payments certain, the exclusion ratio to be used by both A and B if there is no post-June 1986 investment in the contract would be determined in the following manner:
A's expected return (A's payments per year of $4,146 multiplied by his life expectancy from Table 1 of 12.1) $50,166.60
B's expected return (B's payments per year of $2,820 multiplied by his life expectancy from Table 1 of 18.2) $51,324.00
Sum of expected returns to be used in determining exclusion ratio $101,490.60
Percentage of total expected return attributable to A's expectancy of life ($50,166.60 ÷ $101,490.60) 49.4
Percentage of total expected return attributable to B's expectancy of life ($51,324 ÷ $101,490.60) 50.6
Portion of investment in the contract allocable to A's annuity (49.4 percent of $86,000) $42,484.00
Portion of investment in the contract allocable to B's annuity (50.6 percent of $86,000) $43,516.00
Value of the refund feature with respect to A's annuity (percentage from Table III for male, age 70, and duration 10, or 21 percent, multiplied by lesser of guaranteed amount and allocable portion of investment in the contract, $41,460) $8,707.00
A's allocable portion of the investment in the contract adjusted for refund feature ($42,484 less $8,707.00) $33,777.00
Value of the refund feature with respect to B's annuity (percentage from Table III for male, age 60, and duration 20, or 25 percent, multiplied by lesser of guaranteed amount and allocable portion of investment in the contract, $43,516) $10,879.00
B's allocable portion of the investment in the contract adjusted for refund feature ($43,516 less $10,879.00) $32,637.00
Sum of A's and B's allocable portions of the investment in the contract after adjustment for the refund feature $66,414.00
Exclusion ratio for the contract as a whole (total adjusted investment in the contract, $66,414, divided by the total expected return from above, $101,490.60) (percent) 65.4
Example 2.
Assume the same facts as in example (1) except that the total investment in the contract was made after June 30, 1986. The exclusion ratio to be used by both A and B would be 56.9 percent, determined as follows:
A's expected return (A's payments per year of $4,146 multiplied by his life expectancy from Table V of 16.0) $66,336.00
B's expected return (B's payments per year of $2,820 multiplied by his life expectancy from Table V of 24.2) $68,244.00
Sum of expected returns to be used in determining exclusion ratio $134,580.00
Percentage of total expected return attributable to A's expectancy of life ($66,336.00 ÷ $134,580.00) 49.3
Percentage of total expected return attributable to B's expectancy of life ($68,244.00 ÷ $134,580.00) 50.7
Portion of investment in the contract allocable to A's annuity (49.3 percent of $86,000) $42,398.00
Portion of investment in the contract allocable to B's annuity (50.7 percent of $86,000) $43,602.00
Value of the refund feature with respect to A's annuity (percentage from Table VII for age 70 and duration 10, or 11 percent, multiplied by lesser of the guaranteed amount and allocable portion of investment in the contract, $41,460) $4,560.60
A's allocable portion of the investment in the contract adjusted for refund feature ($42,398 less $4,560.60) $37,837.40
Value of the refund feature with respect to B's annuity (percentage from Table VII for age 60 and duration 20, or 11 percent, multiplied by lesser of guaranteed amount and allocable portion of investment in the contract, $43,602) $4,796.22
B's allocable portion of the investment in the contract adjusted for refund feature ($43,602 less $4,796.22) $38,805.78
Sum of A's and B's allocable portions of the investment in the contract after adjustment for the refund feature $76,643.18
Exclusion ratio for the contract as a whole (total adjusted investment in the contract, $76,643.18, divided by the total expected return from above, $134,580.00) (percent) 56.9

(f) Adjustment of investment in the contract with respect to contracts subject to § 1.72-6(d). In the case of a contract to which § 1.72-6(d) (relating to contracts in which amounts were invested both before July 1, 1986, and after June 30, 1986) applies, this section is applied in the manner prescribed in § 1.72-6(d) and, in particular, § 1.72-6(d)(5)(vi).

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as amended by T.D. 8115, 51 FR 45702, Dec. 19, 1986]