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INVESTMENT ANNUITY v. BLUMENTHAL

July 12, 1977

INVESTMENT ANNUITY, INC., et al., Plaintiffs,
v.
W. MICHAEL BLUMENTHAL, et al., Defendants



The opinion of the court was delivered by: RICHEY

 CHARLES R. RICHEY, UNITED STATES DISTRICT JUDGE

 This case came before the Court on June 17, 1977, for oral argument on defendants' motion to dismiss and plaintiffs' motion for preliminary injunction. After hearing oral argument, the Court denied defendants' motion to dismiss, but took under advisement plaintiffs' motion for preliminary injunction. While the Court had plaintiffs' motion under advisement, the parties, on June 27, 1977, stipulated that no material facts were in dispute and that a final disposition of the case on the merits would be appropriate.

 Upon reconsideration of its June 17, 1977, ruling from the bench, which denied defendants' motion to dismiss, the Court has concluded, for the reasons stated herein, that a ruling on the motion to dismiss should be deferred pending good-faith efforts by the plaintiffs to stage a "friendly" third-party challenge toRevenue Ruling 77-85 by way of either a Tax Court or a refund suit.

 I. BACKGROUND

 This case concerns the tax treatment to be accorded to what have been termed investment annuity contracts. Specifically, the legal issue before the Court is whether investment annuity contracts are "contracts with reserves based on a segregated asset account" within the meaning of section 801(g)(1)(B) of the Internal Revenue Code, 26 U.S.C. § 801(g)(1)(B).

 An investment annuity contract is like a conventional annuity contract in that both involve the purchase by the policyholder of a promise by the insurer to make payments to the annuitant at a specified maturity date (often the annuitant's date of retirement). As in the case of all annuities, the investment annuity is predicated on actuarially derived mortality and expense guaranties made to the policyholder by the insurance company. An investment annuity is like a variable annuity (and unlike a fixed-dollar annuity) in that the amount of the annuities paid on or after the maturity date reflect the investment return and market value of the "segregated asset account." The unique feature of an investment annuity contract -- and the only substantive difference between it and other variable annuity arrangements -- is that a separate "segregated asset account," known as a "custodial account," is established for each investment annuity contract, and the policyholder (rather than the insurance company) directs how the assets in the custodial account are to be invested. *fn1"

 This case arises out of the action of the Internal Revenue Service (IRS) in issuingRevenue Ruling 77-85 on March 9, 1977. Internal Revenue Bulletin No. 1977-15, at 7-9 (April 11, 1977). Prior to that date, and since 1965, *fn2" the IRS had treated investment annuity contracts as conventional segregated asset annuity accounts with the result that they were entitled to the favorable tax treatment afforded by section 801(g)(1)(B). In brief, the tax advantages of such treatment are: (1) the annual investment return of the segregated asset account is included not in the policyholder's gross income, but rather in the investment yield of the insurance company, see 26 U.S.C. § 804(c), with the result that such investment return is taxed to the insurance company at a "favorable" rate; and (2) when the annuities are paid upon maturity, the gain reflected in the annuity payments, see 26 U.S.C. §§ 72(a)-(c), is then included in the annuitant's gross income. *fn3" Revenue Ruling 77-85 reversed the previous determination by the IRS and held that investment annuity contracts are not "contracts with reserves based on a segregated asset account" within the meaning of section 801(g)(1)(B). The effect of this ruling is that all income produced by the assets in the custodial account are includible in the gross income of the policyholder for the year in which they become added to the custodial account. The Ruling did, however, "grandfather" all existing investment annuity contracts by holding that all such contracts will continue to be treated for tax purposes as "contracts with reserves based on segregated asset accounts" within the meaning of section 801 (g)(1)(B).

 Plaintiffs herein are Investment Annuity, Inc. (IA) and First Investment Annuity Co. (FIAC). FIAC is a wholly-owned subsidiary of IA and is IA's sole business. FIAC is licensed in Pennsylvania as a legal reserve life insurance company and was organized for the purpose of issuing and marketing investment annuities of various types. Upon being advised of the substance ofRevenue Ruling 77-85, as well as actions taken by the Securities and Exchange Commission and the Insurance Commissioner of the Commonwealth of Pennsylvania in anticipation of the Ruling, *fn4" plaintiff FIAC immediately ceased selling investment annuity contracts. It has not, since March 9, 1977, sold any new investment annuity contracts, nor has it received any additional contributions to existing accounts. Plaintiffs now seek a declaratory judgment thatRevenue Ruling 77-85 is unlawful, beyond statutory authority, and in violation of the Internal Revenue Code. In addition, they seek injunctive relief to restrain the defendants from implementingRevenue Ruling 77-85 and from refusing to treat investment annuity contracts as within the purview of section 801(g)(1)(B).

 II. DEFENDANTS' MOTION TO DISMISS

 As a threshold matter, defendants have moved to dismiss this case on the ground that the action is barred in its entirety by the Anti-Injunction Act, 26 U.S.C. § 7421(a). *fn5" In addition, although they have not strenuously pressed the argument, defendants contend that plaintiffs have no standing to maintain this action. The Court, in its ruling from the bench on June 17, 1977, rejected both these arguments. The Court continues to find defendants' contention that plaintiffs lack standing to be without merit. However, for the reasons stated herein, the Court concludes that, in light of the Anti-Injunction Act, this suit for declaratory and injunctive relief cannot be maintained at least until plaintiffs have demonstrated to the Court that they have made all good-faith efforts to stage a "friendly" third-party challenge toRevenue Ruling 77-85.

 The Anti-Injunction Act, 26 U.S.C. § 7421(a), upon which defendants primarily rely in moving to dismiss this action, provides:

 
Except as provided in [certain sections not here pertinent], no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.

 The purpose of this Act was described by the Supreme Court in the seminal case of Enochs v. Williams Packing & Navigation Co., 370 U.S. 1, 7, 82 ...


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