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INVESTMENT ANNUITY v. BLUMENTHAL

November 9, 1977

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



The opinion of the court was delivered by: RICHEY

 UNITED STATES DISTRICT JUDGE CHARLES R. RICHEY

 This case is now before the Court for a final determination on the merits. Initially, this case came before the Court on plaintiffs' motion for preliminary injunction. Defendants then filed a motion to dismiss on the ground that the instant action was barred by the Anti-Injunction Act, 26 U.S.C. § 7421(a) (1970). While the Court had these initial motions 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.

 After deferring ruling on defendants' motion to dismiss in order to permit plaintiffs to make good-faith efforts to challenge the revenue ruling here in issue in either the Tax Court or in a refund action, *fn1" and based on its finding that "this case is one 'in which the aggrieved party has no access at all to judicial review,' Bob Jones University v. Simon, 416 U.S. 725, 747, 40 L. Ed. 2d 496, 94 S. Ct. 2038 (1974)," the Court, by Order of September 28, 1977, denied defendants' motion to dismiss. Accordingly, pursuant to the stipulation of the parties, the case is now before the Court for a final determination upon the merits as provided for by Fed. R. Civ. P. 56(c).

 I. BACKGROUND AND FACTS

 Since the facts of this case set forth in the Court's initial Memorandum Opinion of July 12, 1977, on the motion to dismiss remain unchanged, the Court will quote the Background section of that opinion in order to provide the reader of this opinion with a recapitulation of the essential facts involved in this dispute:

 
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 actuarily-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.1a
 
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).

 In addition to the undisputed facts set forth above, one other sequence of events, also undisputed, is pertinent to the Court's consideration of the merits: On August 29, 1977, the Internal Revenue Service issued to a competitor of plaintiff FIAC a private ruling which declared that certain variable annuity contracts were considered to be "[contracts] with reserves based on a segregated asset account" within the meaning of section 801(g)(1)(B) of Title 26 of the United States Code. The annuity contracts that were the subject of this private ruling permitted substantial investment control on the part of the policyholder not materially different in degree than the amount of policyholder investment control inherent in the investment annuity contracts marketed by plaintiff FIAC. Upon learning of this private ruling, plaintiffs filed a motion seeking immediate entry of judgment in their favor. The Court then, upon finding that the private ruling of August 29, 1977, raised "grave questions about the propriety ofRevenue Ruling 77-85," ordered the defendants to respond immediately to plaintiff's allegations. Defendants thereafter, on September 13, 1977, revoked the August 29, 1977, private ruling.

 II.REVENUE RULING 77-85

 As indicated above, plaintiffs herein seek judicial review ofRevenue Ruling 77-85 which reversed a series of private rulings that had declared that the investment annuity contracts marketed by plaintiff FIAC were "contracts with reserves based on a segregated asset account" within the meaning of 26 U.S.C. § 801(g)(1)(B). Significantly, the basis for the Service's determination that investment annuity contracts are not within the purview of section 801(g)(1)(B) was not that these contracts failed to satisfy the express statutory criteria of section 801(g)(1)(B). Rather, the Ruling was premised expressly on the Service's determination that an investment annuity policy-holder's "substantial incidents of ownership" with regard to the assets in the custodial account, and particularly his investment control over such assets, warrant the conclusion that the policyholder and not the issuing life insurance company is the owner of the custodial account assets for federal tax purposes. And, reasoned the ruling, since the life insurance company cannot be taxed at all for the income derived from assets which are owned by another taxpayer (here, the policyholder), section 801(g)(1)(B) and the other Code provisions governing life insurance company taxation do not apply to the custodial account assets of an investment annuity contract.

 III. STANDARD OF REVIEW

 In reviewingRevenue Ruling 77-85, this Court is guided by the well-established principles articulated by Judge Parker in Eastern Kentucky Welfare Rights Organization v. Shultz, 370 F. Supp. 325, 334-35 (D.D.C. 1973), rev'd on other grounds sub nom. Eastern Kentucky Welfare Rights Organization v. Simon, 165 U.S. App. D.C. 239, 506 F.2d 1278 (D.C. Cir. 1974), vacated on other grounds, 426 U.S. 26, 96 S. Ct. 1917, 48 L. Ed. 2d 450 (1976), which were approved on appeal by the Court of Appeals for this Circuit:

 
Any discretion incorporated into the IRS's authority to promulgate rules and regulations is necessarily limited by the understanding that Congress, not the Treasury, is responsible for the formulation and institution of basic tax policy. It is true, as a matter of jurisprudence and efficient tax administration, that courts have regularly paid deference to the expertise attributed to the IRS in tax related matters and therefore judicial interference has been reluctantly employed. However, this exhibition of restraint is predicated upon the assumption that administrative rulings will do no more than effectuate, implement and clarify the provisions of the Code which have been congressionally enacted. . . . When this assumption is proven wrong, the courts must act to rectify any administrative determination which is not in accord with the Code.

 506 F.2d at 1286.

 This principle of judicial review -- that the IRS has no authority to take administrative actions inconsistent with the Internal Revenue Code -- has been uniformly embraced by the courts.2a See, e.g., Manhattan General Equipment Co. v. Commissioner, 297 U.S. 129, 134, 80 L. Ed. 528, 56 S. Ct. 397 (1936) ("A regulation which . . . operates to create a rule out of harmony with the statute is a mere nullity."); Service Life Insurance Co. v. United States, 293 F.2d 72, 77 (8th Cir. 1961) ("It is elementary that revenue rulings and even Treasury Regulations are without force if they are in conflict with the statute."); Russell v. United States, 260 F. Supp. 493, 500 (N.D. Ill. 1966) ("A revenue ruling which runs counter to the provisions of a statute is a legal nullity.") It is also well-established that even where the IRS's interpretation of the Code is not expressly inconsistent with the statutory language, such an interpretation will not be sustained if it is "unreasonable and unrealistic." United States v. Cartwright, 411 U.S. 546, 551, 36 L. Ed. 2d 528, 93 S. Ct. 1713 (1973). See Coca-Cola Bottling Co. v. United States, 203 Ct. Cl. 18, 487 F.2d 528, 532 (1973); McMartin Industries, Inc. v. Vinal, 441 F.2d 1274, 1275-76 (8th Cir. 1971); Quaker City Iron Works, Inc. v. United States, 256 F. Supp. 450, 453 (E.D. Pa. 1966).

 The above-articulated principles of judicial review are appropriately applied in all cases in which IRS action is challenged. However, when, as in the instant case, the action challenged is the issuance of a revenue ruling (rather than a regulation or a Treasury Decision), the reviewing court must bear in mind that

 
[a revenue] ruling is merely the opinion of a lawyer in the agency and must be accepted as such. It may be helpful in interpreting a statute, but it is not binding on the Secretary or the courts. It does not have the effect of a regulation or a Treasury Decision.

 Stubbs, Overbeck & Associates v. United States, 445 F.2d 1142, 1146-47 (5th Cir. 1971). Revenue rulings are not intended to create legally binding rights and/or obligations, and they are consistently treated as such by the Service for purposes of the procedural requirements of the Administrative Procedure Act, 5 U.S.C. § 553. Revenue rulings thus fit "the classic definition of an 'interpretative rule.'" Brief for the Secretary of the Treasury, Eastern Kentucky Welfare Rights Organization v. Simon, 426 U.S. 26, 48 L. Ed. 2d 450, 96 S. Ct. 1917 (1976), at 102. See generally Asimow, Public Participation in the Adoption of Interpretive Rules and Policy Statements, 75 Mich. L. Rev. 521 (1977); Comment, Revenue Rulings and the Federal Administrative Procedure Act, 1975 Wisc. L. Rev. 1135. As such, this Court's review "is not limited to determining 'arbitrariness.'" K. Davis, Administrative Law of the Seventies, § 5.03-1, at 154 (1976). Rather, if this Court, after giving due deference to the agency's expertise, finds the Service's statutory interpretation as embodied inRevenue Ruling 77-85 to be erroneous, this Court can, and indeed must, substitute its judgment for that of the Service.

 IV.REVENUE RULING 77-85 IS AN ERRONEOUS AND UNREASONABLE INTERPRETATION OF THE INTERNAL REVENUE CODE, AND, IN VIEW OF THE FACT THAT SUBSTANTIAL DEFERENCE TO THE AGENCY'S EXPERTISE IS NOT WARRANTED BY THE FACTS OF THIS CASE, THE COURT WILL DECLARE THE RULING TO BE UNLAWFUL AND BEYOND THE SERVICE'S STATUTORY AUTHORITY

 The Court has given careful and serious consideration to the arguments propounded by both sides in this controversy. While as a general rule this Court is, as are most other courts, see Eastern Kentucky Welfare Rights Organization v. Shultz, 370 F. Supp. at 334, quoted supra, reluctant to interfere with the IRS in tax-related matters, application of the aforestated principles of judicial review to the Service's decision inRevenue Ruling 77-85 compels this Court to conclude thatRevenue Ruling 77-85 is erroneous and unreasonable, and therefore unlawful and beyond the ...


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