Compared with three-martini lunches, annuities constitute a minor item in the administration's tax-reform package. Yet to W. Thomas Kelly, the creator of the investment annuity, they are everything. In his case, a year of Capitol Hill lobbying paid off earlier this month when the House Ways and Means Committee in a preliminary vote favored overturning an Internal Revenue Service ruling and treating the investment annuity like other annuities for tax purposes.

The annuity question had provoked strong infighting in the insurance industry. At one point, the major companies were lined up against Kelly and smaller companies. When the votes were cast, the committee also approved by a comfortable margin pro rata taxation of withdrawals from all deferred annuities. The net effect was to revive one and continue another popular tax shelter, albeit in somewhat limited form.

Simply stated, an annuity is a contract that requires an insurance company to pay a person a given sum monthly from retirement until death. If the person buys the annuity prior to retirement - as often happens - taxes on the interest accrued over the years are deferred, or not due, until the payments begin. By then, the annuitant is often in a lower bracket.

Traditionally the annuity had been a noncontroversial, low-interest-bearing type of individual pension plan. But then came the Arab oil embargo and in its wake skyrocketing interest rates, recession, inflation, bear markets, risky municipal bonds, etc. The annuity began to look increasingly attractive to Wall Street, not so much as a retirement vehicle but as a shelter for those in high tax brackets.

For example, a person in the 35 percent bracket puts $30,000 into a savings account at age 30. Assuming a 7.5 percent interest rate, the account holder will collect $158,722 at age 65. The lump sum available to a person with a deferred annuity will be $377,066.

Last year $1 billion to $1.5 billion flowed into nonqualified, largely single-payment deferred annuities, seven times the amount in 1974. (Non-qualified means the IRS does not recognize them as valid Individual Retirement Account pension plans.)

Anchor National Life of Phoenix is the largest underwriter of deferred annuities. In 1975, sales were $40.2 million; in 1977, $346.2 million, representing 93 percent of the company's total premium income. The annuities are marketed through the Security First Group of Los Angeles and in turn through Dean Witter Reynolds and other brokers. Capitol Life of Denver, whose parent company is a Gulf & Western subsidiary, has doubled its annuity premiums in each of the past three years, rising to $271 million in 1977. Last year 89 percent of its premiums came from annuities.

The added attraction of these vehicles is the assurance of getting back all one's principal plus accumulated interest whenever desired. Under current law, an individual is allowed to take out a sum equal to the entire original investment and leave the interest in the account without paying taxes. If the money is withdrawn in a short period of time, however, a no-load fund will often charge a commission of 7 percent.

The investment, or wrap-around, annuity, which Kelly began marketing in 1968, has a further twist: It allows the policyholder to retain control (though not ownership) of his portfolio by having it managed by a stockbroker rather than by an insurer who is not am expert in the market. The idea is to allow greater freedom to take advantage of market trends and thereby maximize the size of the account.

Stock dividends and bond interest are tax deferred. Capital gains are paid by the insurance company, which may have an effective lower tax rate than the individual because payouts and heavy start-up costs for young companies offset capital gains. Taxes are subtracted from the value of the account as they are incurred. However, the individual is also subject to capital gains taxes when the money is eventually turned over. The expectation is that the policyholder will then be in a lower tax bracket.

Kelly formed his own company, First Investment Annuity Co. of America (FIAC) of Valley Forge, Pa., expressly to sell this product. Other companies sell several types of deferred anuities. FIAC had about 20,000 accounts totaling $380 million before the IRS declared last March that the investment annuity no longer qualified for tax deferral. His business cut off, Kelly took the IRS to court and won. The U.S. District Court for the District of Columbia found the IRS ruling illegal in November. The IRS is appealing.

But that appeal will become a moot issue if Congress follows the lead of the preliminary vote of Ways and Means. Kelly's intense lobbying of all the members of the committee paid off when a bill by Rep. Barber Conable (R.-N.Y.), ranking minority member, passed the first vote. His victory may have resulted in part from sympathy for the way Kelly's firm was treated by the IRS, a staffer said. Nevertheless it was a bittersweet victory. The shell of FIAC was sold March 29, three weeks before the vote, to the Insurance Co. of North America which intends to use it to generate other types of business.

Reached at his home near Philadelphia, Kelly - who now is unemployed - said he was pleased with the vote. As for the future of the investment annuity, he admitted pro rata taxation of partial withdrawals would have some negative impact on sales. "But the investment annuity is good for America and it can survive with (taxation)," he added. Kelly said he hopes to get back into the business himself.

Throughout Kelly's travails, the administration was readying its opposition to the taxi-deferred status of all annuities, as well as the investment annuity, which Treasury officials termed "an even more serious abuse." In testimony, they presented promotional literature for annuity sellers containing inducements like "How to Postpone Taxes Legally and Earn Interest on Uncle Sam's Money." The administration urged Congress to make policyholders pay taxes as interest is earned, just as taxes are paid on savings account interest.

This position had evolved from a set of options, one of which was to eliminate tax deferral for ordinary whole life insurance policies. Because these are the meat and potatoes of the life insurance industry, whole life sellers became nervous and began looking around for a sacrificial lamb, insiders say. That lamb was the individual annuity, which represents only a fraction of the major companies' business. For example, Equitable Life wrote only $74 million in individual annuities last year out of a total premium volume of $4.2 billion. This option apparently overruled another which held that to accept government regulation of even deferred annuities meant letting the camel's nose under the tent.

Others say major insurance companies, as well as savings and loans, feared the competition. The financial press wrote of persons taking their funds out of savings accounts and portfolios, and borrowing money at low interest rates against the cash value of their life insurance policies (held by the majors) to invest in higher-yield annuities sold by small companies.

At a meeting in early February of the American Council of Life Insurance, whose 476 members account for 92 percent of the life insurance in force in the country, a staff decision similar to the administation's was announced, according to William Stalnacher of Anchor Life. Immediately the smaller companies selling the most annuities protested, said Richard Coleman, senior vice president of Bankers National Life in New Jersey, which has 20 percent of its assets in annuities. So, at a board meeting, the ACLI modified its position to favor true retirement vehicles but not "abuses."

The three-part alternative plan presented by ACLI Executive Vice President William Harman Jr. called for no taxation of interest until withdrawal, pro rata taxation of principal and interest, and an equalization tax on withdrawals prior to age 59 1/2.

The third provision would have had the same effect as the administration's proposal to the extent that a person buying an annuity with the intention of cashing it in before 59 1/2 would have incurred the same tax consequences then, except in case of death or disability, as if he had paid taxes all along. However, it would not have prevented a 55-year-old individual, for example, from putting in a lot of money and taking it out as a lump sum 10 years later when presumably in a lower tax bracket.

In the end, only the first two provisions were approved. There will be no concurrent taxation of annuity interest. Under current law, a policyholder can remove a sum equal to the original investment without taxes because it is assumed all principal is being withdrawn. As voted by Ways and Means, there would be an allocation so that if, for example, the ratio of principal to interest were 10 to 1, one-eleventh of the amount withdrawn would be subject to tax. As ACLI's chief counsel Bill Gibb put it, "This won't change things much."

A less charitable committee staffer remarked, "There goes the administration's program down in flames."