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Taxation of a Deferred Annuity Owned by a Trust

Taxation of a Deferred Annuity Owned by a Trust

The information on this page was taken from

The concept of the "non-natural" person rule as used in the Tax Reform Act of 1986 has consequences for trust-purchased annuities which had remained somewhat unclear. The IRS, in a private letter ruling released late last year, examined the application of the non-natural person rule in the case of a trust which had invested assets in a single premium deferred variable annuity.

Reaching an outcome generally favorable to those involved with annuities, the Service concluded that the rule, which would disallow a trust from reaping the annuity tax benefits to which an individual annuitant is entitled, does not apply.

In the ruling request an individual, whom we will call Mr. White, died leaving a will which provided that a certain portion of his property be placed in a trust. The terms of the trust provided that the trustee should divide the property in separate shares for each of the remaindermen and that, if the life beneficiary survived Mr. White, the income from each share would be distributed to the life beneficiary. For purposes of this discussion, we will call the life beneficiary Mr. Green.

The trustee wishes to invest some of the trust assets in a single premium individual deferred variable annuity of which Mr. Green, the life beneficiary of the trust, would be the annuitant. The trust itself will be both the owner of the annuity contract and the beneficiary.

Found in Section 72(u) of the Code, the non-natural person rule provides basically that if an annuity contract is held by a person who is not a natural person (e.g., a "non-natural" person) the annuity is not treated as an annuity contract for tax purposes. Generally, this means that the income on the contract is treated as ordinary income to the holder of the annuity contract. In effect, if the non-natural person rule applies, the annuity holder loses the income tax deferral on the interest earned inside the annuity contract and must include this amount in income each year.

However, in order to allow certain entities to own annuities and continue to be taxed in the same manner as individual annuity owners, Congress created an exception to the non-natural person rule. Generally, the non-natural person rule was put in place as part of the Tax Reform Act of 1986, in order to curb perceived abuses, primarily by corporations, of the income tax-free treatment of the interest accumulating in an annuity contract.

Prior to the 1986 legislation, it was thought that nonqualified annuity contracts were being purchased by corporations in order to provide tax-deferred funding for nonqualified deferred compensation plans, a type of benefit plan which typically is available only to a corporation's top executives. The exception to the non-natural person rule states that an annuity contract held by a trust or other entity as an agent for a natural person is considered to be held by a natural person.

In determining that the trust in the private letter ruling was not subject to the non-natural person rule, the Service looked to the legislative history of Code section 72(u). This history states that an annuity contract will be considered to be held by a natural person if the nominal owner is not a natural person (such as a corporation or a trust) but the beneficial owner of the annuity contract is a natural person.

After looking at this language, the Service concluded that even though the trust is the owner of the variable annuity contract, it is a nominal owner as compared to Mr. Green, the life beneficiary, and the trust remaindermen. Thus, the trust is the nominal owner but Mr. Green and the remaindermen are the beneficial owners of the annuity contract. This particular letter ruling involved a fact situation in which the same individual (a natural person) was the sole life beneficiary of the trust and the sole annuitant under the annuity contract.

It is interesting to consider whether the Service would have reached the same conclusion if the trust's life income beneficiary and the annuitant were not the same person or if the trust had several life income beneficiaries but only one was named as the annuitant.

from Giarmarco, Mullins & Horton, P.C.

IRC Section 72 governs the income taxation of annuity contracts. IRC Section 72(u)(1) taxes the income on an annuity contract owned by a "non-natural" person by treating it as though it was received by the non-natural owner. If, however, a non-natural person is merely holding the contract as an "agent" for a natural person, the income on the contract will not be so treated. Unfortunately, neither the Internal Revenue Code nor the regulations explain when an agency arrangement will be deemed to exist.

For 2010, irrevocable trusts reach the highest income tax rate (35 percent) at $11,200 of taxable income. In comparison, married couples filing jointly and single taxpayers do not reach the 35 percent income tax rate until $357,700 of taxable income! Thus, wealthier individuals tend to invest in trusts for growth rather than for income. This is particularly true for credit shelter trusts (also known as family trusts and residuary trusts) where the surviving spouse neither needs nor wants current income, but wants to allow the trust assets to grow -- estate tax free -- for the benefit of children and grandchildren. If an annuity contract is to be used as a trust investment, the critical question to avoid current income taxation becomes whether the trust, a non-natural person, can be an agent for its natural person beneficiaries.

Single beneficiary trusts
In PLRs 9204010 and 9204014, the IRS determined that a trust was acting as an agent for a natural person when it purchased an annuity for the sole beneficiary of the trust. Under the terms of the trust, the trustee had discretion to pay income and corpus to the beneficiary until the beneficiary attains age 40, at which point the entire trust corpus (including the annuity contract) was to be distributed to the beneficiary. The IRS simply concluded that the trustee's ownership of the annuity contract was nominal compared to that of the beneficiary and, consequently, the beneficiary was the beneficial owner of the annuity contract. The PLRs did not address what bearing, if any, there would be on the ruling if the beneficiary died prior to age 40 and the trust property passed to a contingent remainder beneficiary.

In PLRs 200449011, 200449013, 200449014, 200449015, 200449016 and 200449017, with almost identical facts, the IRS determined that the trust was acting as an agent for a natural person when it purchased an annuity contract for the sole benefit of the grantor's grandchild. In those rulings, the annuity contracts were to be distributed in-kind. The PLRs did not address, however, what the tax consequences would be under IRC Section 72 if any distribution from the trusts were in cash.

Multiple beneficiary trusts
In PLR 9752035, the IRS determined, with no discussion, that a trust was acting as an agent for a natural person when it purchased an annuity contract. In PLR 9752035, there was a life income beneficiary (who was also the annuitant) and remaindermen. Although the outcome of PLR 9752035 was favorable, it provides little guidance as to when a trust is acting as an agent for a natural person.

Trust distributions
IRC Section 72(e)(4)(C) provides, in part, that if an individual transfers an annuity contract without full and adequate consideration, the individual will be taxed on the amount in excess of the contract's surrender value. However, in PLR 199905015 and PLR 9204014, the IRS ruled that IRC Section 72(e)(4)(C) does not apply when an annuity is transferred in-kind from a trust to the beneficiary. The trust beneficiary would simply become the owner of the annuity contract, would inherit its cost basis, and would continue to enjoy its tax-deferred status.

Other Section 72 issues
Required Distributions. IRC Section 72(s) sets forth the required distribution rules which an annuity contract must satisfy upon the death of the holder of the annuity contract. Following is a summary of those rules:

If the holder dies after the annuity starting date, the remaining interest must be distributed at least as rapidly as the method of distributions being used at the date of the holder's death.

  • Generally, if the holder dies before the annuity starting date, the entire interest must be distributed within 5 years of the holder's death.
  • An exception to the five-year rule allows a designated beneficiary to elect, within one year of the holder's death, to take distribution of the proceeds over his/her life expectancy. A designated beneficiary is an individual named by the holder as the beneficiary of the annuity contract. A trust does not qualify as a designated beneficiary.
  • If the holder's surviving spouse is the designated beneficiary, the surviving spouse has the ability to continue the decedent's contract as though it were his/her own.

With a trust-owned annuity contract, the annuitant is defined to be the holder. Thus, it is the annuitant's death that triggers a required distribution under IRC Section 72(s)(6). If, as is usual, the trust is the beneficiary of the contract, then the five-year rule applies. Since a designated beneficiary must be an individual, the opportunity for a life expectancy pay-out appears to be unavailable. But under IRC Section 401(a)(9), which governs distributions from qualified retirement plans and IRAs, the beneficiaries of a properly designed trust which name trusts as beneficiaries (called a "see-through trust" by the IRS) will be treated as having been designated as the beneficiaries of the plan or IRA. Does the same hold true for trust-owned annuities, thereby allowing a life expectancy payout for annuities that name see-through trusts as the beneficiaries? Unfortunately, this issue has not yet been addressed by the courts or the IRS.