Preserving Tax-Deferred Status For Trust Owned Deferred Annuities

By: Randall A. Denha, J.D., LL.M.

Annuities have long enjoyed preferential treatment under the tax code – so extensive, that they merit an entire portion of the tax code, IRC Section 72, all to themselves. The favorable rules are generally intended to support the use of annuities as a vehicle for retirement savings and/or retirement income, and as such, the rules generally only apply in situations where annuities are owned directly by individual, living, breathing human beings who may in fact someday retire (known in the tax code as “natural persons”).

Trust-Owned Annuities and Tax Deferral

Accordingly, whether annuities owned by trusts still enjoy tax-deferred growth depends upon the exact details of the trust. Put another way, several special tax provisions apply. First, the annual growth inside a deferred annuity is generally not taxable until it’s withdrawn. Thus, the tax on this gain is deferred until such withdrawal. We said “generally not taxable” because this is not always true. If a “non-natural person” (a corporation, partnership, or other entity that is not a human being) owns a deferred annuity, the annual growth is taxable as earned unless that entity is acting as “the agent of a natural person” (IRC [Internal Revenue Code] Section 72(u)). Unfortunately, the tax code itself does not describe what constitutes “an agent for a natural person” and the rules are not entirely clear from the supporting Treasury Regulations, either. The IRS has held, in numerous Private Letter Rulings, that a trust can qualify as such, so long as all the beneficiaries are human beings. But you should not assume that your trust will qualify.

For instance, if a grantor trust owns the annuity, it is clearly eligible for tax-deferred growth. This would appear to be true both given the general treatment of grantor trusts, and with the supporting guidance of PLR 9316018. Accordingly, if a revocable living trust owns an annuity, it would remain tax deferred, and there is no problem with having such a trust purchase and own an annuity. On the other hand, since annuities already pass directly to beneficiaries by operation of contract, they avoid probate without any need for ownership by a revocable living trust, raising the question of why individuals would choose to transfer an annuity into such a trust in the first place, unless for management in the event of disability. Nonetheless, to the extent that a revocable living trust does own an annuity, it can do so on a tax-deferred basis.

Whose death triggers the death benefit when the Trust is the Owner?

Deferred annuities cannot continue in force forever. In the Tax Reform Act of 1986, Congress created a rule (IRC Section 72(s)) stating that they must pay out in full, either in a lump sum or a series of payments, when the owner dies. But corporations, trusts, and other “non-natural persons” don’t die as human beings do, so Congress created a special rule IRC Section 72(s)(6)(A), which states that when a deferred annuity is owned by a non-natural person, the primary annuitant will be deemed to be the owner.

So, when a trust owns a deferred annuity, it must be paid out upon the death of the primary annuitant. But it’s not quite that simple. Suppose James establishes an irrevocable “grantor trust” for the benefit of his daughter, Gabrielle. (A grantor trust is taxed differently from other trusts; all income is taxed, not to the trust, but to the person who created the trust – the “grantor” – and an irrevocable trust cannot generally be changed or undone by the grantor. Because of this, the trust is generally not includible in the grantor’s estate for estate tax purposes). Now, suppose that Gabrielle, as trustee of the trust, buys a deferred annuity, naming herself as annuitant. You’d think that the annuity must be paid out at Gabrielle’s death, because she’s the annuitant. And so would many insurance companies, but not all of them. Some insurers apply the “grantor trust” rules in this situation and require the annuity to pay out at James’s death. What does this mean for you, the consumer? It means that if you’re thinking of doing something like this, find out how the insurance company you’re considering will handle this. You need to know when that annuity must pay out.

When the Owner Dies, What Are the Beneficiary’s Options?

But an even more important, and much more common, question is: When a deferred annuity must pay out, how must it pay out? Here are the rules when an owner of a deferred annuity dies before annuity payments have begun. If the beneficiary is a human being, he/she has four choices (Under IRC Section 72(s)).

1. To take the annuity value as a lump sum.

2. To take the annuity value within five years of death.

3. To take the annuity value in regular annuity payments for life or a shorter period.

4. If the beneficiary is the surviving spouse of the owner, to treat the annuity as his/her own. Under this option, the survivor beneficiary may keep the contract in force, just as if he/she had been the original buyer.

But what if the beneficiary of that annuity is a trust? The last two options are generally not available. Most insurance companies will require the annuity to be fully paid out over no longer than five years.

So, is this a problem? Well, suppose the annuity is worth $1 million at death, but its “cost basis” (basically, the amount the purchaser paid) is only $500,000. If the beneficiary is a trust, that half million dollars of profit (the annuity value minus the cost basis) must be included in the beneficiary’s taxable income within five years. But if the beneficiary were a human being, that tax on the profit could be “stretched out” over the beneficiary’s lifetime. And if the beneficiary were the owner’s spouse, he/she could keep from paying tax on that gain for as long as desired. Eventually, the profit will be taxed to that spouse, or his/her heirs, because “tax deferred” means what it says, not “tax free”. Would you rather stretch that income tax liability over your entire lifetime or pay it all over five years?

The bottom line, though, is simply this: while annuities can be owned by trusts in many situations, and transferred into or out of many (but not all) types of trusts, it’s important to understand the particular details of the trust and its beneficiaries to determine the tax treatment of the transaction. When it comes to annuity and trust taxation, all trusts are not created equal! But I hope that this very general discussion will give you an idea of the problems that can arise when you name a trust as owner or beneficiary of a deferred annuity.