Ned created a trust, which became irrevocable upon his death. The trust provided for a nominal mandatory annual cash distribution to his sister Nancy, and additional distributions of income to his brother Nick, at the discretion of the trustee. Undistributed income is to be accumulated, and ten years after Ned`s death, the entire corpus is to be distributed to Ned`s nieces and nephews, Alex, Bonnie and Cindy.
Shortly after Ned`s death, the trust purchased three single premium deferred annuities (SPDAs), with the trust as the owner and beneficiary, and Alex, Bonnie and Cindy as the respective annuitants. Upon the date specified for termination of the trust, the annuity contracts are to be distributed to Alex, Bonnie and Cindy, respectively. The agent that placed the SPDAs has retired and the family group has turned to you to fill her shoes. At an initial meeting convened by the attorney representing the trust, the following questions have been raised:
1. Will the trust be taxable on the annual equity increases in the single premium deferred annuity contracts because it is not a natural person?
2. Will the eventual transfer of the single premium deferred annuity contracts to Alex, Bonnie and Cindy trigger income as "an amount not received as an annuity?"
What do you think?
What are the issues?
Trust owned annuities and the non-natural person rule
One of the key features of annuity contracts as investment vehicles is the fact that, assuming that all of the technical requirements of I.R.C §72 are met, there is no current taxation of the inside build-up of value in the contract prior to surrender or annuitization. When annuity payments commence, each periodic payment is deemed to consist partly of previously accumulated income and partly of return of cost basis. Thus, the income which was accumulating tax-free within the contract prior to the annuity starting date is taxed only in installments as the annuitant receives payments. The method of taxation is sometimes referred to as the "annuity method." Among other requirements for qualification for this favorable annuity tax treatment is the requirement that the holder of the annuity be a natural person. I.R.C §72(u). Thus, for example, if a corporation were to own the contract, the annuity method would not be available, and instead, each year`s increment (i.e., inside build-up) in equity in the contract would be taxable to the corporate holder as it accumulates; the tax deferral feature would, thus, not apply.
Transfer of an annuity contract by gift or for less than adequate consideration
Even when an annuity is owned by a natural person and equity has built up tax-free over a period of years, if ownership of the contract is transferred for less than full and adequate consideration (e.g., by gift) to any party, this will trigger recognition of income by the transferor of the accumulated equity build-up as of the date of the transfer. I.R.C §72(e)(4)(C). This rule is applicable to annuities with an issue date after April 22, 1987.
Recap of issues: application of the non-natural person rule and the gift transfer rule to a trust as owner of an annuity contract
1. Ownership of annuity contracts by trusts, is in many circumstances, a useful form of investment to meet the future needs of the trust beneficiaries. But what about the non-natural person rule? Certainly a trust is not a natural person. Does that mean that the trust is taxable each year on the increase in equity in the annuity contract?
Trust is treated as merely an agent in applying the non-natural person rule
2. Additionally, what happens if the trust distributes the annuity contract to a beneficiary? Does this transfer for no consideration trigger income under I.R.C. §72(e)(4)(C) as "an amount not received as an annuity?"?
With respect to the non-natural person rule, §72(u) contains a specific exception, stating that "holding by a trust or other entity as an agent for a natural person shall not be taken into account." IRS private letter rulings also refer to the legislative history of §72(u) wherein committee reports state that if a non-natural person is only a nominal owner for the beneficial interest of a natural person, the annuity contract will be treated as held by a natural person. [See Ltr. Rul.199905015.] Thus, the first issue is easily resolved. The trust will not be taxable on the annual equity increase in the respective single-premium deferred annuities.
Transfer for less than adequate consideration Issue
The second issue also resolves favorably for the family. The eventual transfer of the single premium deferred annuity contracts to Alex, Bonnie and Cindy will not trigger income as "an amount not received as an annuity?"
The rule of I.R.C. §72(e)(4)(C) technically applies when an "individual" transfers an annuity contract. In private rulings, the IRS has stated that transfers of annuity contracts to trust beneficiaries "does not constitute a transfer without full and adequate consideration under section 72(e)(4)(C), because [the trust] is not an individual for purposes of section 72(e)(4)(C)." See Ltr. Ruls. 9204014, 9204010 and 199905015 wherein the IRS addressed and resolves the issue by simply adopting a literal reading of the word "individual," and since the trust transferor is not an individual, the section is said to be inapplicable. The broader rationale would seem to be that the transfer by the trust to its beneficiaries, being simply a transfer of property from an agent-nominee to its principals, should not be regarded as a transfer within the scope of §72(e)(4)(C).]
This case study serves as a useful reminder to financial advisors that the usual deferral of income in an annuity contract will not apply when the contract is beneficially owned by a corporation or other entity. The case also highlights the exception to the non-natural person rule when a trust is involved, all the beneficiaries of which are "natural" persons.
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