Are annuities appropriate for estate planning?

By Jason Ryan

Optimum Wealth


If you have ever wondered if a deferred annuity could be used as an effective estate planning tool, here is an example of an efficient and often underutilized wealth transfer opportunity. IRS Private Letter Ruling 199905015 reaffirms the view that a Credit Shelter Trust (CST) can be funded with deferred annuities. This may be a valuable strategy that enables advisors to not only help their clients pass assets free of estate taxes, but to also allow the heirs that receive these assets to continue the tax deferral on any growth.

What is a Credit Shelter Trust?

A Credit Shelter Trust is an estate planning device used to minimize the combined estate taxes payable by spouses. The credit shelter trust is also known as a bypass or A-B trust.

Under the will, at the death of the first spouse, the estate is divided into two parts. One part, equal to the applicable exclusion amount ($3.5 million for 2009) sheltered from tax by the applicable credit amount ($1,455,800 for 2009), is placed in a trust that may provide liberal benefits to the surviving spouse, but will bypass his or her estate at death. The other part either passes outright to the surviving spouse, or is placed in a marital deduction trust for the spouse's benefit.

The general idea is to make full use of the applicable credit amount at each death. If everything is passed outright to the surviving spouse at the first death, it could all be subject to estate tax at his or her later death. By using the applicable credit amount to shelter assets at the first death, this amount (and more if the property has gone up in value) can escape estate taxation at the second death. The property placed in the credit shelter trust does not qualify for the unlimited marital deduction at the first death; nevertheless, no estate tax is due on the assets put into the credit shelter trust because the applicable credit amount sheltered these assets from federal estate taxation. Further, no estate tax liability will be incurred on the property passing via the unlimited marital deduction to the surviving spouse. So, there are no federal estate taxes at all at the first death. Then, at the second death, the surviving spouse can use his or her own applicable credit amount to shelter additional assets.

The advantages of using a deferred annuity

With many larger estates, the surviving spouse has sufficient income from other sources and doesn't need or want income from the credit shelter trust. Instead, the surviving spouse may wish to grow the trust assets for the beneficiaries. Using a deferred annuity gives the trust the option to allow the investment to potentially grow on a tax-deferred basis. Further, the beneficiaries can continue to defer income taxes on the death benefit by choosing from a number of different distribution options. These options can also help the beneficiaries to pass wealth on to their heirs, creating a lasting legacy.

Doesn't the Internal Revenue Code pose an obstacle?

Section 72(u) of the Internal Revenue Code states that if an annuity contract is held by a non-natural person, then the growth inside the annuity contract is treated as ordinary income taxable to the contract owner. However, section 72(u)(1) provides an exception for annuities owned "by a trust or other entity acting as an agent for a natural person." Does a Credit Shelter Trust fall under this exception? Definitely.

In PLR 199905015, the IRS ruled that (1) the annuity owned by the CST is deemed to be owned by a natural person for purposes of Section 72(u) and, (2) upon dissolution of the trust, the re-titling of the annuity contracts to the named beneficiaries is not a taxable event. This approach is often referred to as a "pass-in-kind" strategy. Once the individual annuity contracts are retitled from the trust to the named beneficiary as owner, the new contract owner can then change the beneficiary to anyone they personally choose (i.e., spouse, child, charity, etc.). Subsequently, the asset avoids any additional estate taxation, asset ownership is easily transferred to the trust beneficiary and the asset continues to potentially grow on a tax deferred basis.

Creating a "pass-in-kind"

It is easy to set up a pass-in-kind strategy using a deferred annuity within a Credit Shelter Trust. First, the trust needs to be established as the owner and beneficiary of each annuity contract. Ideally, a separate annuity contract should be purchased for each of the trust beneficiaries. Each trust beneficiary, respectively, should be named as annuitant on his or her contract. Of course, you and your clients need to consult a qualified attorney to determine the appropriate trust design.

There are a number of annuity strategies that can be used to accomplish different estate planning objectives. When assisting your clients with their estate planning needs, remember that annuities may make sense on a number of levels. Whether your clients are looking to avoid probate, reduce the size of their taxable estate or control the income and deferred asset growth inside of a credit shelter trust, an annuity may help them accomplish these goals.

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