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”).
Accordingly, whether annuities owned by trusts still enjoy tax-deferred growth depends upon the exact details of the trust. The rules do allow that when a trust owns an annuity “as an agent for a natural person” the contract can still keep its tax-deferral treatment, such as when it’s owned by a revocable living trust; even if merely all the beneficiaries of the trust are natural persons, such as with a bypass trust for the benefit of a surviving spouse and children, favorable treatment is still available. However, if other beneficiaries are involved – even and including charities – a trust-owned annuity may lose its preferential treatment.
An even more complex point of intersection between annuities and trusts is when annuity contracts are transferred to/from a trust. The problem is a key section of the tax code designed to prevent the unrealized gains of annuities from being shifted to another individual through gifting; as a result, if an individual transfers an annuity “without full and adequate consideration” its gains are immediately recognized. By this rule will not apply to transfers to a revocable living trust, or most types of transfers out of a trust, in the case of some common estate planning techniques – like gifting an annuity to an Intentionally Defective Grantor Trust (IDGT) – the situation remains unclear, and clients and their advisors must be cautious not to accidentally create an unfavorable taxable event!
Trusts And Tax Deferral Of Annuities
The “standard” tax treatment for deferred annuity is that they are tax-deferred (note: the reason they’re called “deferred” annuities is not because they’re tax-deferred, but because they date of annuitization is deferred to the future; i.e., they have not yet been “annuitized”). However, IRC Section 72(u) actually limits this treatment in the event that an annuity is not held by a “natural person” (i.e., a living, breathing human being). Instead, the tax code prescribes that when an annuity is not held by a natural person – e.g., a corporation or other business entity – any gains in the contract will be taxable annually as ordinary income. The exception to the 72(u) “natural person rule” is that if an annuity is held “by a trust… as an agent for a natural person” it will still be eligible for tax-deferral treatment. (Michael’s Note: It’s important to remember that in the case of annuities owned inside of IRAs or other retirement accounts, the tax rules of retirement rules are controlling, including the tax-deferral treatment for retirement accounts; IRC Section 72 and its associated rules and regulations apply only to so-called “non-qualified” annuities held outside of retirement accounts.)
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. In the original guidance from the Senate Report from the Tax Reform Act of 1986 (which created this code section, see page 567), Congress indicated that the point of the rule was that if the nominal owner was not a natural person but the beneficial owner was a natural person, the annuity would still qualify, such as where a corporation technically holds title to a group annuity for the pure benefit of the (natural person) employee participants.
In the context of trusts, the IRS has generally interpreted the rules in a similar manner, as evidenced by a series of Private Letter Rulings over the years. For instance, PLRs 9120024, 9204014, 9322011, 9639057, 9752035, 199905015, 199933033, and 200449017 all reviewed situations where various types of trusts would own an annuity and all the beneficiaries of the trust were natural persons; as a result, the IRS interpreted the annuities as being held by an agent for a natural person, retaining favorable tax-deferral treatment. In the case of PLR 9316018, the situation was even more straightforward – when a grantor trust owns an annuity, the contract retains tax-deferral status under IRC Section 72(u) by virtue of the grantor trust treatment alone. By contrast, in PLR 9009047, the trust’s remainder beneficiary was a charitable organization and not a natural person, so the tax-deferral treatment was lost; similarly, in PLR 199944020 found that a partnership holding an annuity would not be eligible for tax-deferral treatment, as a partnership is a business entity unto itself and not merely the nominal owner for a natural person beneficiary.
The basic conclusion from the rules – while a formal legal agency status is not required (at least based on the most recent rulings), for a trust to qualify as an “agent for a natural person” all the beneficiaries, both income and remainder, current and future, must be natural persons.
Trust As Owner Of A Deferred Annuity
Given these rules for tax-deferral treatment of a deferred annuity, some situations of trust ownership are fairly straightforward.
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.
Another common situation of trust ownership is where an annuity is owned inside of a bypass trust, which is typically a non-grantor trust and thus a situation where proper determination of whether IRC Section 72(u) will apply is crucial. The aforementioned guidance indicates that the general rule is where all the beneficiaries of the trust – income and remainder – are natural persons, the trust should qualify as an agent for a natural person. However, this may create complications in situations where a bypass trust includes a charity amongst the remainder beneficiaries; given the presence of PLR 9009047, caution is merited, as it appears such a trust would not actually qualify for tax deferral treatment.
In the case of a situation like a special needs trust, though, the outcome is less clear. If the sole beneficiary/ies of the trust are natural persons (e.g., the disabled beneficiary, with other family members as remainder beneficiaries) the trust should be eligible for tax deferral. However, in situations where there is a Medicaid payback provision – such that technically, “the State” may be a beneficiary of the trust, ownership of an annuity may no longer be tax-deferred. However, this particular scenario has not yet been directly evaluated in any Tax Court case or Private Letter Ruling, and as such remains a “gray” area.
Transferring Annuities To/From Trust Owners
The scenarios discussed above where a trust may own an annuity and receive tax-deferral treatment are all situations where a trust purchases and initially funds the annuity itself. A related situation – with potentially differing outcomes – is where an existing annuity is transferred to (or from) a trust, rather than being purchased by it in the first place.
The reason annuity transfers are more complicated is not IRC Section 72(u) – pertaining to the ongoing tax-deferral treatment of an annuity – but instead IRC Section 72(e)(4)(C), which controls whether a transfer itself can be done without triggering the recognition any embedded gain on an annuity, and was created to prevent individuals from shifting the unrealized gains of an annuity to another person through gifting. Under this section of the tax code, if “an individual who holds an annuity contract transfers it without full and adequate consideration” any gains are recognized when the transfer occurs; in other words, the tax code treats it as though the contract was liquidated in a taxable event, and the proceeds were then transferred to purchase a brand new annuity.
In the case of a transfer to a revocable living trust, this is not an issue, as the annuity is not treated as transferred for income or estate or gift tax purposes, and accordingly there has been no “transfer” to which a full-and-adequate-consideration exchange can be considered. For tax purposes, the ownership is the same before and after the transfer.
Ironically, in situations where an annuity is transferred out of a trust, the transaction also does not trigger IRC Section 72(e)(4)(C), as the IRS reads the provision literally, and since it states that it must be “an individual who holds an annuity…” a trust that owns the annuity in the first place isn’t an individual and therefore cannot trigger tax treatment by transferring the contract. Thus, in PLR 201124008, where an annuity was distributed in-kind by a bypass trust to its trust natural person trust beneficiary, the transfer was not taxable at the time.
However, in situations where the annuity is being transferred as a (taxable) gift to a trust, the situation is less clear. If the trust is not a grantor trust and the transfer is a gift, IRC Section 72(e)(4)(C) will clearly be triggered, even if all the beneficiaries are natural persons such that subsequent gains may again be tax-deferred once the trust owns the annuity. Perhaps the most confusing situation is when an annuity is transferred to an Intentionally Defective Grantor Trust (IDGT), which is a grantor trust for income tax purposes but outside of the individual’s estate for gift and estate tax purposes. While some have contended that the transfer of the annuity to the IDGT should not trigger taxation upon transfer – it certainly wouldn’t face ongoing under 72(u) since it’s a grantor trust – it’s difficult to claim that the annuity was not “a transfer without full and adequate consideration” when the grantor has to file a gift tax return to report the transfer in the first place! Notably, while popular Revenue Ruling 85-13 has indicated that a sale of property to a grantor trust should not trigger gain, as one cannot have a sale between a grantor and the grantor’s trust, in this case the problem is actually that the annuity was not sold but gifted as a gratuitous transfer (without full and adequate consideration). Ironically, this suggests that while a sale of an annuity to an IDGT might avoid gains treatment, the gratuitous gift transfer of an annuity to an IDGT may trigger gain. Unfortunately, though, neither situation has been directed address on point in a Tax Court case or even via a Private Letter Ruling.
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!
For those looking for additional objective information regarding the technical rules and taxation of annuities in general, check out my book “The Advisor’s Guide To Annuities” as well!