| -- End Ad Box ---> | | | | annuitant is defined to be the holder. Thus, it is |
| IRC Section 72 governs the income taxation of | | | | the annuitant’s death that triggers a |
| annuity contracts. IRC Section 72(u)(1) taxes the | | | | required distribution under IRC Section 72(s)(6). If, |
| income on an annuity contract owned by a | | | | as is usual, the trust is the beneficiary of the |
| non-natural person by treating it as though | | | | contract, then the 5-year rule applies. Since a |
| it was received by the non-natural owner. If, | | | | designated beneficiary must be an individual, the |
| however, a non-natural person is merely holding | | | | opportunity for a life expectancy pay-out appears |
| the contract as an agent for a natural | | | | to be unavailable. But under IRC Section 401(a)(9), |
| person, the income on the contract will not be so | | | | which governs distributions from qualified |
| treated. Unfortunately, neither the Internal | | | | retirement plans and IRAs, the beneficiaries of a |
| Revenue Code nor the regulations explain when | | | | properly designed trust which name trusts as |
| an agency arrangement will be deemed to exist. | | | | beneficiaries (called a see-through trust by |
| For 2010, irrevocable trusts reach the highest | | | | the IRS) will be treated as having been designated |
| income tax rate (35%) at $11,200 of taxable | | | | as the beneficiaries of the plan or IRA. Does the |
| income. In comparison, married couples filing jointly | | | | same hold true for trust-owned annuities, thereby |
| and single taxpayers do not reach the 35% | | | | allowing a life expectancy payout for annuities |
| income tax rate until $357,700 of taxable income! | | | | that name see-through trusts as the beneficiaries? |
| Thus, wealthier individuals tend to invest in trusts | | | | Unfortunately, this issue has not yet been |
| for growth rather than for income. This is | | | | addressed by the courts or the IRS. |
| particularly true for credit shelter trusts (also | | | | What if the irrevocable trust is a grantor |
| known as family trusts and residuary trusts) | | | | trust for income tax purposes and the grantor |
| where the surviving spouse neither needs nor | | | | and annuitant (normally the trust beneficiary) are |
| wants current income, but wants to allow the | | | | not the same person? While not clear, arguably |
| trust assets to grow — estate tax free | | | | the grantor should be treated as the holder of the |
| — for the benefit of children and | | | | contract. If so, then it would be the |
| grandchildren. If an annuity contract is to be used | | | | grantor’s death (not the annuitant’s) |
| as a trust investment, the critical question to | | | | that would determine when distributions from the |
| avoid current income taxation becomes whether | | | | contract must be made. |
| the trust, a non-natural person, can be an agent | | | | Penalty for Premature Distributions. IRC Section |
| for its natural person beneficiaries. | | | | 72(q) imposes a 10% penalty tax on premature |
| Single Beneficiary Trusts | | | | distributions from an annuity contract. Generally, |
| In PLRs 9204010 and 9204014, the IRS | | | | the penalty tax applies to distributions to the |
| determined that a trust was acting as an agent | | | | taxpayer prior to attaining age 59 ½. If |
| for a natural person when it purchased an annuity | | | | the annuity contract is owned by a trust, then |
| for the sole beneficiary of the trust. Under the | | | | who is the taxpayer for purposes of IRC |
| terms of the trust, the trustee had discretion to | | | | Section 72(q)? |
| pay income and corpus to the beneficiary until the | | | | As discussed above, the annuitant is treated as |
| beneficiary attains age 40, at which point the | | | | the holder of a trust-owned annuity for purposes |
| entire trust corpus (including the annuity contract) | | | | of the required distributions upon the death of the |
| was to be distributed to the beneficiary. The IRS | | | | holder. Thus, it is logical to look at the annuitant |
| simply concluded that the trustee’s | | | | for purposes of applying the age 59 ½ |
| ownership of the annuity contract was nominal | | | | exception for the premature distribution penalty. |
| compared to that of the beneficiary and, | | | | Assuming the annuitant’s age is not the |
| consequently, the beneficiary was the beneficial | | | | relevant measure, then presumably it must be |
| owner of the annuity contract. The PLRs did not | | | | the beneficiary’s or beneficiaries’ |
| address what bearing, if any, there would be on | | | | age. If so, must all the beneficiaries be over age |
| the ruling if the beneficiary died prior to age 40 | | | | 59 ½ for the exception to apply? Moreover, if |
| and the trust property passed to a contingent | | | | the irrevocable trust is a grantor trust, is the |
| remainder beneficiary. | | | | penalty then based on the grantor’s age? |
| In PLRs 200449011, 200449013, 200449014, | | | | Unfortunately, each of these questions remains |
| 200449015, 200449016 and 200449017, with | | | | unanswered. To avoid these issues, consideration |
| almost identical facts, the IRS determined that | | | | should be given to distributing the contract |
| the trust was acting as an agent for a natural | | | | outright to the beneficiary before the date |
| person when it purchased an annuity contract for | | | | withdrawals are to begin. |
| the sole benefit of the grantor’s grandchild. | | | | Designing the Trust |
| In those rulings, the annuity contracts were to be | | | | Keeping in mind that the PLRs cited above are |
| distributed in-kind. The PLRs did not address, | | | | only binding on taxpayers who requested the |
| however, what the tax consequences would be | | | | ruling, they do suggest that an annuity contract |
| under IRC Section 72 if any distribution from the | | | | acquired by an irrevocable trust or credit shelter |
| trusts were in cash. | | | | trust can provide tax deferral. But great care |
| Multiple Beneficiary Trusts | | | | must be exercised to make sure that both the |
| In PLR 9752035, the IRS determined, with no | | | | trust and annuity contract are properly structured. |
| discussion, that a trust was acting as an agent for | | | | Consider these factors when setting up a |
| a natural person when it purchased an annuity | | | | trust-owned annuity: |
| contract. In PLR 9752035, there was a life income | | | | ~ The trust agreement should not require its |
| beneficiary (who was also the annuitant) and | | | | assets be invested in income-producing property. |
| remaindermen. Although the outcome of PLR | | | | ~ The trust agreement should specifically |
| 9752035 was favorable, it provides little guidance | | | | authorize the trustee to invest in an annuity |
| as to when a trust is acting as an agent for a | | | | contract. |
| natural person. | | | | ~ The trust agreement should specifically allow |
| Trust Distributions | | | | distribution of the annuity contract in-kind to avoid |
| IRC Section 72(e)(4)(C) provides, in part, that if | | | | adverse income tax consequences. If separate |
| an individual transfers an annuity contract without | | | | contracts are established for each trust |
| full and adequate consideration, the individual will be | | | | beneficiary, with each beneficiary named as the |
| taxed on the amount in excess of the | | | | annuitant for his or her respective contract, the |
| contract’s surrender value. However, in | | | | in-kind distribution of the contract to the |
| PLR 199905015 and PLR 9204014, the IRS ruled | | | | beneficiary-annuitant should be a non-taxable |
| that IRC Section 72(e)(4)(C) does not apply when | | | | event. |
| an annuity is transferred in-kind from a trust to | | | | ~ To avoid gift taxes, the trust should purchase |
| the beneficiary. The trust beneficiary would simply | | | | the annuity contract directly. |
| become the owner of the annuity contract, would | | | | ~ The trust should be the owner and beneficiary |
| inherit its cost basis, and would continue to enjoy | | | | of the annuity contract. |
| its tax-deferred status. | | | | ~ If the grantor of the trust is named the |
| Other Section 72 Issues | | | | annuitant, his or her death will likely trigger a |
| Required Distributions. IRC Section 72(s) sets | | | | complete and taxable liquidation of the contract |
| forth the required distribution rules which an | | | | within five years. |
| annuity contract must satisfy upon the death of | | | | ~ If the annuitant were to die while the annuity |
| the holder of the annuity contract. Following is a | | | | contract was still held in trust, the contract will |
| summary of those rules: | | | | likely have to be liquidated in five years. Thus, |
| ~ If the holder dies after the annuity starting | | | | consideration should be given to distributing the |
| date, the remaining interest must be distributed at | | | | annuity contract to the beneficiary-annuitant |
| least as rapidly as the method of distributions | | | | before his or her death. By doing so, the |
| being used at the date of the holder’s | | | | beneficiary-annuitant, as the new owner, will |
| death. | | | | continue to enjoy all of the contract’s |
| ~ Generally, if the holder dies before the annuity | | | | benefits and guarantees, and can name a new |
| starting date, the entire interest must be | | | | designated beneficiary. |
| distributed within 5 years of the holder’s | | | | ~ Avoid the 10% early distribution penalty when |
| death. | | | | possible. |
| ~ An exception to the 5-year rule allows a | | | | ~ The named annuitant should never be changed. |
| designated beneficiary to elect, within 1 year of | | | | Otherwise, the contract must be liquidated within |
| the holder’s death, to take distribution of | | | | 5 years. |
| the proceeds over his/her life expectancy. A | | | | Although trust-owned annuities involve a significant |
| designated beneficiary is an individual named by | | | | degree of complexity and uncertainty, they can |
| the holder as the beneficiary of the annuity | | | | be extremely beneficial. This is particularly so for |
| contract. A trust does not qualify as a designated | | | | credit shelter trusts where it’s possible to |
| beneficiary. | | | | pass on an inheritance and not an income tax bill. |
| ~ If the holder’s surviving spouse is the | | | | THIS ARTICLE MAY NOT BE USED FOR |
| designated beneficiary, the surviving spouse has | | | | PENALTY PROTECTION. THE MATERIAL IS |
| the ability to continue the decedent’s | | | | BASED UPON GENERAL TAX RULES AND FOR |
| contract as though it were his/her own. | | | | INFORMATION PURPOSES ONLY. |
| With a trust-owned annuity contract, the | | | | |