Take-Away: In a recent Private Letter Ruling the IRS clarified that an irrevocable trust can hold an annuity and not run afoul of IRC 72(u)(1).

Background: There is a lot of confusion surrounding if an irrevocable trust can hold a tax-sheltered annuity. That confusion stems from the provisions of the Tax Code that suggest that the income generated by a tax-sheltered annuity is immediately taxable if owned by an ‘entity.’

Example: In limited circumstances the trustee of an irrevocable trust might view the purchase of a single premium tax-deferral annuity to be a wise investment. One reason a trustee might consider the purchase of a single premium tax-deferred annuity is that it is a discretionary trust which accumulates income inside the trust because the trust beneficiary is at a high income tax bracket and the trustee wants to avoid its own compressed income high tax rates. Re all that an irrevocable trust faces the highest marginal federal income tax bracket when its income exceeds $11,000 a year. The income accumulated in an annuity is not currently taxed until distribution.

IRC 72: This Tax Code Section prescribes the income tax treatment of an annuity contract.The amounts paid under an annuity contract are subject to this code section. [Regulation 1.72-2(a).] Normally, the accumulation of income within an annuity is not immediately taxable until there is a distribution from the annuity contract.

IRC 72(u) Natural Person: This subsection to IRC 72 generally provides that if an annuity contract is held by a person who is not a natural person, then such arrangement or contract is not treated as an annuity contract for federal income tax purposes, and the income generated by such contract for any taxable year is treated as ordinary income presently received or accrued by the annuity owner during that taxable year. This leads to the confusion from the fact that an irrevocable trust is not a natural person.

IRC 72(u)(1) Exception: There is, however, an exception provided to IRC 72(u) which provides (in what is termed ‘flush language’) that holding a tax-deferred annuity by a trust or other entity as an agent for a natural person is not taken into account for purposes of IRC 72(u.)

But a Trustee is Not an Agent: Narrowing the question further, a trustee serves as a trustee, not an agent for the trust beneficiary who is a natural person. [Restatement (Third) of Trusts, Section 5(e); Restatement (Second) of Agency, Section 14B.] 

Question: Thus, the question is whether an irrevocable trust that holds a single premium tax-deferred annuity qualifies for the statutory exception, as the trustee is not technically an agent.

History of IRC 72: It may help to understand the purpose behind IRC 72(u). It was added to the Tax Code back in 1986. The concern at that time was that employers would use deferred annuity contracts to fund deferred compensation arrangements for a select group of their employees, which would create a disincentive for the employer to provide benefits to all of its employees under qualifed pension plans which are subject to greater restrictions imposed by ERISA. In addition, because deferred annuity contracts can be provided to a limited class of employees (rather than all employees as required by ERISA) the goal with IRC 72(u) was to curb the use of tax-deferred annuities which would “otherwise dilute the effect of ERISA’s non-discrimination rules.”

– The source of the confusion is the Legislative History that accompanied the adoption of IRC 72(u): “In the case of a contract the nominal owner of which is a person who is not a natural person (e.g. a corporation or a trust), but the beneficial owner of which is a natural person, the contract is treated as held by a natural person. Thus, if a group is treated as held by a corporation as agent for natural persons who are the beneficial owners of the contracts, the contract is treated as an annuity contract for federal income tax purposes. However, the Committee intends that if an employer is the nominal owner of an annuity contract, the beneficial owners of which are employees, the contract will be treated as held by the employer.” 

Private Letter Ruling 202118002 (Released May 7, 2021): This new private letter ruling (not precedent setting but informative, nonetheless) seems to clarify the confusion if an irrevocable trust can own a single premium tax-deferred annuity.

Facts: The beneficiary, call her Alice, is the sole income beneficiary of the irrevocable trust. Alice and her siblings, Ben and Charlie, are the co-trustee’s of Alice’s trust. Alice cannot alienate or transfer her interest in the trust. The co-trustees intend to purchase a single premium deferred annuity contract for Alice’s  trust. (No reason is provided why this was viewed as a good trust investment.) The trust is to be the owner and beneficiary of the annuity contract during Alice’s life. Alice is the ‘measuring life’ for the annuity contract. If Alice dies, the annuity contract proceeds (if any) will be paid to the trust. If Alice dies the surviving co-trustees then pay the annuity proceeds to Alice’s heirs and the trust terminates. The trust is taxable under IRC 641, not IRC 671, i.e. it is not a grantor trust.

Ruling: The IRS narrowed the focus of IRC 72(u) when it found that the phrase ‘other entity’ as referenced in the statute does not pertain to a trust. Thus, for purposes of IRC 72(u)(1), the holding of an annuity contract by an irrevocable trust is not taken into account if the contract is held for a natural person.“Accordingly, the holding of the annuity contract by the trust will not be taken into account for purposes of IRC 72(u)(1).”

Definition of Trust: The IRS referred to the definition of a trust that is found in the Procedure and Administration Regulations. [301.7701-4(a).] That definition defines a trust as an arrangement created either by Will or an intervivos declaration where the trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in probate courts. The IRS’s formal position is that an agreement creates a trust rather than an agency relationship if the trustee is vested with broad discretionary powers of administration and management. [Revenue Ruling, 69-300, 1969 C.B.]

Non-Employment Context: However, because the single premium annuity contract would not be issued in an employment context, the arrangement would not provide the sort of tax-favored benefit that IRC 72(u) was intended to limit.

Conclusion: In sum, IRC 72(u)(1) will not apply when an irrevocable trust holds a single premium tax deferred annuity for the benefit of the trust beneficiary who is a natural person. Despite the language of the Tax Code, and the confusion that it has caused, the IRS has now clearly stated that a non-grantor trust can hold an annuity and avoid having to recognize the income that accumulates inside the annuity as present ordinary income. There may not be too many situations where the trustee views the annuity as an appropriate investment, but this is something to keep in mind, if the goal is to avoid the high taxation of accumulated income in an irrevocable trust.