Take-Away: The ownership of an annuity in any manner other than by an individual can be very complicated. Multiple tax questions arise, without a lot of answers, if a trust owns a tax deferred annuity. In general, annuities are supposed to be owned by natural persons. A trust is not a natural person.

Background: This topic came to my attention recently when a wealth management advisor asked if the extremely high income taxation of accumulated income in an irrevocable trust [taxed at 37% when trust income exceeds $10,950 for the year, along with the 3.8% net investment income tax] could be avoided by the trustee investing trust assets in a tax-deferred annuity. I did not have a good answer to give him off the top of my head, but I did recall that there are some quirks when an entity other than an individual owns an annuity. Consequently, I decided to dig a bit deeper into the mysteries of annuities and the peculiar rules that govern them in the Tax Code in order to understand if the highly compressed income tax brackets faced by an irrevocable trust could be avoided by accumulating income inside a tax deferred annuity contract. My conclusion is that if all risk is to be avoided, a trust should not own a tax-deferred annuity.

Annuity Basics: Annuities are confusing all by themselves, without injecting the question if a trust should own an annuity. Some of the basic rules with regard to annuities follow to help to understand their complexity (not to mention the high commissions usually paid to purchase an annuity.)

  • Three Parties: All annuities have three parties: Owner, Annuitant and Beneficiary. The Owner owns the annuity contract. The Annuitant must be an individual who is the measuring life, i.e. whose life expectancy is used to determine when annuity payments will begin and end. Often the Owner and the Annuitant are the same person. The Beneficiary is an individual or entity that will receive the remaining benefits under the annuity contract, if any, when the Annuitant dies.
  • Three Types of Annuities: While annuities can be structured in many different ways, there are three basic types. (i) A deferred annuity is a contract to which contributions are made over time that eventually grows into a lump sum to be liquidated at a later date, the annuity starting date. (ii) An immediate annuity is purchased with a single contribution, and the annuity starting date begins within one year of that contribution. (iii) A non-qualified annuity is an annuity contract that is funded with after-tax dollars, i.e. the annuity not held inside a retirement plan account or IRA.
  • Income Tax Deferral: The key attraction to an annuity is the potential for tax deferral. In general, increases in the annuity’s value are not taxable until funds are actually distributed from the annuity; thus, the ‘buildup’ of value grows unimpeded by taxes inside the annuity for a long period of time. [IRC 72.] This feature is what prompted the question from the wealth management advisor- can this tax deferral be exploited to avoid the high tax burden faced by irrevocable trusts?
  • Income-First Rule: Most deferred annuities permit the owner to take a distribution prior to the annuity starting date. Distributions taken before the annuity starting date are included in the owner’s taxable income to the extent that there is gain in the annuity contract. [IRC 72(e)(2)(B).] As such, annuities are generally subject to what is called an income-first rule, where the untaxed income of the annuity contract is distributed before any tax-free principal (basis). If the annuity contract is partially surrendered, then the contract’s gain is determined without regard to surrender charges. If the distribution is a complete termination of the annuity contract, then any surrender charges will reduce the amount of the tax that is reported by the owner.
  • No RMDs: Non-qualified annuities generally do not have to make required minimum distributions to the annuity owner. [IRC 72(s)(5).]
  • 10% Penalty: The taxable portion of an annuity distribution will be subject to a 10% penalty tax unless the recipient who receives the distribution is (i) at least 59 ½ years old, or (ii) disabled, or (iii) receives the annuity proceeds pursuant to substantially equal periodic payments over the recipient’s life expectancy. [IRC 72(q).]
  • Loans and Pledges: If an individual takes a loan from an annuity, the loan is treated as a distribution, and the individual will be subject to taxation to the extent of the gain in the annuity contract. Additionally, if an individual assigns the annuity, or pledges it as collateral security for a loan, the amount assigned or pledged is treated as a distribution that is subject to ordinary income tax. [IRC 72(e)(4)(A)(i) and (ii).] If income taxes are recognized by the annuity owner due to a loan or pledge of the annuity, then the owner’s basis in the annuity contract is increased by the income taxes paid. [The import of the use of the word individual in the statute is addressed below.]

No Tax Deferral if Annuity is Owned by Non-Natural Person, i.e. a Trust: An annuity can lose its tax deferred status if the annuity is owned by a non-natural person, such as a trust. [IRC 72(u).] In this situation, the inside buildup of wealth in the annuity will be taxed annually as ordinary income to the trust. [IRC 72(u)(1)(B).]

  • Default Rule: Consequently, the default rule is that an annuity owned by a trustee will not receive tax-deferred growth. Consequently, if a non-natural person owns the annuity contract it will not be treated as an ‘annuity.’ [IRC 72(q).]
  • Trustee Acts as Agent for Natural Person: However, not all trust-owned annuities are subject to the taxation on the inside buildup during the wealth accumulation phase before the annuity is annuitized. The inside buildup of value in the annuity will avoid current taxation if the trustee acts as an agent for a natural person. [IRC 72(u)(1).] It is not clear, though, when a trustee acts as agent for a natural person. This agency exception to the general rule is gleaned from the legislative history to IRC 72, which refers to when a non-natural person acts as merely a nominal owner of the annuity, while the ‘beneficial owner’ of the annuity is a natural person. This nominal owner exception is not referenced in the Regulations that implement the rules that govern annuities [IRC 72(u).] However, the agent-nominal owner concept is used in several private letter rulings to permit a trust to own a tax-deferred annuity.
  • Grantor Trust: It seems likely that a grantor trust would qualify an agent if the grantor of that trust is a natural person, since grantor trusts are disregarded for income tax purposes. [IRC 671.]
  • Agent: Much less clear is when a non-grantor trust acts as an agent for a natural person. This agent-nominal owner  for a natural person, and thus continued tax deferral of the annuity appreciation could turn on whether all of the non-grantor trust beneficiaries are natural persons. The Regulations that implement IRC 72(u) are not enlightening on this possible interpretation.
  • Big Picture: Combining all of these bewildering rules, a fair generalization is that a grantor trust, with an individual as grantor, can hold tax deferred annuities in the trust without jeopardizing the annuity’s tax deferred growth. If the trust is classified as a non-grantor trust, a handful of private rulings indicate that tax deferral with an annuity can be preserved during the wealth accumulation phase if all beneficiaries of the non-grantor trust are natural persons, where the trustee acts as agent and nominal owner on behalf of the individual trust beneficiaries. However, there is no clear guidance or authorization with regard to a non-grantor trust owning the tax deferred annuity. All of which presents something of a risk for the non-grantor trust to acquire a tax-deferred annuity.

Trust Ownership Of Transferred Annuities: Some interesting consequences can occur with a trust-owned annuity, which will often turn on if the trust is a grantor trust or a non-grantor trust.

  • Gift of Annuity- Deemed Distribution: A tax trap exists if a settlor who owns an annuity personally transfers a tax-deferred annuity to an irrevocable trust. If the settlor transfers the annuity without ‘full and adequate consideration’ before the annuity starting date, i.e. a gift of the annuity to the trust, the settlor will be taxed on a deemed distribution from the annuity equal to the amount of gain in the annuity contract at the time of the transfer. [IRC 72(e)(4)(C)(i).] This deemed distribution is taxed as ordinary income to the settlor-donor, not capital gain. [IRC 61(a)(8); IRC 1222(3) as distributions from an annuity are not considered a ‘sale or exchange.’] The trust will then increase its tax basis in the annuity contract by the amount of income that the settlor recognizes on the transfer to the trust. [IRC 72(e)(4)(C)(iii.)] In short, the donor will have an income tax to pay, but will no longer own the tax deferred annuity.
  • Grantor Trusts: The deemed distribution tax trap might be avoided if the trust is classified as a grantor This would include the settlor’s revocable trust. [IRC 676.] A gift of an annuity to a grantor trust should not trigger the deemed distribution rule if the grantor is considered the owner of the annuity both before and after the transfer for income tax. [Revenue Ruling 85-13.] Unfortunately, there is no IRS authority on this interpretation. Assuming a gift of the annuity to the grantor trust does not trigger the deemed distribution of the annuity, that result could change if the trust ceases to be a grantor trust, e.g. the settlor releases the retained power to substitute assets with the trust, where the grantor would then be taxed on the annuity’s inside buildup of value as if the grantor had made a gratuitous transfer of the annuity as of the date the trust was reclassified.
  • Loans and Pledges of the Annuity: As noted above, the statute uses the term individual rather than person when it describes the tax consequences that arise from a loan taken from an annuity, or the pledge of the annuity as collateral for a loan. That distinction [individual v person] seems to create two separate rules, depending on the status of the trust and the identity of the grantor. If the trust is a grantor trust with an individual as its grantor, then income could be triggered to the grantor if the trustee takes a loan from the annuity or pledges it as collateral on other loans. Alternatively, for a non-grantor trust, the trustee could presumably borrow against the annuity itself, or pledge the annuity as collateral for other trust loans without triggering income, since a non-grantor trust is not an This could provide an opportunity for a non-grantor trust to access the annuity’s cash value income tax-free by purchasing the contract the non-grantor trust and pledging the annuity as security for a loan. This seems like ‘splitting-hairs’ and I am not sure if that is what Congress intended when it used the word individual in the Tax Code.
  • No ‘See-Through’ Trust Rules: Unlike the see-through rules that apply to retirement accounts that are paid to irrevocable trusts, neither the Tax Code nor the Regulations contain similar rules to those for qualified plan accounts and IRAs payable to irrevocable trusts when it comes to an annuity that is owned by a trust. As a result, if a new annuity is purchased by a trust, if the annuity is paid to the trustee on the annuitant’s death, the trust owned annuity is likely to be subject to the five-year forced distribution rule if the annuitant’s death occurs prior to the annuity beginning date.

Conclusion: The rules that pertain to tax deferred annuities can be confusing. Even more confusing is the tax treatment of an annuity owned by a trust, due to the agent-nominal owner exception to the general rule that non-persons cannot own a tax deferred annuity. Treasury Regulations are silent when it comes to providing guidance as to when a trustee will meet the agent-nominal owner exception. If the purpose of the annuity is tax deferral on the inside growth in value of the annuity, that purpose is jeopardized it would seem by having the annuity owned by a trust. Perhaps if the trust is classified as a grantor trust tax-deferred growth can be achieved, but there is a greater risk that the tax deferral will be lost if the owner of the annuity is a non-grantor trust.