Taxation of a Tax-Deferred Annuity Owned by a Trust

The income taxation of annuity contracts is governed by Section 72 of the Internal Revenue Code (“IRC”).  In the 1980s, as a result of the tax simplification and reform measures, the code section went through extensive revisions.  The legislation was intended to encourage the use of tax-deferred annuity contracts as long-term retirement savings vehicles.

As such, the legislation altered the manner in which amounts withdrawn from a tax-deferred annuity are taxed and imposed penalties on income withdrawn prior to the contract owner’s attaining 59 1/2 years of age.  Then, in 1986, Congress added a new code section, 72(u), which denies tax-deferred treatment to any tax-deferred annuity (hereinafter referred to as “annuity contract” or “contract”) that is not held by a natural person.

The Non-Natural Person Rule

Section 72(u)(1) provides that “if any annuity contract is held by a person who is not a natural person:

(A)  Such contract shall not be treated as an annuity contract for purposes of [the Internal Revenue Code] . . . (other than sub chapter L), and

(B)  The income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the owner during such taxable year.”

However, if the non-natural person is merely holding the contract as an agent for a natural person, this rule will not apply and deferral will be available.  Thus, the critical questions is “Under what circumstances will an agency arrangement be deemed to exist?”  Neither the IRC nor the regulations provide any explanation; however, within the legislative history the following explanation was provided:

“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.”

In addition to the aforementioned exception, Section 72(u)(3) notes five additional specific exceptions, including:

1.  a contract acquired by the estate of a decedent;

2.  a contract held under a qualified retirement plan, 403(a) plan, 403(b) program, or an individual retirement plan;

3.  a contract which is a qualified funding asset (as defined in section 130(d));

4.  a contract which is purchased by an employer upon termination of a qualified retirement or 403(a) plan and is held until all amounts are distributed to the employee for whom the contract was purchased, or to the employee’s beneficiary; or

5.  the contract is an immediate annuity.

As such, Section 72(u) does not prohibit ownership of annuity contracts by corporations and other entities, it simply denies such entities the benefit of tax deferral.  The changes to section 72(u) were effective with respect to contributions to annuity contracts after February 28, 1986.  Thus, a pre-March 1, 1986 annuity contract, where no later contributions were made, is grandfathered.  Additionally, if contributions are made to a pre-March 1, 1986 contract, Section 72(u) should apply only to the later contributions.  However, most tax advisers caution against making a post-February 28, 1986 contribution to a pre-March 1, 1986 contract on the premise that the ultimate tax treatment is uncertain.

The legislative history further suggests that unless a contract meets one of the above exceptions, there is no other circumstance under which a corporation can be deemed to be acting as an agent for a natural person.  The same treatment would appear to be true of ownership of a contract by a partnership, LLC, or S corporation, despite the fact that these are all “flow-through” entities for income tax purposes.

In contrast, it is far more likely that a trust could be deemed to be the nominal owner of an annuity contract given the nature of the relationship between trust beneficiaries and the property held in trust – the beneficiaries are the ultimate owners of the trust property, while the trustee only holds temporary legal title during the trust’s existence.  Thus, the relationship of the parties would support an argument that a trustee’s ownership is nominal and that the contract should consequently be treated as held by a natural person.

Ownership of a Tax-Deferred Annuity by a Grantor Trust

The grantor trust rules of IRC Sections 671 through 678 cause the grantor of a trust to be treated as the owner of trust assets for income tax purposes and require trust income to be reported on the grantor’s income tax return.  If a grantor trust were to own an annuity contract, the grantor would be treated as owning the contract for income tax purposes, and it would seem to follow that the grantor would be treated as the owner for purposes of the non-natural person rule.  This would seem particularly true if the grantor trust was a revocable living trust since the grantor would have retained the power to terminate the trust and reacquire title to all assets.

However, if the grantor trust is an irrevocable trust, the application of the rule is less clear because although the granter would be treated as the owner for income tax purposes, he or she would normally not have any retained right to income, or principal and would have no beneficial interest in any trust asset, including the annuity contract.  Under these circumstances, it is not clear that the trust’s status as a grantor trust, in and of it, is sufficient to cause the annuity contract to be deemed to be held by a natural person.  It may, instead, be necessary to look to the trust beneficiaries for this purpose.

Annuity contracts present special problems and raise special considerations when the owner or beneficiary is not a natural person.  Although the law is intended to prevent corporations and other entities from enjoying the benefits of tax-deferral, ownership of an annuity by a trust appears to permit tax-deferral in many situations.