There are many circumstances where placing a non-qualified annuity within a trust is appropriate. Similarly, there are a number of circumstances in which it may be desirable to name a trust as the beneficiary of an owner’s interest in a NQ annuity.
The tax planning considerations can be quite complex. They involve a number of very technical rules, and some situations have not been addressed by the Internal Revenue Service. Following are some potential traps for insurers and advisors confronted with these circumstances.
Trusts as owners. The purchaser of a NQ annuity generally expects the earnings to be tax-deferred until a distribution of some sort occurs from the annuity. However, since 1986, Internal Revenue Code section 72(u)(1) has provided that when an annuity is “held by a person who is not a natural person,” the contract “owner” is treated as currently receiving earnings under the annuity (measured by a special formula set out in the code).
Trusts are an obvious example of a “non-natural person,” but not all trust owned annuities are currently taxable. This is for 2 reasons.
First, if a grantor trust for which the grantor is an individual owns an annuity, the annuity is treated for purposes of section 72(u) as held by that individual, not by a “non-natural person” (IRS Information Letter 2001-0121; PLR 9316018).
Second, section 72(u)(1) provides that “holding by a trust or other entity as an agent for a natural person” is disregarded for these purposes. The legislative history of this “agent” exception explains that it was intended to exclude from the sweep of section 72(u) any annuity “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…” [H.R. Rep. No. 426, 99th Cong., 1st Sess. 703, 704 (1985)].
Despite this statement of congressional intent, a couple of IRS private letter rulings issued in the mid-1990s suggested that in order to qualify for this second exception, it was necessary to establish that the trust acted as the legal agent for a natural person under general principles of agency law (PLRs 9639057 and 9810015).
This raised some concerns as to whether the “agent” exception might be construed by the IRS in a narrower fashion than the legislative history suggested because it is not common for a trustee to be acting as an agent for the trust beneficiaries. However, later PLRs involving trust-owned annuities have not addressed the agency relationship and instead focus (consistent with the legislative history) on whether the beneficial interest in the annuity resides with a natural person (PLRs 200449011, 200018046, and 199905015, among others).
Thus, at this time, it appears that the key to maintaining tax-deferred status for a NQ annuity in a case where a non-grantor trust will be the owner is to assure that all beneficial interests in the annuity reside with individuals.
This is relatively straightforward if all trust beneficiaries are individuals. Many trusts, though, identify a charity as a primary or possibly a contingent beneficiary of the trust. Is tax deferral available in that circumstance? An old PLR would suggest that the IRS believes the answer is no.
In PLR 9009047, issued in 1989, the IRS maintained that an annuity held by a charitable remainder unitrust was not held for the benefit of a natural person. (Such a trust benefits both individuals and one or more charities.) Presumably, this holding was based on the IRS view that a charity (typically a corporation) is a non-natural person and that an annuity that will pay out to a charity (even in part) is thus held for the benefit of a non-natural person.