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.
While one might argue that a charity benefiting only individuals (as opposed to, say, animals) is consistent with the non-natural person rule in section 72(u), caution is warranted in placing annuities in non-grantor trusts with charitable beneficiaries.
Trusts as beneficiaries. Just as there are many reasons to name a trust as the owner of a NQ annuity, 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.
If that is done, one of the questions that arises is the manner in which the distributions required by Code section 72(s) on the death of the owner must be made. By way of background, although section 72(s) generally requires the owner’s entire interest in a deferred NQ annuity to be distributed within 5 years of the owner’s death prior, there are 2 widely used exceptions.
First, if any portion of the owner’s interest is payable to or for the benefit of a “designated beneficiary,” and if that beneficiary is the deceased owner’s spouse, the spouse can continue the contract as its owner [Code section 72(s)(3)].
Second, if any portion is payable to or for the benefit of a designated beneficiary, including a beneficiary who is not the deceased owner’s spouse, the interest can be distributed over the life or life expectancy of the designated beneficiary [Code section 72(s)(2)].
Is either exception available if a trust is named as beneficiary? Consider the definition of the term “designated beneficiary” in Code section 72(s)(4): “any individual designated a beneficiary by the holder of the contract” (emphasis added).
One might think this definition would be the end of the analysis, since a trust is not an individual. However, what if the trust that is the beneficiary of the NQ annuity is a grantor trust and an individual is treated for income tax purposes as owning the trust assets? Here it would seem appropriate to treat the individual grantor as the designated beneficiary. And, indeed, the IRS has ruled that this can be done (PLR 200323012).
As a result, if the grantor is the spouse of the deceased NQ annuity owner, the grantor can continue the contract, or, irrespective of whether the grantor is the spouse of the deceased owner, he or she can receive the owner’s interest over life or life expectancy.
If a trust that is not a grantor trust is the contract beneficiary, the waters become very murky.
Although the beneficiary is not an individual, Treasury regulations under Code section 401(a)(9)–which is the qualified plan rule analogous to section 72(s) and contains the same definition of a designated beneficiary as section 72(s)–allow trust beneficiaries to be treated as the designated beneficiaries if certain requirements are met. One might look to those regulations in the case of a NQ annuity with a trust beneficiary, and, if their requirements are satisfied, reasonably conclude that it would be appropriate to treat the trust beneficiary as the designated beneficiary.
However, there are no rulings so providing. In addition, the author is aware that some IRS representatives have argued that the regulations under 401(a)(9) do not provide a basis for such treatment in the case of a NQ annuity. As a result, here too, insurers and advisors should proceed with caution.