The hinge around which estate planning revolves is gifting. The future growth in value of the asset from the date of gift to the date of death will be removed from the estate for estate tax purposes. In a 45% combined federal and state estate tax bracket, this transfer can result in large estate tax savings over a period of time. This concept works very well with life insurance, where the death benefit is actuarially leveraged, income tax free and estate tax free, if owned by an irrevocable trust.
But what can be recommended to an estate owner who is uninsurable or medically rated for life insurance so as to make the internal rate of return on the death benefit uneconomical from a financial point of view? Or what about an estate owner who has already purchased life insurance owned by an irrevocable trust to offset estate taxes? Can we still achieve a measure of estate tax savings within the framework of another non-leveraged financial asset?
The answer is yes, as long as the client lives a reasonable number of years from the date of gift to the date of death. Non-qualified deferred annuities owned by an irrevocable trust can provide income tax-deferred growth and estate tax-free growth to the trust beneficiaries over an extended period of time. Let’s summarize the case design and the income, estate and gift tax issues both during the estate owner’s life and after the estate owner has died.
Basic structure of trust-owned annuities
- Client creates a “grantor” irrevocable trust with multiple adult children (assume three children) as the trust’s beneficiaries. Client transfers cash to the trustee of the trust who purchases a deferred annuity contract with the estate owner as the annuitant. The trust is the applicant, owner and beneficiary of the contract.
- As legal owner of the contract, the trustee has all the usual contractual rights, including the right to make withdrawals, transfer ownership, surrender the contract, or do a Section 1035 exchange of the contract for another annuity while the annuitant is alive.
Gift tax issues during lifetime of estate owner
- Client utilizes only gift tax annual exclusions each year ($13,000 per donee and $26,000 per donee for spousal “split-gifts”) to transfer cash to the trust. With three children, client and spouse could gift $78,000 per year ($26,000 x 3) to the trust. Trustee could purchase a series of $78,000 deferred annuity contracts each and every year the gifts are made to the trust. The value of these annual exclusion gifts plus all future annuity growth is totally removed from the taxable estate for estate tax purposes.
- Client uses some of their lifetime gift exemption ($5,000,000 per donor and $10,000,000 for married donors until the “sunset” of the current law on Dec. 31, 2012) to transfer cash to the trust. Trustee could purchase a one-time deferred annuity contract using some of their lifetime gift exemption amount, as the case may be. Clients file a Form 709 U.S. Gift Tax return to allocate the use of these lifetime gift exemptions. Only the future annuity growth over and above the date of gift value is removed from the taxable estate for estate tax purposes. The lifetime gift exemption amount is considered to be an “adjusted taxable gift” and is added back (recapitulated) into the taxable estate amount at death on Line 4 of the Form 706 U.S. Estate Tax return.
Income tax issues during lifetime of the estate owner
- The annuity contracts will provide tax-deferred growth just like any personally owned deferred annuity. IRC Section 72(u) provides that the contract must be held by a “natural person” to achieve tax deferral. The trustee is considered to be an agent for the trust beneficiaries, who are considered to be “natural persons” for purposes of IRC Section 72(u). Accordingly, the annuity may continue to be tax-deferred all the way until the death of the estate owner, if the estate owner is the annuitant of the contract.
- Any lifetime withdrawals from the deferred annuity by the trustee will be taxed under the typical LIFO gain-first method of IRC Section 72(e)(2). Since the trust is a “grantor” trust for income tax purposes during the lifetime of the estate owner, any LIFO income taxation will flow to the estate owner personally on their Form 1040 U.S. Individual Income Tax return.
Income tax issues after death of the estate owner
- At the estate owner’s death, the trust becomes a “non-grantor” trust for income tax purposes. As such, the trust is now a separate tax entity and will file a Form 1041 U.S. Fiduciary (Trust) Income Tax return on all items of trust income and take distributable net income (DNI) deductions for any income that is passed through to trust beneficiaries via trust K-1s.
- IRC Section 72(s) governs the required distribution of the annuity value after the annuitant has died. Option One (IRC Section 72(s)(1)) is to distribute the annuity value within 5 years to the contract beneficiary. The character of the income (ordinary income gain and then tax-free cost basis) retains its tax character, as it’s passed through the trust as DNI and then out to the trust beneficiaries personally via trust K-1s (IRC Sections 651 and 652). The trust beneficiaries will report this K-1 trust income on Schedule E of their Form 1040 U.S. Individual Income Tax returns.
- The Option Two distribution method is unclear. IRC Section 72(s)(2) allows the non-qualified annuity to be distributed over the life expectancy of a designated individual beneficiary as long as distributions start no later than 1 year after the annuitant’s death. But, what is the rule when a trust is the beneficiary of the annuity as opposed to an individual? The extensive Treasury Regs.1.72 are silent with regard to a trust as a designated beneficiary of an annuity for post-death distribution purposes. Interestingly, for IRAs or qualified plans paid to a trust as beneficiary, Treasury Regs. 1.401(a)(9)-4 allow a life expectancy payout, using the trust beneficiary with the shortest life expectancy. Clients are advised to consult their tax advisor regarding post-death life expectancy payouts to trusts from non-qualified annuity contracts. The IRS has not ruled publicly or privately on this specific issue.
Estate tax issues at death
- At the estate owner’s death, the annuity value is not included in the gross estate for estate tax purposes. Clearly, the estate owner irrevocably gifted away the cash used to purchase the annuity in the irrevocable trust. However, as described above, any lifetime gift exemption used is considered to be an “adjusted taxable gift” and is added back into the taxable estate at death on Form 706 U.S. Estate Tax return (IRC Section 2001(b)(1)).
- There is no stepped-up basis, to date, of death value for non-qualified deferred annuities (IRC Section 1014(b)(9)). The trust beneficiaries will eventually receive the annuity values estate tax free, although they will pay personal income taxes on the LIFO annuity gain amount.
Case Example Option #1:
Assume a 75-year-old estate owner transferred $1,000,000 in cash to a newly created irrevocable trust for the benefit of her adult children. She filed a Form 709 Gift Tax return using $1,000,000 of her $5,000,000 lifetime gift exemption. The trustee used the cash to purchase a deferred annuity with the 75 year old as the annuitant (defined as the “holder” under the special rule of IRC Section 72(s)(6) for entities owning annuity contracts). The trust is the legal owner and beneficiary of the annuity contract.
- If the original deferred annuity (and any subsequent Section 1035 tax-free exchanges) earned 4.75% over a 15-year period of time, until the estate owner’s death at age 90, the annuity would grow in value to about $2,000,000.
- The $1,000,000 of growth is excluded from the estate for estate tax purposes and will save the family about $450,000 of potential estate taxes (45% x $1,000,000).
- At the death of the annuitant, the $1,000,000 of taxable LIFO gain plus the $1,000,000 of non-taxable cost basis would be paid to the trustee. The trustee would then flow these taxable and non-taxable amounts out of the trust and over to the trust beneficiaries personally (adult children) via trust K-1s as described above.
- This K-1 gain amount would be considered “income in respect of decedent” (IRD) to the adult children of the estate owner (IRC Section 691(a)).
Case Example Option #2:
Assume the same facts of Case Example Option #1, except that each trust beneficiary (adult children of grantor) is designated as annuitant of separate deferred annuity contracts. The trust is still the legal owner and beneficiary of each contract.
- Under the special rule of IRC Section 72(s)(6), for entities owning annuity contracts, the adult children (annuitants) are defined as the holders of each contract for purposes of distribution at death.
- At the death of the grantor parent, the trustee could transfer the contracts from the trust as a tax-free distribution of trust principal to the adult children holders by a simple change of ownership form, and the children would each name their own personal beneficiary. This distribution from a trust is not a gift, but simply a discretionary distribution of trust principal.
- The children now own their own annuity contracts, subject to the usual rules of LIFO income taxation. If desired, the adult children could keep their annuities tax deferred all the way until their own deaths, many years in the future. At the time of their deaths, IRC Section 72(s) would require a distribution to their personal beneficiaries (i.e., grandchildren of the original donor) either under the 5-year rule or the life expectancy rule.
- This LIFO gain amount on the contracts would be considered IRD to the personal beneficiaries of each deceased adult child.
The risk tolerance and time horizon of the client may determine which type of deferred annuity product to recommend. If the client is looking for fixed guaranteed rates of return with no downside risk of loss, then a fixed annuity product with the longest current multi-year guarantee could make sense. If the client is looking for higher non-guaranteed upside potential, with no downside risk of loss, then indexed annuity products may be the best match. Finally, if a client is seeking unlimited upside potential but is also willing to accept downside risk of loss, then a variable annuity product could fit into the risk tolerance profile.
Russell E. Towers, J.D., CLU, ChFC, joined Brokers’ Service Marketing Group in 2002 as vice president of business & estate planning. Previously, he served in a number of advanced planning attorney positions with John Hancock Life Insurance Company. Russ’ area of expertise is estate, business and retirement planning for wealthy business owners, executives and professionals, and he provides customized case consultation for advanced legal, tax and insurance plan designs. Contact him at firstname.lastname@example.org.