Both trust entities and annuity products can play powerful planning roles for clients in a variety of situations—but unfortunately, when the two strategies collide, the tax consequences can be disastrous. This is especially true in the case of deferred annuity products, which are typically purchased with a view toward both future income security and tax deferral.
Whether a trust is to be named owner or beneficiary of the annuity contract at issue, the client purchasing the contract needs to be aware of the serious tax consequences that can result from involving a trust in the transaction. Fortunately, for clients who have legitimate reasons for involving a trust, there may be ways to structure the transaction to include the trust entity while avoiding the tax headache.
Trust as Annuity Owner or Beneficiary
When a non-natural person (essentially, a non-human being, such as trusts, business entities, etc.) owns a deferred annuity product, the tax benefits afforded to annuities no longer apply. This means that income on the contract will be taxed as ordinary income each year (similarly to a mutual fund investment). As a result, the tax deferral benefits traditionally offered by the annuity are lost—and the compressed income tax rates applicable to trusts may apply (trusts are taxed at the highest 39.6% income tax rate when income exceeds only $12,400 in 2016).
Clients should note that immediate annuities are specifically exempted from this non-natural person rule. Annuities held by retirement plans are similarly exempt.
Further, when a trust is named as beneficiary of an annuity contract, several of the more favorable distribution options (i.e., using the beneficiary’s life expectancy to stretch the value of tax deferral) are lost. The trust beneficiary will be required to take the annuity proceeds as a lump sum, or over a five-year period after the original owner’s death—rapidly accelerating the tax liability associated with the contract.
This is because most insurance carriers find that a trust, unlike a human being, does not have a life expectancy. Further, the option for a spouse to choose to treat the annuity as if it were his or her own (and continue the contract as such) is also lost when a trust is named beneficiary.
The Potential Save
A primary exception to the “non-natural person rule” discussed above allows for the preservation of tax deferral where the non-natural person owns the annuity as an agent for a natural person. Based on several IRS rulings, a revocable (living) grantor trust should qualify for this exception because the trust and the grantor are treated as one entity for tax purposes—meaning that the trust is only the nominal holder of the trust assets.
Problems can still arise, however, if non-natural persons are also named as trust beneficiaries (such as in a case where the owner wishes to leave some assets to a charity or family business) or if the trust is irrevocable (where the grantor does not retain substantial interests in the trust). Because the IRS rules in this area are not concrete, clients must exercise caution in leaving even a partial trust interest to a non-natural person.
It should also be noted that these rules apply to a trust that owns the annuity contract—when the trust is named as beneficiary of the annuity, the rapid distribution method discussed above will still apply (and the terms of the actual contract should be examined to determine whether the insurance carrier itself imposes any restrictions).
Clients should remember that annuity contracts are not subject to the potentially expensive and prolonged probate process that may apply to other assets when determining whether to attempt to avoid the non-natural person rule by using a revocable grantor trust entity. In some cases, the trust structure may be desirable (such as if the intended beneficiary is disabled, perhaps), but for most clients, the trust structure may create more problems than it solves.
In general, clients who wish to name a trust as owner or beneficiary of an annuity contract should be advised to think again—while the rules in the area are far from concrete, one thing is certain: the risk of losing the valuable tax deferral benefits of the contracts is great.
– See ThinkAdvisor’s complete tax planning home page: 23 Days of Tax Planning Advice: 2016.