As a financial asset, an annuity is necessarily part of the overall financial and estate plan of its purchaser.
However, it is sometimes not well coordinated with the other components. Indeed, the ownership and beneficiary arrangement of an annuity may be inconsistent with — or even in conflict with — the rest of a client’s plan.
Not uncommonly, this results from an advisor’s decision to employ the annuity in connection with a trust without a full understanding of the rules governing both.
(Related:Trust Planning with Annuities)
In the following discussion, we will examine some of the problems advisors may encounter when annuities are owned by, or made payable to, a trust, and the rules (i.e., the tax rules and the contractual provisions and administrative policies of annuity issuers) that are not well understood.
For most of the following discussion, we will be concerned only with deferred annuities. Not only are most annuities sold of this type, but the Internal Revenue Code (IRC) provisions that cause most of the difficulties where annuities are owned by or payable to a trust (Section 72(u) and certain paragraphs of Section 72(s)) do not apply to immediate annuities. We will also be concerned only with nonqualified contracts, because qualified annuities, or annuities used to fund IRAs, cannot be owned by a trust other than the trust for the type of retirement plan being funded.
Problematic Annuity Structuring with Trusts
Problems can arise when a deferred annuity is:
owned by and payable to a trust;
owned by a trust and payable to another party; or
owned by another party and payable to a trust.
When an annuity is owned by a trust, the holder of the annuity is deemed by Section 72(s)(6)(A) to be the primary annuitant. This provision applies to any annuity owned by an entity other than a natural person, including a corporation, partnership, or trust. Primary annuitant is defined by IRC Section 72(s)(6)(B) as “the individual, the events in the life of whom are of primary importance in affecting the timing or amount of the payout under the contract.”
It is vital that the advisor understand that this provision applies with regard to distributions required to be made from the annuity upon the death of any holder by Section 72(s), if the annuity is to be considered an annuity for income tax purposes. However, what if a particular annuity does not provide for payment upon the primary annuitant’s death when the annuity is owned by a trust? The result could be a conflict — an incongruity, which might pose serious problems as will be discussed later in this chapter. This is unlikely, however, because the language in today’s deferred annuities typically requires payouts in accordance with Section 72. Moreover, most insurers that will issue a deferred annuity owned by a trust or other “non-natural person” require that entity to be the primary beneficiary.
Also, an annuity owned by a trust (or other nonnatural person) will not be considered an annuity for income tax purposes unless the owning entity is acting as the agent of a natural person. This requirement, too, is a source of potential problems. Although many trusts qualify as such agents, not all do.