564 / Can a grantor trust own a deferred annuity contract? How is a deferred annuity owned by a grantor trust taxed?

A grantor trust can own a deferred annuity contract, but, in certain circumstances, the "non-natural person rule" of IRC Section 72(u) will cause the denial of the tax-deferral benefits to a deferred annuity owned by a trust. If annuity tax benefits are denied under the non-natural person rule, income on the annuity for any taxable year will be treated as ordinary income received.¹ However, if a trust owns a deferred annuity contract as the agent for a natural person, Section 72(u) does not apply.²

A revocable grantor trust will usually fall within this exception because the grantor (presumably a natural person) and the grantor trust are treated as one "person" for income tax purposes,³ and, moreover, because the property is generally held in trust specifically for that grantor. More generally, as long as the grantor trust (a non-natural person) owns the deferred annuity contract, and the primary beneficiaries of the trust are natural persons, the annuity contract should escape the non-natural person rule of Section 72(u).⁴ If significant interests in the trust are held by non-natural persons, however, it is possible that the trust will not qualify as an agent for a natural person.

It should be noted that most insurers require that when the owner of their deferred annuity contract is a trust, the trust must also be the primary beneficiary of that contract.

If the grantor trust is irrevocable, determining whether the trust is exempt from the non-natural person rule becomes more complicated because the grantor of the trust might not retain any right to the trust assets or income. In making the determination whether significant interests in the trust are held by natural or non-natural persons, it is important to determine who will receive the primary economic benefit of the trust assets.⁵

The IRS has ruled privately that deferred annuity contracts owned by an irrevocable grantor trust established by an employer-corporation (a non-natural person) were held for the benefit of natural persons (the employees) because (1) the employee-beneficiaries of the trust would receive all of the trust income and (2) the employer held no future interest in the trust assets.⁶ Therefore, even though the actual grantor of the trust was a non-natural person, the deferred annuity contract was able to escape the non-natural person rule because the beneficiaries were natural persons.

Note that immediate annuities are explicitly exempted from the non-natural person rule of IRC Section 72(u).⁷