IRS has privately ruled that flexible premium deferred annuity contracts purchased by a trust, of which each of the trust beneficiaries will be the named annuitant of a contract in proportion to his residuary share of the trust, will be considered owned by natural persons for Code Sec. 72(u) purposes. Additionally, the trust's distribution of the contracts to the beneficiaries won't be treated as an assignment of an annuity contract without full and adequate consideration under Code Sec. 72(e)(4)(C).
Background. An annuity is a contract providing for regular payments beginning on a fixed date and continuing for the life of one or more individuals or for a term of years. Generally, the contract is a life insurance, endowment, or annuity contract purchased from an insurance company, but an annuity may be issued by a party other than a commercial insurer. The special tax rules for annuities under Code Sec. 72 generally permit the annuitant to recover the cost of the contract tax-free over the term of the annuity.
However, under Code Sec. 72(u), an annuity contract won't be treated as an annuity contract if it is held by a person who isn't a “natural person.” Instead, the income on the contract for any tax year of the policyholder will be treated as ordinary income received or accrued by the owner during that tax year. Corporations and trusts aren't natural persons according to the’86 TRA Committee Reports, but Code Sec. 72(u)(1) provides that the holding by a trust or other entity as an agent for a natural person will generally be disregarded.
An individual who holds an annuity contract transfers it for less than full and adequate consideration, is treated under Code Sec. 72(e)(4)(C)(i) as receiving a nonannuity payment equal to the excess of: (i) the cash surrender value of the contract at the time of transfer, over (ii) his investment in the contract.
Facts. Husband (H) established a grantor trust (Trust) and named as beneficiaries Wife (W) and their six descendants. H and W were co-trustees during H's life.
Upon H's death, W became the sole trustee, and the trust was divided into subtrusts A, B, and C. Subtrust A was allocated an amount based on the allowed estate tax exemption and marital deduction. Subtrust C was allocated an amount based on the estate tax exemption, provided the amount was not used for the payment of taxes, debts, or administration expenses of H's estate. Once all taxes, debts, and expenses have been paid, the assets of subtrust C are to be distributed to subtrust B, which contains all remaining trust property.
During the life of W, in her capacity as trustee and subject to an ascertainable standard, W may pay or use the property of subtrust B for the benefit of herself and others partly or wholly dependent upon her. At her death, the property of subtrust B is to be divided and distributed among the descendant-beneficiaries in the proportions stated in Trust.
W, as trustee, intends to purchase flexible premium deferred annuity contracts naming each of the descendant-beneficiaries as the annuitant on one annuity contract, in proportion to each's residuary share of Trust. The material provisions of each contract will be substantially the same, except for the dates of annuitization. Trust will be the owner and beneficiary of the contracts during W's life. Trust anticipates that its other assets will be sufficient to fund its expenses and make nominal distributions to W, and that there should not be any need for Trust to take a distribution from the annuity contracts.
Upon Trust's final distribution, each beneficiary will be distributed the contract for which that beneficiary is the annuitant. This distribution is anticipated to occur before the contract's annuity starting date. Trust won't receive any consideration from any beneficiary in exchange for the contracts.
IRS rules favorably. In a taxpayer-friendly private letter ruling (PLR), IRS concluded that the annuity contracts are considered owned by natural persons for Code Sec. 72(u) purposes, and that the distribution of the contracts by Trust to the beneficiaries won't be treated as an assignment of an annuity contract for less than full and adequate consideration under Code Sec. 72(e)(4)(C).
With regard to the Code Sec. 72(u) ruling, IRS examined the legislative history and determined that provision was largely intended to target employers' use of annuity contracts to fund significant amounts of deferred compensation for employees on a tax-favored basis. In contrast, the annuity contracts at issue are owned by a trust under which all of the beneficial interests are owned by natural persons in a non-employment context. Accordingly, IRS determined that the contracts were properly treated as being owned by a natural person for Code Sec. 72(u)(1).
Looking to the Code Sec. 72(e)(4)(C) issue, IRS found that the legislative history of this provision indicates that this rule is intended to prohibit taxpayers from avoiding Code Sec. 72(s)’s required distribution rules by continuing tax deferral beyond the life of an individual taxpayer. Here, since the transfer of the contracts from Trust to the beneficiaries doesn't have the effect of avoiding Code Sec. 72(s)’s required distribution rules, the distribution of the contracts won't be treated as an assignment for less than full consideration.
References: For the requirement that annuity benefits be available only to natural persons, see FTC 2d/FIN ¶J-5005; United States Tax Reporter ¶724.25; TaxDesk ¶146,506; TG ¶12656. For transfers of annuity contracts without adequate consideration, see FTC 2d/FIN ¶J-5061; United States Tax Reporter ¶724.13; TaxDesk ¶146,531.