Annuity Trust Taxed as Natural Person

The concept of the "non-natural" person rule as used in the Tax Reform Act of 1986 has consequences for trust-purchased annuities which had remained somewhat unclear. The IRS, in a private letter ruling released late last year, examined the application of the non-natural person rule in the case of a trust which had invested assets in a single premium deferred variable annuity.

Reaching an outcome generally favorable to those involved with annuities, the Service concluded that the rule, which would disallow a trust from reaping the annuity tax benefits to which an individual annuitant is entitled, does not apply.

In the ruling request an individual, whom we will call Mr. White, died leaving a will which provided that a certain portion of his property be placed in a trust. The terms of the trust provided that the trustee should divide the property in separate shares for each of the remaindermen and that, if the life beneficiary survived Mr. White, the income from each share would be distributed to the life beneficiary. For purposes of this discussion, we will call the life beneficiary Mr. Green.

The trustee wishes to invest some of the trust assets in a single premium individual deferred variable annuity of which Mr. Green, the life beneficiary of the trust, would be the annuitant. The trust itself will be both the owner of the annuity contract and the beneficiary.

Found in Section 72(u) of the Code, the non-natural person rule provides basically that if an annuity contract is held by a person who is not a natural person (e.g., a "non-natural" person) the annuity is not treated as an annuity contract for tax purposes. Generally, this means that the income on the contract is treated as ordinary income to the holder of the annuity contract. In effect, if the non-natural person rule applies, the annuity holder loses the income tax deferral on the interest earned inside the annuity contract and must include this amount in income each year.

However, in order to allow certain entities to own annuities and continue to be taxed in the same manner as individual annuity owners, Congress created an exception to the non-natural person rule. Generally, the non-natural person rule was put in place as part of the Tax Reform Act of 1986, in order to curb perceived abuses, primarily by corporations, of the income tax-free treatment of the interest accumulating in an annuity contract. Prior to the 1986 legislation, it was thought that nonqualified annuity contracts were being purchased by corporations in order to provide tax-deferred funding for nonqualified deferred compensation plans, a type of benefit plan which typically is available only to a corporation's top executives. The exception to the non-natural person rule states that an annuity contract held by a trust or other entity as an agent for a natural person is considered to be held by a natural person.

In determining that the trust in the private letter ruling was not subject to the non-natural person rule, the Service looked to the legislative history of Code section 72(u). This history states that an annuity contract will be considered to be held by a natural person if the nominal owner is not a natural person (such as a corporation or a trust) but the beneficial owner of the annuity contract is a natural person.

After looking at this language, the Service concluded that even though the trust is the owner of the variable annuity contract, it is a nominal owner as compared to Mr. Green, the life beneficiary, and the trust remaindermen. Thus, the trust is the nominal owner but Mr. Green and the remaindermen are the beneficial owners of the annuity contract.

This particular letter ruling involved a fact situation in which the same individual (a natural person) was the sole life beneficiary of the trust and the sole annuitant under the annuity contract.

It is interesting to consider whether the Service would have reached the same conclusion if the trust's life income beneficiary and the annuitant were not the same person or if the trust had several life income beneficiaries but only one was named as the annuitant.

Perhaps future rulings will clarify these alternative fact situations.

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