Funding a Trust with Annuities? Beware.

There are income tax consequences to transferring annuities for less than full and adequate consideration.

If you are considering making a gift of annuities in trust, keep the following in mind:

If an individual who holds an annuity contract transfers it without full and adequate consideration, such individual shall be treated as receiving an amount equal to the excess of the cash surrender value of such contract at the time of transfer, over the investment in such contract at such time, under the contract as an amount not received as an annuity.

In other words, gifting an annuity triggers gain to the annuity owner to the extent the cash surrender value exceeds basis, as a general rule.

In may be possible to avoid the general rule through proper drafting. There is at least one IRS private letter ruling that indicates there is no ownership change for income tax purposes when an annuity owner transfers his annuity to a grantor trust. A grantor trust is a trust containing certain provisions that cause it to be ignored as a separate entity for income tax purposes (but not necessarily estate and gift tax purposes). However, private letter rulings may not be relied upon as binding authority against the IRS. Nonetheless, there is reason to believe that gain is not triggered when the transferee is a grantor trust.

There is another issue, but it seems to be more theoretical than real. I.R.C. § 72(u) states:

If any annuity contract is held by a person who is not a natural person, such contract shall not be treated as an annuity contract for purposes of this subtitle (other than subchapter L), and the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the owner during such taxable year. 

However, the statute goes on to say that holding by a trust or other entity as an agent for a natural person shall not be taken into account.

Source: I.R.C. § 72(e)(4)(C), PLR 200449017

Posted by Joel D. Roettger, JD, LLM, EPLS

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