Distribution of Annuity Contracts from Trust to Beneficiaries Not Treated as Gratuitous Transfer
The IRS has privately ruled that flexible premium deferred annuity contracts purchased by a trust, of which each of the trust beneficiaries is the named annuitant of the contract in proportion to his residuary share of the trust, will be considered owned by natural persons, so that the distribution of the contracts to the beneficiaries will not be treated as a gratuitous transfer.
Facts. Husband established a grantor trust (the “Trust”) and named his Wife and their six descendants as beneficiaries of the Trust. Husband and Wife served as co-trustees during Husband’s life and, upon the death of Husband, Wife became the sole trustee. Wife divided the Trust into Subtrusts A, B, and C, pursuant to the terms of the Trust. Subtrust A was allocated an amount based on the allowed estate tax exemption and marital deduction. Subtrust B 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 Husband’s estate. Once all taxes, debts, and expenses have been paid, the assets of Subtrust B were to be distributed to Subtrust C, which contained all of the remaining trust property.
During the time that Wife is serving as trustee of the Trust, she is authorized to distribute the property in Subtrust C for the benefit of herself and others who she considered dependent upon her for support (subject to an ascertainable standard). Upon her death, the Trust directs that the property of Subtrust C is to be divided and distributed among the children of Husband and Wife.
While serving as trustee, Wife intends to purchase flexible premium deferred annuity contracts and name each of the children as the annuitant on one annuity contract, in proportion to each beneficiary’s residuary share of Trust. The material provisions of each contract will be substantially the same, except for differing dates of annuitization, and the Trust will be the owner and beneficiary of the contracts during Wife’s lifetime. The Trust is expected to have sufficient assets to fund its expenses and make nominal distributions to Wife, and there should not be any need for Trust to take a distribution from the annuity contracts. Upon the final distribution of the Trust, each beneficiary will receive an outright distribution of the contract purchase on behalf of the beneficiary. This distribution is anticipated to occur before the contract’s annuity starting date.
According to Internal Revenue Code Section 72(u), an annuity contract will not be treated as such if it is held by a person who is not a “natural person.” Therefore, if the Trust is not considered a “natural person,” the income on the contract for any tax year of the policyholder would be treated as ordinary income received or accrued by the owner during that tax year and, when transferred for less than full and adequate consideration, is treated 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. In order to determine whether the Trust would be treated as a “natural person,” Wife requested a private letter ruling from the IRS.
IRS’ Decision. In a private letter ruling, the IRS determined that the annuity contracts are considered owned by natural persons for the purposes of Internal Revenue Code Section 72(u), and that the distribution of the contracts by the Trust to the beneficiaries will not be treated as an assignment of an annuity contract for less than full and adequate consideration. This rule is intended to prohibit taxpayers from avoiding the 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 does not have the effect of avoiding the required distribution rules, the distribution of the contracts will not be treated as an assignment for less than full consideration.