The income tax treatment of annuities is provided for under Code § 72. That section provides various rules, including extra income tax for some distributions to younger taxpayers and limits on deferral for entity owners. The provisions can be difficult to interpret when the owner of the annuity is a grantor trust, and the annuitant and current beneficiary of the trust is not the grantor. A recent private letter ruling gives the IRS’ take on some of these issues. The following conclusions are based on the above scenario – a grantor trust is the owner of the annuity, and there is a current beneficiary that is not the grantor and whose life is the measuring life for the annuity.
- Code § 72(q) 10% additional tax on early distributions. This provision imposes a 10% addition to tax if a distribution from the annuity is made on or after the taxpayer attains age 59 ½ , but with exceptions for a disabled taxpayer, or if the distribution is part of a series of substantially equal periodic payments made for the life of the taxpayer or the taxpayer and his or her designated beneficiary. The PLR provides that the grantor, since the grantor is treated as owner of the trust under the grantor trust rules, is the “taxpayer” for purposes of the foregoing age, disability, and equal periodic payment exceptions to the 10% addition to tax rules under Code § 72(q).
- Code § 72(q)(2)(B) exception to 10% additional tax for death. This provision provides an exception to the 10% additional tax if the distribution is made on or after the death of the “holder” or, when the “holder” is not an individual, the death of the primary annuitant. The PLR provides that the “holder” is the grantor trust. Since it is not an individual, this exception applies to distributions after the death of the primary annuitant. That primary annuitant is the individual beneficiary (not the grantor), so distributions after the death of that beneficiary are not subject to the 10% addition to tax.
- Code § 72(u)(1) nondeferral to trust owners. This provision denies tax deferral for an annuity contract that is not owned by a natural person, although it does allow for a trust or other entity to hold the annuity as an agent for a natural person without running afoul of the loss of deferral. The PLR concludes that this provision does not apply where the grantor is a natural person. The reasoning is somewhat strained, but taxpayer friendly. It reads the exception to the rule to apply to a trust for a natural person (without regard to the “as an agent” language since that language only applies to entities other than a trust). Since the grantor is treated as owning the trust assets, it is treated as the owner of the contract. The grantor trust is holding the contract (as holder) for the grantor, who is a natural person. Thus, income tax deferral is allowed. The PLR notes that Code § 72(u) was adopted to encourage employers to offer benefits to employees under qualified plans (by stripping corporate nonqualified annuity plans of income tax deferral). So for private trust arrangements not in the employment context, there is no policy reason to deny deferral.
PLR 202031008, July 31, 2020