by Darlene Chandler
Since the
"non-natural" person rule was enacted as part of the Tax Reform Act
of 1986, the effect that the rule has on annuities owned by trusts has not been
entirely clear. In a private letter ruling released late last year, the
Internal Revenue Service considered whether the non-natural person rule would
apply to a trust which had invested trust assets in a single premium deferred
variable annuity. Reaching an outcome generally favorable to those involved
with annuities, the Service concluded that the rule 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 other words, if an annuity contract is owned by an entity
that is acting as agent for a real person, the annuity will receive favorable
income tax treatment. The difficulty since the non-natural person rule was put
in place has been in knowing when an entity is acting as agent for 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.
The citation for
the private letter ruling discussed in this article is Let.
Rul. 9752035.
Darlene Chandler,
J.D., CLU, ChFC, is an associate editor of Tax Facts, a National
Underwriter Co. publication.