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Taxation of an Annuity Contract Purchased by a Trust

Taxation of an Annuity Contract Purchased by a Trust

IRS says it’s taxed as annuity, not ordinary income, in a recent PLR.

In Private Letter Ruling 202118002 (May 7, 2021), the taxpayer sought a ruling on whether an annuity contract purchased by a trust would be taxed as an annuity or as ordinary income.

The trust in question was an irrevocable, nongrantor trust for the sole benefit of the grantor’s child, who was also a co-trustee along with the grantor’s other children. The beneficiary couldn’t transfer his interest in the trust. The co-trustees purchased a single premium deferred annuity contract of which the trust was the owner and beneficiary during the beneficiary’s life.

The PLR confirmed that the annuity contract held by the trust for the benefit of a natural person (the beneficiary) would be taxed as an annuity and not as ordinary income. Internal Revenue Code Section 72(u)(1) generally provides that an annuity contract held by a nonnatural person isn’t taxed as an annuity contact, and instead, the income on the annuity contract is treated as ordinary income. However, IRC Section 72(u)(1) doesn’t apply if the annuity contract is held by a trust or other entity “as an agent for a natural person.”

The PLR confirmed that Section 72(u)(1) doesn’t apply to an annuity contract held by a trust for a natural person. The PLR considered whether a trust must be acting as agent for the natural person to meet this exception. However, the Internal Revenue Service stated that a trust relationship is incongruent with an agency relationship, and the phrase “as an agent” in Section 72(u)(1) pertains only to “other entity” and doesn’t pertain to “trust.” As a result, Section 72(u)(1) doesn’t apply to annuity contracts held by trusts for natural persons. The PLR also noted that the decision was consistent with the purpose of Section 72(u)(1), which was created to tax employers holding plans for employees.

This is a departure from prior rulings that delved into the terms of the trust to determine if the trust held the annuity contract as an agent for the beneficiary/annuitant. (See PLRs 9752035 (Dec. 24, 1997), 9639057 (June 24, 1996), 199933033 (Aug. 20, 1999), 199905015 (Feb. 5, 1999), 200449016 (Dec. 3, 2204), and 202031008 (July 31, 2020)). This ruling seems to say that if the trust beneficiary is a natural person, Section 72(u)(1) doesn’t apply even if the trust amounted to an agency relationship.

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