Trust Titling (funding) and Non-Qualified Annuities

Revocable Living Trusts (referred to also just as Living Trusts) are a common foundational estate plan technique. Not only can Revocable Living Trusts replace a Will (become a “Will substitute”) in distributing property after a person dies, but these trusts also provide planning in case a person is living but becomes incapacitated and unable to manage their own financial affairs – which a Will cannot do. Avoiding court management of a person’s financial affairs can save money, time, and administrative complexity. Due to courts becoming more congested and the increasing fees for using courts, Revocable Living Trusts’ popularity have increased. In North Carolina, for example, court fees for probate can be as much as $6,000 and this does not include the extra accounting work required to complete the probate. Since Revocable Living Trusts do not become incapacitated or die, they do not require those court services to manage or transfer assets. But, there is a catch!

The catch is that Revocable Living Trusts are only effective if they own the assets of the trustmaker(s) or become the owner through a beneficiary designation. It is possible, for example, to have a Revocable Living Trust be the beneficiary of a life insurance policy or an IRA or 401(k) retirement account. Your Will can also make the Revocable Living Trust the residuary beneficiary of your assets, but Wills must go to court in order to be administered through a process commonly referred to as “probate.” Avoiding probate and court is accomplished by proper titling of assets and proper beneficiaries on insurance and retirement accounts. In our Firm, we call that “funding” the trust. Think of the Revocable Living Trust as a finely tuned and crafted automobile, and the “funding” process as filling up the gas tank so it runs efficiently.

One asset that has always been a source of funding confusion is the non-qualified annuity (“NQA”). Despite a specific Internal Revenue Code section (§ 72(u)), many insurance companies and insurance professionals have advised against making the trust the owner and/or beneficiary of a NQA for fear of losing its tax-deferred income tax feature. These professionals question whether the Revocable Living Trust is a “natural person” such that it comes within the exception of Internal Revenue Code § 72(u)(1) allowing for a Revocable Living Trust or other entity to hold the annuity as an agent for a natural person without running afoul of the loss of deferral. Moreover, Internal Revenue Code § 72(q) imposes a 10% additional tax on early distributions from the annuity. The 10% tax is applied if a distribution from the annuity is made on or before 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.

A 2020 IRS Private Letter Ruling (PLR 202031008, July 31, 2020 ) chimed in on this debate by issuing a taxpayer-favorable ruling. The IRS interprets the § 72(u) 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 trusts). Since the grantor is treated as owning the trust assets, it is treated as the owner of the NQA. The grantor trust is holding the NQA contract (as holder) for the grantor, who is a natural person. Thus, income tax deferral is allowed. The PLR also ruled favorably on the 10% early distribution issue, reasoning that since the grantor is treated as the owner of the trust under the grantor trust rules, it 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).

While IRS Private Letter Rulings can only be relied on by the taxpayer that requested the Ruling, it is nevertheless an indication of how the IRS would likely address a NQA under a similar fact pattern. The reason that a trustmaker of a Revocable Living Trust might want to make a NQA owned by the trust is that if the trustmaker becomes incapacitated, then the successor incapacity trustees under the Revocable Living Trust could then manage the NQA without the use of a financial power of attorney. After the trustmaker’s death, if the Revocable Living Trust is the beneficiary of the NQA, then the provisions in the trust on who benefits from the annuity and the terms and conditions (including money management, marital, and creditor protections) will apply to the NQA. PLR 202031008 is taxpayer-favorable and should be considered when funding the Revocable Living Trust.