Life Insurance Selling - January 2012

the trust beneficiaries over an extended period of time. Let’s summarize the case design and the income, estate and gift tax issues both during the estate owner’s life and after the estate owner has died.

709 U.S. Gift Tax return to allocate the use of these lifetime gift exemptions. Only the future annuity growth over and above the date of gift value is removed from the taxable estate for estate tax purposes. The lifetime gift exemption amount is considered to be an “adjusted taxable gift” and is added back (recapitulated) into the taxable estate amount at death on Line 4 of the Form 706 U.S. Estate Tax return.

Basic structure of trust-owned
annuities

• Client creates a “grantor” irrevocable trust with multiple adult children ( assume three children) as the trust’s beneficiaries. Client transfers cash to the trustee of the trust who purchases a deferred annuity contract with the estate owner as the annuitant. The trust is the applicant, owner and beneficiary of the contract.

•As legal owner of the contract, the trustee has all the usual contractual rights, including the right to make withdrawals, transfer ownership, surrender the contract, or do a Section 1035 exchange of the contract for another annuity while the annuitant is alive.

Income tax issues during lifetime
of the estate owner

• The annuity contracts will provide tax-deferred growth just like any personally owned deferred annuity. IRC Section 72(u) provides that the contract must be held by a “natural person” to achieve tax deferral. The trustee is considered to be an agent for the trust beneficiaries, who are considered to be “natural persons” for purposes of IRC Section 72(u). Accordingly, the annuity may continue to be tax-deferred all the way until the death of the estate owner, if the estate owner is the annuitant of the contract.

•Any lifetime withdrawals from the deferred annuity by the trustee will be taxed under the typical LIFO gain-first method of IRC Section 72(e)( 2). Since the trust is a “grantor” trust for income tax purposes during the lifetime of the estate owner, any LIFO income taxation will flow to the estate owner personally on their Form 1040 U.S. Individual Income Tax return.

Gift tax issues during lifetime of
estate owner

•Client utilizes only gift tax annual exclusions each year ($13,000 per donee and $26,000 per donee for spousal “split-gifts”) to transfer cash to the trust. With three children, client and spouse could gift $78,000 per year ($26,000 x 3) to the trust. Trustee could purchase a series of $78,000 deferred annuity contracts each and every year the gifts are made to the trust. The value of these annual exclusion gifts plus all future annuity growth is totally removed from the taxable estate for estate tax purposes.

• Client uses some of their lifetime gift exemption ($5,000,000 per donor and $10,000,000 for married donors until the “sunset” of the current law on Dec. 31, 2012) to transfer cash to the trust. Trustee could purchase a one-time deferred annuity contract using some of their lifetime gift exemption amount, as the case may be. Clients file a Form

Income tax issues after death of
the estate owner

•At the estate owner’s death, the trust becomes a “non-grantor” trust for income tax purposes. As such, the trust is now a separate tax entity and will file a Form 1041 U.S. Fiduciary (Trust) Income Tax return on all items of trust income and take distributable net income (DNI) deductions for any income that is passed through to trust beneficiaries via trust K-1s.

“Non-qualified
deferred
annuities
owned by an
irrevocable
trust can
provide income
tax-deferred
growth and
estate tax-
free growth
to the trust
beneficiaries
over an
extended period
of time.”

• IRC Section 72(s) governs the required distribution of the annuity value after the annuitant has died. Option One (IRC Section 72(s)(1)) is to distribute the annuity value within 5 years to the contract beneficiary. The character of the income (ordinary income gain and then tax-free cost basis) retains its tax character, as it’s passed through the trust as DNI and then out to the trust beneficiaries personally via trust K-1s (IRC Sections 651 and 652). The trust beneficiaries will report this K-1 trust income on Schedule E of their Form 1040 U.S. Individual Income Tax returns.