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
• 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
•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.
owned by an
to the trust
• 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.
• The Option Two distribution method
is unclear. IRC Section 72(s)( 2) allows the non-qualified annuity to be