Taxation of Annuities
Transfers of Annuity Ownership
While a contractholder may exchange one annuity for another tax-free under Section 1035, transfers of an annuity's ownership to another person may raise serious income tax and/or gift tax consequences. As we'll learn in Chapter 3, there is a market for existing annuities. If an annuity owner exchanges ownership for “full and adequate consideration”, the transfer is treated as a sale. This is a murky area of tax law. Presumably, one would only sell the contract, rather than surrender it, if one could obtain more than its surrender value from the sale. For example, a contractholder has a cost basis of $60,000 in a contract that has an $80,000 surrender value -- and due to favorable contract provisions, a buyer is willing to pay $85,000 for the contract. If the contractholder sells the contract for $85,000, he should recognize $20,000 in ordinary income (just as he would had he surrendered the contract for $80,000) and an additional capital gain of $5,000 from the sale. If sold for less than its cost basis, the seller realizes an ordinary loss (a contractholder might do this if the sale price is more than could be obtained by surrendering the contract after taking surrender charges into account.) By the way, if the surrender value is less than the owner's cost basis, surrender will result in an ordinary loss in the year of sale.
For contractholders who transfer an annuity for “less than full consideration” — the transfer is considered a gift, not a sale . Contractholders must treat the excess of the surrender value over the cost basis as ordinary income. If the annuity was issued after April 22, 1987, the income will be taxed in the year of the donation (if issued before that date, that income will be taxed when the donee surrenders the annuity, or otherwise receives the contract value.) The recipient (donee) of the annuity will retain the donor's original cost basis (adjusted by adding any gift tax the donor paid on the gift, plus any consideration the donee paid to the donor). This tax treatment does not apply to gifts between spouses, transfers to ex-spouses due to divorce, or a gift from a trust to its beneficiary. Obviously, gifts of annuities can be a complicated affair for tax purposes.
Transfers to Trusts
Sometimes a contractholder may wish to transfer ownership of his or her annuity to a trust. These may or may not be subject to income and gift taxes, depending on whether the trust is revocable or irrevocable, and whether the trust is a “grantor trust” or a “nongrantor trust”.
A grantor trust is one in which the grantor is a beneficiary of the trust (directly or indirectly). If the grantor or the grantor’s spouse benefits from the trust, such as receiving income payments, it is a grantor trust. If the grantor or spouse exercises control over the trust assets, it is a grantor trust. If the trust distributes income to third parties to cover obligations of the grantor, such as to pay off a debt or make child-support payments, it is a grantor trust. Generally speaking, the IRS will view grantor trusts as an extension of the grantor, not as a separate entity. This means that income from the trust will be taxable on the grantor’s tax return as though the grantor earned it. If the trust is a non-grantor trust, the IRS will tax it as a separate entity. Income earned in a nongrantor trust is subject to special tax rates (which may be more or less than the rate the grantor pays on his personal income tax return).
The IRS imposes a gift tax on “completed gifts” of a “present interest”. A present interest means that the recipient can enjoy the gift today, and a completed gift is one with no strings attached. If the donor can reclaim the gift, it is not “completed”.
This is a brief summary of very complicated tax law. Individuals who would like to transfer an annuity into a trust should obtain expert tax advice. Generally speaking, advisors should be aware that:
transfers to the individual's revocable living trust are not a taxable for income tax purposes, since the trust falls under the "grantor trust" rules (the grantor remains in control of the trust) — and the transfer is not subject to gift taxes; the grantor can revoke the trust, so the gift is not considered a "completed gift"
transfers to the individual's irrevocable grantor trust are not taxable for income tax purposes (again, due to the grantor trust rules) — but the transfer is subject to gift taxes as the gift is irrevocably completed.
transfers to an individual's irrevocable non-grantor trust will trigger possible income taxation, as described earlier, and full value of the annuity is considered a taxable gift. In addition, the non-grantor trust will not qualify as an "agent of a natural person", so the trust loses the contract's tax deferred status — the trust will have to include each year's growth as ordinary income on the trust tax return.
Sometimes an annuity owner will want to give an annuity to a charity. This usually occurs when the contract contains a large amount of tax-deferred earnings. Given the complex tax treatment of gifted annuities, it is usually better for the annuity owner to surrender the contract and donate the cash proceeds to the charity instead.