During the run-up to the Republican Presidential Primary in Iowa last year, Mitt Romney famously said, “Corporations are people, my friend.”
Whether or not that was taken out of context, the truth is that the law treats natural persons and unnatural persons differently. And this is never more clear than in looking at how annuity contract ownership is treated by the US Treasury and the IRS. And the difference between a natural person and an unnatural person is the difference between getting paid as you expected and a horror show for yourself or your heirs.
What do I mean? Why does this matter? Well, the devil’s in the details and annuity contracts are notoriously complex. Most consumers don’t read or understand everything within them. I dare say that most financial advisors don’t read or understand them either. (Heck, one clear difference between corporations and people: Corporations have a boatload of lawyers who drafted these contracts and most people don’t have the same deep pockets to hire their own boatload to interpret them).
For the unwary there are many traps with unexpected and unintended surprises. Those consumers or advisors who may not understand the implications of the ownership of an annuity can end up in their own personal financial nightmare.
As they say, you can’t tell the players without a scorecard so it’s a good idea to get a lay of the land here before diving into the legal and tax issues involved.
Basically, an annuity is a tool. It may be used to provide a future lump sum, a guaranteed income, a legacy or some combination. The players include the insurer that issues the contract (hey, a corporation!), the owner (usually a natural person), the annuitant (who receives the income) and the beneficiary (who gets the remainder).
Mistakes in Structuring Annuity Contracts
Usually, the owner and the annuitant are the same and the beneficiary is a spouse. This keeps things simple. But sometimes, folks may make the annuitant and owner different people. Sometimes they even name a trust as an owner, annuitant or beneficiary.
When the owner of an annuity is a trust, don’t expect the same rules to apply as if it were a real person. Under Section 72(u)(1) of the Internal Revenue Code, any annuity contract that is “held by a person who is not a natural person (such as a corporation) … is not treated as an annuity contract for Federal income tax purposes and the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the owner of the contract during the taxable year.” (IRS Public Letter Ruling 199905015)
There are several advantages of annuities. Tax deferral is certainly one of them. Another is the treatment of part of the annuity payment as a return of principal which is not subject to income tax.
For those who remember the famous catchphrase from Monty Python’s Flying Circus, you’ll recall how this transitioned viewers from one funny sketch to another. In our context here, the transition doesn’t produce the same humorous result.
By replacing a natural person with a trust in the capacity of owner of a contract, the law suggests there will be a completely different outcome. In this case, the annuity contract no longer exists. Voila! Presto Change-o! Through the magic of legalese – and a little help from the IRS – the careful planning of an unsuspecting consumer is undone.
Since there is no annuity any longer, the income or accrued income now becomes completely taxable. This can have all sorts of consequences – on total Adjusted Gross Income, taxable income, and maybe the taxation of Social Security benefits, too. Now that’s got to hurt.
Sure, there may be remedies in Tax Court or by appealing to the IRS for a Private Letter Ruling, but all that adds uncertainty and costs to a consumer’s financial and estate plan.
Don’t try to be “too cute by half” in setting up an estate plan to avoid taxes. Read the fine print and bring in an expert — preferably a professional who deals with annuity contracts regularly (not necessarily a lawyer) — to evaluate the deal.
Corporations may be people (though I really doubt it) but they sure don’t play by the same rules – certainly not when it comes to annuities and taxes.