Annuity Contract Cashed Out in Irrevocable Trust

[Art]

Client transferred an insurance annuity contract to his irrevocable trust many years ago. He originally purchased the annuity for lump sum payment of $40,000. In May 2018 the accumulation phase of the contract ended, and he and the trust administrator made the election to take out the value ($95,000) as a single payment with $15,000 of federal tax withheld. Since this asset was held in the trust, it appears the entire gain of $55,000 must be taxed to the trust at trust income tax rates and the $15,000 withholding applied to the trust tax. Client was wanting to have the “income” passed thru to him to be paid on his personal return and take the $15,000 tax payment against that income. The trustee stated that the proceeds were reinvested in an existing trustee brokerage account. I am not a trust expert, but I do not see any way to avoid paying the higher tax at the trust level. Comments?

Question: If they had not cashed out the annuity while it was in the trust, could they have pulled it back out of the trust to the taxpayer and then had him cash it out personally to get the tax result he was looking for?

I am concerned that there may be another annuity in the trust and we could be back in the same boat again.

[Burke]

IMO, you are correct. If contract ownership had been transferred to the TP before it was cashed in, it might have been treated as a distribution from the trust and calculated in DNI. If the trust cashed it in, and worse than that, reinvested the proceeds in another trust-owned account, I don't see any way the trust can get out of paying the tax. You say that there was $15K withheld at the source? Then the 1099R should show the distribution and taxes paid under the trust EIN. Does it? It will not qualify as a capital gain, but ordinary income. As to whether this would work with another annuity inside the trust may depend on the trust agreement. You need to review a copy of it. Also review the annuity contract about change of ownership. This is a contract between the owner (trust) and the insurance company.

[Art]

Yes the 1099-R is in the name of the trust and $15,000 in fed withholding. I looked further into the whole situation and..

Did some digging into the trust document and got copies of the last 3 years of trust returns and the income beneficiary’s returns.

1. The only governing provision states “ The Trustee shall distribute so much of the net income of the trust as the trustee believes desirable for the support, comfort, companionship, enjoyment, and medical care of both of us or for any other purpose the Trustee considers to be for our best interest, adding to principal any net income not applied for such purposes. Except as provided otherwise herein, the Trustee shall have no authority to use any portion of the principal of the trust for the benefit of either of us.”

2. Looking at the prior returns virtually all of the ordinary dividends, interest, capital gain dividends and capital gains were allocated to the beneficiaries and included on the K-1’s for each year. They included the full amount on their individual tax returns. The Trustee only distributed cash out to the income beneficiaries as they requested for their needs, but not the full amount of DNI deduction as shown on the returns.

The beneficiaries (Trustee’s elderly parents) live very frugally, did not really need or want the full cash distributions, and paid no tax on the capital gain income and relatively little tax on the dividend and interest income based on their tax bracket. Looking at the returns I saw, most years the capital gains were under $15,000 and the regular dividends and interest about $10,000. Trustee stated that both the income beneficiaries (parents) and the residual beneficiaries (children) were completely in agreement with this. I confirmed this with a discussion with the parents.

I am at a loss as to what to do about the prior year’s returns, if anything. Going forward can the trust document be amended to allow capital gains to be distributed to the income beneficiaries? This is an irrevocable trust set up in IL. The past practice has been to do pass the capital gain to the beneficiaries, though not correctly. Then, actually pay the cash out in full and on time. I understand their tax motive to save taxes by paying at the lower effective rate on the individual return, but I have a real mess here. I do not know of any trust provision that will allow a full DNI deduction, unless a corresponding distribution is made and only in cash (not property) as far as I know. If someone knows different I would certainly be interested to know how. These are good people but need to get this situation straightened out.


Any advice will be most appreciated.

[Burke]

Yes the 1099-R is in the name of the trust and $15,000 in fed withholding.
The Trustee only distributed cash out to the income beneficiaries as they requested for their needs, but not the full amount of DNI deduction as shown on the returns.
I do not know of any trust provision that will allow a full DNI deduction, unless a corresponding distribution is made and only in cash (not property) as far as I know. If someone knows different I would certainly be interested to know how. Any advice will be most appreciated.

If you look at the DNI calculation on Page 2, it has two lines for distributions. Line 9 is the amount required to be paid currently by the trust document. This usually means trust document says "$1,000 per month to xxxxx" or "all of the net income annually" or something to that effect. The next line is for amounts actually paid, distributed, credited, etc. I do not know how the return can show anything on Line 9 if the only provision for distributions is as you quote above. The trustee has discretion on how much of the annual income to pay out for the reasons stated, which pretty much covers most anything if it is for their benefit. But based on that provision, the way I am reading it, he/she has no right to invade the principal. If all of the annual income is not distributed, then any excess is added back to the corpus.

Line 10 is for the actual monies paid to them during the year. So you are correct, IMO, that a return does not allow a full DNI deduction unless a corresponding distribution is made that equals the taxable income. Also, most courts have been pretty liberal in recent years, allowing capital gains to be allocated to the beneficiary(ies) when distributions exceed the ordinary income earned, as long as the trust document does not specifically prohibit this. But in your case it appears the DNI figures on Lines 9 and/or 10 do not agree with the actual amounts distributed. I know of no way income can be used to calculate DNI unless it is actually distributed. Not sure I understand "past practice has been to pass the capital gain to the beneficiaries, though not correctly. Then, actually pay the cash out in full and on time." What is paid out in full?

[Art]

Burke,

Sorry about my wording regarding "past practice". I only meant that in prior years 100% of the capital gain dividends and capital gains from the investments was included in the K-1's to the beneficiaries and taxed to them on their personal return. For the future I was asking if there was a way to amend the trust document to clearly allow this treatment again if the trustee actually made the distributions as cash payments. I am not aware that any other form of payment ie stock, bond or property would qualify.

[Burke]

You do not have to alter the terms of the trust to distribute capital gains to a beneficiary, assuming this practice is not specifically addressed within the trust document itself. This is not an IRS rule, but a Financial Accounting practice. Courts have recognized that this practice requires the trust to pay much higher tax rates and therefore depletes the monies available to heirs, as opposed to allowing them to pass through to the beneficiaries. There are a number of articles you can research on Google. I will send you a PM as the one I wished to post will not link. To alter any terms of an irrevocable trust would be difficult and involve the courts, IMO, as well as all the beneficiaries' consent. Is this a grantor trust?

[Art]

You do not have to alter the terms of the trust to distribute capital gains to a beneficiary, assuming this practice is not specifically addressed within the trust document itself. This is not an IRS rule, but a Financial Accounting practice. Courts have recognized that this practice requires the trust to pay much higher tax rates and therefore depletes the monies available to heirs, as opposed to allowing them to pass through to the beneficiaries. There are a number of articles you can research on Google. I will send you a PM as the one I wished to post will not link. To alter any terms of an irrevocable trust would be difficult and involve the courts, IMO, as well as all the beneficiaries' consent. Is this a grantor trust?

The document states that this is is an irrevocable trust. Based on the wording I quoted earlier, I am concerned that the trustee does not have the discretion to pass capital gains thru, although he has done so based on past history. sorry, I am not familiar with sending/receiving PMs. What do I need to do?

[Lion]

Click on the person's name and then click on Private Message. Or click on the cartoon balloon next to the name, and a texting pop-up will let you carry on a conversation if the person is online and available.

[Burke]

I am not familiar with sending/receiving PMs. What do I need to do?

Go to the very top of this page -- (above the TaxBook Logo) -- where you will see a toolbar with two boxes, "Notifications" and "Messages." Click on Notifications and you will enter the Private Message feature. My post will be there. If you can't see it, click on Inbox on the left.