Non-Natural Person Rule

Halvor, an individual, owns a nonqualified deferred annuity that grew by 9,000 dollars during the calendar year. He took no withdrawals and did not annuitize. What must he report on his federal income tax return for that year with respect to the annuity?

1. A.Nothing this year, but the 9,000 dollars will later be taxed as long-term capital gain when withdrawnThe deferral half is right and the character half is wrong. Annuity earnings come out as ordinary income.
2. B.Nothing, because the growth inside a deferred annuity owned by an individual is not currently taxableCorrect. Inside build-up is tax deferred; nothing is reported until a distribution occurs.
3. C.The 9,000 dollars as long-term capital gain in the year earnedAnnuity earnings are never capital gain, and there is nothing to report this year in any case.
4. D.The 9,000 dollars as ordinary income in the year earnedCurrent taxation of inside build-up applies to non-natural owners. Halvor is an individual, so deferral applies.

Why: The defining tax feature of a deferred annuity owned by an individual is that the inside build-up is not currently taxable. Halvor reports nothing for a year in which he takes nothing out, regardless of how much the contract earned. Taxation is deferred until money actually comes out, at which point earnings are ordinary income. That deferral is the reason annuities are marketed for retirement accumulation, and it is also the reason Congress restricted it when the owner is a non-natural person.

Two nonqualified deferred annuities are titled in the name of a trust rather than an individual. Trust A is an irrevocable trust whose sole beneficiary is Perrine, a living individual, and the trustee holds the contract purely for her benefit. Trust B is a trust established by a corporation whose beneficiaries are the corporation and its shareholders. Which contract keeps tax deferred treatment of the inside build-up?

1. A.Trust A only, because a non-natural owner holding as agent for a natural person is excepted from the current-taxation ruleCorrect. The agent-for-a-natural-person exception preserves deferral for Trust A; Trust B beneficiaries include an entity, so deferral is lost.
2. B.Neither, because any annuity titled in a trust loses tax deferral without exceptionThat overstates the rule. A trust holding purely for a living individual retains deferral under the agent exception.
3. C.Both, because the non-natural person rule applies only to annuities owned directly by a corporationThe rule reaches trusts, partnerships and other entities, not only corporations. The exception turns on who benefits, not on the form of the owner.
4. D.Trust B only, because a corporate sponsored trust is treated as a business owner entitled to deferralThere is no such rule. Entity ownership is exactly what the non-natural person rule is aimed at.

Why: A deferred annuity owned by a NON-NATURAL person generally loses tax deferral: the annual increase in value is currently taxable to the owner. But the rule contains a specific carve out. If the non-natural owner holds the contract as an AGENT for a natural person, deferral is preserved. A trust holding an annuity solely for the benefit of a living individual fits that exception, so Trust A keeps deferral. Trust B, whose beneficiaries include a corporation, is not holding as agent for a natural person, so the inside build-up is currently taxable. The same principle explains why a corporation owning a deferred annuity directly loses deferral while an individual does not.