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Question: My client has a nonqualified annuity owned by his trust, and he is the current annuitant. He wants to change the annuitant to his wife. Is that an income taxable event?
Answer: It’s not easy to tell, in part because the rules are unclear, and in part because it probably depends on the way the trust is written.
A change in ownership of a nonqualified annuity contract from one spouse to another is a nontaxable transfer under Code Section 1041. In its explanation of DEFRA in 1984, Congress implied that transfers in trust for the benefit of a spouse are also covered by the Section 1041 non-taxation rules. See page 711 of the document at this link: https://www.jct.gov/publications.html?func=startdown&id=3343. Other transfers of annuity contracts are treated as taxable dispositions.
What is the purpose behind non-recognition of gain on spousal transfer, but recognition for other transfers as taxable? We think it’s because Congress doesn’t want the NQDA date of tax reckoning to be put off forever. In theory, if family members made pre-death gifts of an annuity, in the absence of the non-spouse transfer rule they’d put off recognition of taxable gain forever. Congress assumed that spouses are of the same generation—as they did with the unlimited marital deduction for estate taxes or spousal continuation for NQDA death benefits—and so carved out an exception for tax recognition for transfers between spouses.
So, if that analysis is correct, what does it mean for the fact situation?
Where a non-natural person, such as a trust, owns an annuity contract, the annuitant’s death controls when the annuity must be distributed. If you can change the annuitant without a tax result, the day of tax reckoning can be put off forever. So under normal circumstances, a change in annuitant for a trust-owned NQDA must be treated as a taxable disposition.
Does the transfer qualify for the Section 1041 spousal transfer exception. If both husband and wife are the sole beneficiaries of the trust while either is alive, then under the facts provided the Section 1041 exception probably applies. If, on the other hand, the trust is written in a different way—with family members other than the spouses being permissible or mandatory beneficiaries, for example–the change in annuitants is probably an income taxable event.
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