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Annuity Contract Cashed Out in Irrevocable Trust


artp

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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.

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Catherine,

Clarification--Assuming corpus distributions are allowed, are you saying that we could handle a future annuity transaction as I indicated above? For now, aren't we stuck with the result I outlined above for the transaction already completed? There is no way to unwind what they are already done? The other thing I saw on the instructions for the 1041 is that withholding taxes on the annuity could not be passed thru to the beneficiary.  Have you run across this ?

 

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Only backup withholding can be passed through, so no break there.  If the trust did not distribute the income from the annuity in 2018, it is responsible for the taxes anyway.  Corpus is not relevant here, since the trust had $55k in income that it apparently did not distribute.  In the future, it should distribute the income before Dec 31 so the beneficiaries are taxed on it, presumably at a lower rate.  It should also specify no withholding.

If this is an irrevocable trust, I don't see how an annuity can be pulled out and given back to the grantor.  Best to read the trust document.

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It may not apply here but another option is to do this: Trustee makes a regular practice of distributing capital gains: pursuant to Reg. 1.643(a)(b), trustee is  making a regular practice of distributing capital gains to the beneficiary as the trust instrument permits.

The drafter of several trusts for which I've recently been trustee included this language which allowed the benes to have the cash to pay the tax on the distributed net income. I thought for these trusts and these benes, it was a good idea.  And that 65 day rule proved very helpful as determining the distribution correctly was a challenge to manage by Dec. 31.

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I just talked to clients lawyer - sold land in irrevocable trust and the check is in that name - he needs to get a bank account under his soc sec!  to cash it but since he is still alive - he then can take that money and buy and sell or take it out etc to do what he wants with it.. ???

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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? The past practice has been to do so, 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. These are good people but need to get this situation straightened out.

 

 

Any advice will be most appreciated. 

 

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