Revocable Living Trusts have become a very common estate planning technique. A Trust can replace a Will because it outlines how your assets are to be distributed. But a Trust can also protect your assets while you’re living and provide a process of caring for you if you become incapacitated—which a Will can’t do. Unlike a Will, Trusts don’t have to go through a probate process and involve the courts, which can become very expensive.
Avoiding court management of a person’s financial affairs can save money, time and administrative complexity. Courts are becoming more congested and the fees for using the courts are going up as well. In North Carolina, for example, court fees for probate can be as much as $6,000 and does not include the accounting work to complete probate. The story is the same in many other states. Revocable Living Trusts don’t become incapacitated or die, so they don’t require court services to manage or transfer assets. But, Andy Strauss of Strauss Attorneys PLLC says there’s a catch.
According to Strauss, a Revocable Living Trust is only effective if it owns the assets of the Trust maker(s) or if the Trust becomes the owner through a beneficiary designation, like naming the Trust as beneficiary of a life insurance policy, IRA or 401(k) account. Your Will can also make the Trust the residuary beneficiary of your assets, but Wills have to go through probate, which involves the courts and incurs fees, etc., which circumvents the reason you used a Trust to begin with. Avoiding probate is accomplished by proper titling of assets and proper beneficiaries on insurance policies, retirement accounts, annuities or anything with named beneficiaries. Strauss says to “think of a Revocable Living Trust as a finely tuned and crafted automobile, and the funding (or titling) process as filling up the gas tank so it runs efficiently.”
One asset that has always been a source of funding confusion is the non-qualified annuity (“NQA”). Despite a specific Internal Revenue Code section (§ 72(u)), many insurance companies and insurance professionals have advised against making the trust the owner and/or beneficiary of a NQA for fear of losing its tax-deferred income tax feature. These professionals question whether the Revocable Living Trust is a “natural person” because it comes within the exception of Internal Revenue Code § 72(u)(1) allowing a Revocable Living Trust or other entity to hold the annuity as an agent for a natural person without running afoul of the loss of deferral. IRS Code § 72(q) also imposes a 10% additional tax on early distributions from the annuity. The 10% tax is applied if a distribution from the annuity is made on or after the taxpayer attains age 59 ½, but with exceptions for a disabled taxpayer, or if the distribution is part of a series of substantially equal periodic payments made for the life of the taxpayer or the taxpayer and his or her designated beneficiary.
A 2020 IRS Private Letter Ruling (PLR 202031008, July 31, 2020 ) issued a taxpayer favorable ruling. The IRS interprets the § 72(u) exception to the rule to apply to a trust for a natural person (without regard to the “as an agent” language since that language only applies to entities other than trusts). Since the grantor is treated as owning the trust assets, it is treated as the owner of the NQA. The grantor trust is holding the NQA contract (as holder) for the grantor, who is a natural person. Thus, income tax deferral is allowed. The PLR also ruled favorably on the 10% early distribution issue, reasoning that since the grantor is treated as owner of the trust under the grantor trust rules, it is the “taxpayer” for purposes of the foregoing age, disability, and equal periodic payment exceptions to the 10% addition to tax rules under Code § 72(q).
While IRS Private Letter Rulings can only be relied on by the taxpayer that requested the Ruling, it is nevertheless an indication of how the IRS would likely address a NQA under a similar fact pattern. The reason that a Trust maker of a Revocable Living Trust might want to make a NQA owned by the trust is that if the Trust maker becomes incapacitated, then the successor incapacity trustees under the Revocable Living Trust could then manage the NQA without use of a financial power of attorney. After the Trust maker’s death, if the Revocable Living Trust is the beneficiary of the NQA, then the provisions in the trust on who benefits from the annuity and the terms and conditions (including money management, marital and creditor protections) will apply to the NQA. PLR 202031008 is taxpayer favorable, and should be considered when funding the Revocable Living Trust.
This information is intended as information only and should in no way be considered legal advice.