A recent case before the IRS (PLR 200803002) exposes some problems with not reviewing the beneficiary designations of annuities in relation to your overall estate plan.

In this case a decedent had purchased a non-qualified annuity during his life and named his trust as the beneficiary. During his lifetime, the annuity increased in value. At the time of his passing, the decedent had not received any distributions from the annuity, nor had the annuity reached its starting date.

The normal rule regarding the taxation of gain in a deferred annuity is that if the owner/annuitant dies before the annuity has reached its starting date and the beneficiary receives a lump sum death benefit, then the amount above the decedent’s investment is taxable income to the beneficiary and is called Income in Respect of a Decedent. For example, assume the decedent had purchased an annuity for $100,000 and named his daughter as the beneficiary. Upon the decedent’s passing, the annuity is worth $175,000, and the daughter received $175,000 as a lump sum death benefit. The daughter must report the $75,000 ($175,000 value at decedent’s passing less the $100,000 decedent’s investment) in her gross income.

In the case at hand, the terms of the decedent’s living trust provided that a portion of the trust assets were to be distributed to a charity. Since the decedent had named his trust as the beneficiary of the annuity, upon the decedent’s passing the successor trustees of the decedent’s trust attempted to minimize income taxes by assigning the annuity to the charity.

The question before the IRS was whether the trust should have included the gain as income or whether the charity would be able to include the gain in its income. It is in the trust’s benefit to have the income from the annuity considered as the charity’s income because qualified charities do not pay income taxes. The trustees did not include the gain from the annuity on the trust’s income tax return.

After some time and expense, the IRS ruled that the charity would be able to include the income from the annuity on the charity’s income tax return. This was the best result for both the trust and the charity.

While this decision was favorable for the successor trustees, the expense and problems could have been easily resolved by the decedent. The decedent knew that he had named a charity in his living trust. Instead of naming the trust as the beneficiary of the annuity, the decedent should have named the charity as the beneficiary of the annuity. By naming the charity, the entire proceeds of the annuity would have easily passed to the charity free from income tax. Had the decedent reviewed his beneficiary designation on the annuity, the successor trustees would not have had to deal with this issue before the IRS.

You might recall from the article in my Winter 2007 newsletter, “Confusion with Beneficiary Designations on IRA’s and Annuities”, I discussed the various issues that I have seen regarding beneficiary designations. This case illustrates the problems that can ensue when the wrong beneficiary designation is made on an annuity.