Payments under a nonexempt trust are also generally taxed under the same rules relating to annuities, except that distributions of trust income before the annuity starting date are subject to inclusion in income under the generally applicable “interest first” rule without regard to the “cost recovery” rule retained (for certain cases) by IRC Section 72(e)(5) ( Q 527, Q 515).3 Furthermore, a distribution from the trust before the “annuity starting date” for the periodic payments will be treated as distributed in the following order:
(1) Income earned on employee contributions made after August 1, 1969(2) Other amounts attributable to employee contributions
(3) Amounts attributable to employer contributions (made after August 1, 1969 and not previously includable in employee’s gross income)
(4) Amounts attributable to employer contributions made on or before August 1, 1969
(5) The remaining interest in the trust attributable to employer contributions4
The IRS has privately questioned whether the annuity rules of IRC Section 72 are applicable to distributions to highly compensated employees from an employer-funded nonexempt trust under a plan that fails the minimum participation or the minimum coverage tests applicable to qualified plans ( Q 3841, Q 3842); the taxation of such distributions is unclear ( Q 3534).5 In fact, according to the IRS website, the tax treatment of an employee who has participated in a failed qualified plan is as follows:
General Rule – Employees Include Contributions in Gross Income
Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions.