Annuities

<div class="Section1">For contracts issued after 1996, but only for tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="477">477</a>) that is a rider to the annuity or life insurance contract reduces the investment in the contract of the annuity or life insurance contract. This charge against the cash surrender value, however, does not cause the taxpayer to recognize gross income (because it is applied against the cost basis).<a href="#_ftn1" name="_ftnref1">¹</a> On the other hand, such charges are also not eligible for a medical expense deduction under Section&nbsp;213(a).<a href="#_ftn2" name="_ftnref2">²</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(e)(11).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 7702B(e)(2).<br /> <br /> </div></div><br />

<div class="Section1">The annuity starting date is the “first day of the first period for which an amount is received as an annuity.”<a href="#_ftn1" name="_ftnref1">¹</a> For a deferred annuity, the annuity starting date is triggered when the annuity owner elects to annuitize and begin payments; a deferred annuity contract also specifies an annuity starting date by which annuitization payments must begin, if the owner has not elected to start them prior to such date.</div><br /> <div class="Section1"><br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> The annuity starting date is important not only to determine the onset of payments themselves, but also because the exclusion ratio for taxing annuity payments under a particular contract is determined as of the annuity starting date.<br /> <br /> <hr /><br /> <br /> For an immediate annuity, the annuity starting date is generally immediate upon the purchase of the contract. For example, suppose that a person purchases an immediate annuity on July 1 providing for monthly payments beginning August 1. The annuity starting date is July 1 (the first payment is for the one month period beginning July 1). Payments under settlement options usually commence immediately rather than at the end of the month or other payment period; hence the annuity starting date is the date of the first payment.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(c)(4); Treas. Reg. § 1.72-4(b).<br /> <br /> </div>

<div class="Section1">The interest of a donee spouse in a joint and survivor annuity in which only the donor and donee spouses have a right to receive payments during the spouses’ joint lifetimes is treated as qualified terminable interest property (“QTIP”) for which the marital deduction is available unless the donor spouse irrevocably elects otherwise within the time allowed for filing a gift tax return.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 2523(f)(6).<br /> <br /> </div>

<div class="Section1">If a donor irrevocably names one person to receive the income for life and irrevocably names another to receive the refund, the value of the refund at the donee-annuitant&rsquo;s death should not be includable in the donee-annuitant&rsquo;s gross estate. IRC Section&nbsp;2039 is not applicable because the donee-annuitant is not the purchaser of the contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="620">620</a>).<div class="Section1"><br /> <br /> However, if the refund is payable to the donee or the donee&rsquo;s estate (or the donee can otherwise direct where the refund goes), it will generally be included in the donee&rsquo;s estate for estate tax purposes.<br /> <br /> </div></div><br />

<div class="Section1">A structured settlement is a settlement of a lawsuit that calls for periodic payments to be made over time, rather than as a lump sum. Structured settlements are common in tort actions (usually personal injury lawsuits) where the amount of the judgment can be particularly large.</div><br /> <div class="Section1"><br /> <br /> Structured settlements are typically employed where either the financial position of the defendant requires that payments be spread over time or the plaintiff prefers to receive steady income over time, rather than a lump sum. The defendant may also prefer a structured settlement because the present dollar value needed to fund a stream of settlement payments into the future will be smaller than that which would be required with a lump sum payment.<br /> <br /> </div>

<div class="Section1">A married couple typically purchases a Medicaid compliant annuity if the two spouses are in unequal health positions to ensure that the healthy spouse—known as the “community” spouse—has sufficient income, while allowing the second, less healthy, spouse to qualify for Medicaid assistance in paying for long-term care expenses, typically within a nursing home.</div><br /> <div class="Section1"><br /> <br /> Rather than treating the purchase of the annuity as an impermissible asset transfer effected in order to meet Medicaid’s means-tested eligibility requirements, if the requirements discussed below are satisfied, the federal Deficit Reduction Act (DRA) treats the purchase as a permissible exempt investment, and the annuity payout stream is shielded as the community spouse’s income.<br /> <br /> In order to qualify as a Medicaid compliant annuity under the DRA, the terms of the annuity contract must satisfy certain criteria. The income from the annuity contract must be payable to the community spouse, the contract must be irrevocable, and the payment term must be based on the life expectancy of the community spouse.<br /> <br /> This is because, in a situation where one spouse requires long-term care and the other remains in the community, the assets of the community spouse are counted—up to a certain level—in determining whether the institutionalized spouse qualifies for Medicaid, but the <em>income</em> of that spouse is not counted.<br /> <br /> Further, the state must be named as the remainder beneficiary on the contract, allowing it to receive up to the amount that it has paid for the institutionalized spouse’s long-term care.<br /> <br /> </div>

<div class="Section1">If a structured settlement of a personal physical injury or sickness claim is properly planned, each payment will be tax-free to the recipient.</div><br /> <div class="Section1"><br /> <br /> Usually, when the plaintiff in a personal injury lawsuit receives a settlement, the proceeds of that settlement are taken tax-free.<a href="#_ftn1" name="_ftnref1">¹</a> Despite this, if the payments are structured so that the plaintiff receives the settlement funds over time, the earnings on the settlement will be taxable to the plaintiff unless a “structured” settlement is created.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The plaintiff may prefer to receive settlement payments over time. For example, although the plaintiff can invest a lump sum payment, earnings on that investment would be fully taxable. In contrast, if a structured settlement is used, any earnings on the settlement are not taxed.<br /> <br /> Whether or not the earnings on the settlement amount will be taxed depends largely on how the parties to the lawsuit characterize the payments. For example, the Tax Court has concluded that portions of a settlement that were labeled by the parties as “interest” were taxable as ordinary income (the case did not specifically deal with structured settlements).<a href="#_ftn3" name="_ftnref3">³</a> However, in the usual case, a structured settlement will avoid this result because it will not distinguish between amounts paid to satisfy the claim and amounts paid as interest (e.g., the settlement will require the defendant to pay $150,000 per year for 10 years). As such, the entire amount of each payment will be treated as proceeds of the settlement and can be taken tax-free.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 104(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 104(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Kovacs v. Commissioner</em>, 100 TC 124 (1993).<br /> <br /> </div>

<div class="Section1">A designated settlement fund (DSF) is a fund that is established pursuant to a court order to completely extinguish a defendant’s liability with respect to a claim for personal injury, death or property damage.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> A DSF must also meet the following requirements: (1) no amounts may be transferred to it except in the form of “qualified payments,” (2) it must be administered by persons, a majority of whom are independent from the defendant transferring the claim, (3) it must be established for the purpose of resolving and satisfying claims against the defendant (or related persons) for claims arising out of personal injury, death or property damage, (4) the defendant (and related persons) may not hold any beneficial interest in the income or corpus of the fund, and (5) the defendant must make an election to treat the fund as a DSF.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A “qualified payment” is a payment made to a DSF pursuant to a court order other than payments that (1) may be transferred back to the defendant (or a related person) or (2) are transfers of stock or indebtedness of the defendant (or any related person).<a href="#_ftn3" name="_ftnref3">³</a> Once a defendant has made the election to treat a fund as a DSF, it is revocable only with the consent of the Secretary of the Treasury.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 468B.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 468B(d)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 468B(d)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 468B(d)(2).<br /> <br /> </div>

<div class="Section1">A payor who uses the cash receipts and disbursement method of accounting can deduct qualified payments made pursuant to a structured settlement in the year they are paid.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> If the payor uses the accrual method of accounting, he or she can deduct any allowable expenses in the year in which: (1) all events that prove liability have occurred, (2) the amount of the liability can be determined with reasonable accuracy and (3) the economic performance requirement has been met with respect to the liability.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In the context of a structured settlement, economic performance by the defendant will typically occur as the defendant actually makes the required payments to the plaintiff.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> For example, assume that the parties to a lawsuit enter into a structured settlement that requires the defendant to pay $150,000 per year to the plaintiff for 10 years, and the defendant immediately purchases an annuity to provide for the entire $1.5 million obligation. Economic performance occurs when each $150,000 payment is made to the plaintiff—<em>not</em> when the defendant purchases the annuity. Therefore, assuming all other requirements are met, the defendant is entitled to deduct $150,000 for each of the 10 years in which payment to the plaintiff is properly made under the structured settlement.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.461-1(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.461-1(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 461(h).<br /> <br /> </div>

<div class="Section1">If an annuity contract was purchased before August&nbsp;14, 1982 (and no additional investment was made in the contract after August&nbsp;13, 1982), the lump sum withdrawn is excludable from gross income as &ldquo;an amount not received as an annuity&rdquo; that is a return of principal received before the annuity starting date. Thus, the lump sum is subtracted from the unrecovered premium cost, and the balance is used as the investment in the contract. A new exclusion ratio ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a>) must be computed for the annuity payments.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> If the lump sum withdrawn is allocable to investment in an annuity contract made after August&nbsp;13, 1982, it would appear that there will be a taxable withdrawal of interest if the cash surrender value of the contract exceeds investment in the contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="515">515</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="523">523</a>) and a new exclusion ratio must be computed given a lower anticipated expected return due to the withdrawal of a portion of contract gains (paired with the existing investment in the contract that remains).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.72-11(e).<br /> <br /> </div></div><br />