IRC 72(u): Entity-Owned Annuities, Exceptions, and Reporting

When a corporation, partnership, LLC, trust, or other entity owns a deferred annuity, Internal Revenue Code Section 72(u) generally strips the contract of its tax-deferred status and forces the owner to report the annual increase in contract value as ordinary income, even if nothing is withdrawn. An IRC 72(u) entity-owned annuity is still a valid insurance contract, but for federal income tax purposes it is no longer treated as an annuity. Five statutory exceptions preserve deferral, and a separate rule for trusts holding the contract for a natural person can also keep ordinary annuity tax treatment intact.

What the Rule Does to the Contract

Section 72(u) does two things at once when an annuity is held by a “person who is not a natural person.” The contract loses its classification as an annuity under Subtitle A of the Code, and the annual increase in its value is treated as ordinary income received by the owner that year.¹ The reclassification is the piece people overlook. Because the contract is no longer an annuity for income tax purposes, the usual favorable rules do not attach.

A non-natural person is any entity holding the contract in its own right: a C corporation, S corporation, partnership, LLC, or trust. A natural person is a human being. When an individual owns an annuity, the inside build-up compounds tax-free until withdrawals begin. When an entity owns one and no exception applies, that deferral is gone.

The income recognized each year is ordinary income. A corporation reports it on Form 1120. A partnership reports it on Form 1065, and it flows to each partner’s Schedule K-1. Leaving the money inside the contract does not postpone the tax, which is exactly what Congress intended when it enacted 72(u) in 1986 to shut down the use of deferred annuities as entity-level tax shelters.

Exceptions That Preserve Tax Deferral

Five categories of entity-owned contracts escape the annual inclusion rule.¹

An annuity acquired by the estate of a decedent because the owner died. This prevents an immediate income hit during estate administration.
Annuities held inside a qualified retirement plan under Section 401(a), a 403(a) plan, a 403(b) program, or an IRA. Those arrangements have their own distribution rules.
Annuities that qualify as funding assets for a structured settlement under Section 130(d), typically used to fund tax-free periodic payments in personal injury cases.²
Annuities an employer purchases upon terminating a qualified plan and holds until all amounts are distributed to the employee or beneficiary.
Immediate annuities that meet all three statutory requirements: a single premium, an annuity starting date within one year of purchase, and substantially equal periodic payments made at least annually throughout the annuity period.

The immediate-annuity exception trips up more entity owners than any other. All three prongs must be satisfied. An annuity funded with multiple premiums over time fails the single-premium requirement even if payments begin promptly, and a contract that defers the first payment past the one-year mark is out regardless of how it is otherwise structured.

Trusts Holding Annuities for a Natural Person

The statute carves out a separate rule for trusts: “holding by a trust or other entity as an agent for a natural person shall not be taken into account.”¹ If the trust holds the annuity for an individual rather than in its own interest, 72(u) does not strip the contract of its annuity status.

In Private Letter Ruling 202031008, the IRS drew an important distinction. A trustee owes fiduciary duties that differ fundamentally from those of an agent, so the “agent” language in the statute applies to “other entity,” not to “trust.” For trusts, the question is whether the trust holds the contract for a natural person, not whether the trustee is technically acting as an agent.³

Grantor Trusts

A grantor trust is the clearest path to preserving deferral. Because the grantor is treated as the owner of the trust’s assets under the grantor trust rules, the IRS concluded that the grantor trust is holding the contract for the grantor, who is a natural person. Section 72(u) does not apply. The 2020 ruling reached that result even though one of the trust beneficiaries was a charitable organization rather than a natural person.³

Non-Grantor Trusts

Non-grantor trusts are harder. Legislative history from 1986 supports treating the contract as held by a natural person when the nominal owner is an entity but the beneficial owner is an individual.⁴ When a non-grantor trust names multiple beneficiaries, or when the trust itself holds the beneficial interest rather than acting as a conduit, the exception is uncertain. The safer structure identifies one or more natural persons as the beneficial owners and gives the trust no independent interest in the contract’s value. An irrevocable trust that accumulates annuity income for eventual distribution to a class of unnamed beneficiaries is a weak candidate.

Calculating the Annual Income Inclusion

The annual income an entity must recognize equals the contract’s growth for the year, which the statute calls “income on the contract.”¹ The calculation:

Start with the net surrender value at the end of the taxable year. Add all distributions received during the current year and any prior year. From that total, subtract two items: the net premiums paid for the current year and all prior years, and any amounts already included in gross income under 72(u) in prior years. Net premiums means total premiums paid minus any policyholder dividends received.

An example. An LLC buys a deferred annuity for $100,000. By the end of Year 1, the net surrender value is $105,000 and no distributions have been taken. Income on the contract is $5,000, which the LLC reports as ordinary income.

In Year 2, the net surrender value is $112,000. The subtraction side now includes the $100,000 premium plus the $5,000 already included in Year 1, totaling $105,000. The Year 2 inclusion is $7,000. Each year only the new growth is taxed, because the formula credits prior inclusions against the current value.

One anti-abuse point: the Secretary of the Treasury has authority to substitute the contract’s fair market value for its net surrender value when necessary to prevent avoidance. That rule targets contracts deliberately structured to suppress surrender value while economic value compounds.

How Later Distributions Are Taxed

Because 72(u) taxes the entity on growth as it accrues, those already-taxed amounts increase the owner’s investment in the contract. Total basis equals the original net premiums plus everything previously included under 72(u). When distributions eventually occur, the entity does not pay tax a second time on amounts already reported.

This flips the result that an individual annuity owner would see. For an individual holding a non-qualified annuity, distributions come out earnings-first: every dollar withdrawn is taxable until all gain has been distributed, and only then does basis return tax-free. For an entity subject to 72(u), the growth has already been taxed, so distributions recover the inflated basis first. Only amounts exceeding total adjusted basis produce additional taxable income.

Take an entity that paid $100,000 in premiums and recognized $50,000 of income under 72(u) over five years. Its basis is $150,000. A $60,000 withdrawal is entirely tax-free as a return of basis, leaving $90,000 of basis remaining. An individual making the same withdrawal from an identical contract would owe tax on the first $50,000.

Recordkeeping matters. The entity must track each year’s inclusion to substantiate the basis it claims when distributions are made. Without those records, there is no way to prove how much of a distribution should come out tax-free.

Transferring an Existing Annuity to an Entity

Moving an annuity from an individual to a corporation, partnership, or trust is itself a taxable event. Under Section 72(e)(4)(C), transferring an annuity contract without full and adequate consideration triggers income to the transferor equal to the excess of the cash surrender value over the investment in the contract at the time of transfer.¹ The only carve-out is a transfer between spouses or incident to divorce under Section 1041.

After the transfer, the receiving entity gets a basis equal to the prior owner’s basis plus any gain the transferor recognized. From that point forward, 72(u) applies to any future growth. The combination of gain recognition on the transfer and loss of future deferral makes contributing an annuity to an entity an expensive step. If the transferor is under age 59½, the 10% early distribution penalty under Section 72(q) may also apply to the gain triggered on transfer.

Penalties for Failing to Report the Annual Income

An entity that owns an annuity subject to 72(u) and does not report the annual inclusion risks accuracy-related penalties. The IRS imposes a 20% penalty on an underpayment attributable to negligence or a substantial understatement of income tax.⁵ For corporations other than S corporations, a substantial understatement exists if the understatement exceeds the lesser of 10% of the correct tax (or $10,000, whichever is greater) or $10,000,000.

The most common compliance mistake is failing to recognize that 72(u) applies at all. The entity buys a deferred annuity, the insurance company issues no 1099 because no distribution was made, and the preparer never picks up the annual growth as reportable income. Years of unreported income accumulate, and the correction often arrives as an IRS notice with penalties and interest. If an entity holds an annuity, the preparer needs to know that the annual increase in surrender value is taxable regardless of whether any cash changed hands.

Decisions Before Placing an Annuity in an Entity

Before putting an annuity inside an entity, run the math honestly. The main reason to own an annuity rather than a comparable taxable investment is tax-deferred compounding. If 72(u) eliminates the deferral, what remains is an insurance product carrying mortality and expense charges that a brokerage account would not. Unless a statutory exception applies, the entity pays tax on growth every year while still bearing those internal costs.

Trusts need the most care. A revocable grantor trust generally preserves deferral because the grantor is treated as the owner for income tax purposes. An irrevocable grantor trust can work too, as PLR 202031008 confirmed. But a grantor trust can convert to a non-grantor trust automatically, often at the grantor’s death, and that conversion may bring 72(u) into play from that point forward. Annuity ownership and trust design should be coordinated, not sequenced.

For entities that already own annuities subject to 72(u) and have not been reporting the annual income, the problem does not resolve by surrendering the contract. The better course is to correct the prior returns, report the accumulated income, and decide whether the annuity should be surrendered or transferred to a natural person going forward. Correction almost always costs less than audit.

1
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Joint Committee on Taxation. Tax Treatment of Structured Settlement Arrangements
3
Internal Revenue Service. Private Letter Ruling 202031008
4
Internal Revenue Service. Private Letter Ruling 199905015
5
Internal Revenue Service. Accuracy-Related Penalty