Trust-Owned Annuity Rules: IRC 72(u), NIIT, and 1035 Exchanges

An annuity owned by a trust loses its tax deferral by default. Under Internal Revenue Code Section 72(u), a contract held by a “non-natural person” is no longer treated as an annuity for federal income tax purposes, and its annual earnings become taxable as ordinary income each year. Trust owned annuity tax rules turn on a single exception: if the trust holds the contract for the benefit of natural persons, the IRS looks through the trust and deferral survives. Everything else, from which type of trust you use to how the contract is titled to what happens when someone dies, flows from that one test.¹

The Default Rule and the Natural-Person Exception

Section 72(u)(1) says that if a non-natural person holds an annuity, the contract is not treated as an annuity, and the income on the contract is taxed to the owner each year. A trust is a non-natural person. The flush language of the same subsection carves out the exception that saves most trust-owned contracts: “holding by a trust or other entity as an agent for a natural person shall not be taken into account.”¹

In Private Letter Ruling 202031008, the IRS treated the “agent” language as applying to “other entity” and applied a broader “held for a natural person” standard to trusts. So the practical test is whether the contract is held for the benefit of living human beings. If yes, deferral continues. If any interest in the trust runs to an entity, the exception can fail.²

Revocable (Grantor) Trusts

A revocable living trust is the easiest structure. Because the grantor can revoke or amend the trust, the IRS treats the grantor as the owner of trust assets for income tax purposes. The grantor is a natural person, the trust is holding the annuity for that person, and deferral is preserved. Annuity income is reported on the grantor’s personal return rather than on a separate trust return.²

The trade-off is that a revocable trust does nothing for estate tax during the grantor’s lifetime. The assets remain in the taxable estate. If the goal is probate avoidance, this is fine. If the goal is estate tax reduction or creditor protection, a revocable trust doesn’t get you there.

Irrevocable (Non-Grantor) Trusts

An irrevocable non-grantor trust is a separate taxpayer. It files Form 1041 and pays its own taxes. It can reduce the taxable estate and provide asset protection, but it faces the harder version of the 72(u) test.

For a non-grantor trust to preserve annuity deferral, every beneficiary must be a natural person. That includes current income beneficiaries and remainder beneficiaries. In PLR 199933033, the IRS blessed a trust-held annuity where all beneficiaries were natural persons and no circumstances allowed distribution to a non-natural entity.³

This is where estate planning trusts get into trouble. A charity, a foundation, or another trust named as even a contingent remainder beneficiary can disqualify the annuity from the exception. The favorable rulings have consistently relied on representations that no non-natural person could ever receive a distribution. One sentence in the trust document can cost every dollar of deferral.³

Moving an Existing Annuity Into a Trust

Retitling an annuity you already own is not automatically tax-free. Under Section 72(e)(4)(C), a transfer of an annuity without full and adequate consideration is treated as a taxable distribution. The transferor recognizes ordinary income equal to the contract’s cash surrender value minus its cost basis at the time of transfer.¹

Transferring to your own revocable grantor trust generally does not trigger this rule, because the grantor and the grantor trust are the same taxpayer to the IRS. Transferring to an irrevocable non-grantor trust is a transfer to a separate legal entity, and the accumulated gain is likely to be taxed immediately. The only statutory exception in Section 72(e)(4)(C)(ii) is for transfers between spouses or incident to divorce under Section 1041(a). There is no parallel exception for transfers to irrevocable trusts.¹

If you want an irrevocable trust to own an annuity, it is usually far better to have the trust buy a new contract with trust funds than to transfer an existing contract with built-up gains.

What Happens When the Annuitant Dies

Section 72(s) requires every non-qualified annuity to include post-death distribution provisions. When the holder is not an individual, the statute substitutes the “primary annuitant,” the natural person whose life events primarily control payouts. Death of the primary annuitant triggers the same post-death rules that would apply if an individual holder had died.¹

The Five-Year Rule

If the primary annuitant dies before the annuity starting date, the default rule is that the remaining interest must be distributed within five years. If death occurs after annuitization has begun, remaining payments must continue at least as rapidly as the method already in use.¹

No Life-Expectancy Stretch for the Trust Itself

Section 72(s)(2) allows an alternative to the five-year liquidation: if a portion of the interest is payable to a designated beneficiary and distributions over that beneficiary’s life or life expectancy begin within one year of death, that portion is treated as already distributed. But Section 72(s)(4) defines a designated beneficiary as an individual. A trust does not qualify.¹

When the trust is both the owner and the named beneficiary on the contract, the life expectancy option is unavailable, and the five-year rule applies. Naming a natural person directly on the contract can preserve the stretch, but that designation can conflict with the trust’s own distribution provisions and needs to be coordinated with counsel.

Changing the Annuitant Is a Deemed Death

Section 72(s)(7) treats a change in the primary annuitant on a non-individual-owned contract as if the holder had died. Swapping the annuitant on a trust-owned contract triggers the post-death distribution rules immediately, potentially forcing the five-year liquidation even though nobody has actually died. This is not an administrative adjustment; it is a taxable event.¹

No Spousal Continuation

Section 72(s)(3) allows a surviving spouse of an individual owner to step in as the new holder and continue the contract without forced distributions. That option is generally unavailable when a trust owns the annuity. Even if the surviving spouse is the sole trust beneficiary, the trust is the holder, not the spouse, and the distribution rules apply.

Trust Tax Rates and the 3.8% NIIT

Any annuity income actually taxed at the trust level runs into the compressed trust brackets. For 2026, trusts and estates hit the top federal rate at very low income:⁴

10% on taxable income up to $3,300
24% from $3,300 to $11,700
35% from $11,700 to $16,000
37% above $16,000

An individual doesn’t reach 37% until well over $600,000 of taxable income. A trust reaches it at $16,000.

Trusts also pay the 3.8% Net Investment Income Tax on the lesser of undistributed net investment income or the amount by which adjusted gross income exceeds the top-bracket threshold, which is also $16,000 for 2026. Annuity income counts as net investment income. A non-grantor trust with $30,000 of annuity earnings that distributes nothing could face 37% income tax plus 3.8% NIIT on the amount above the threshold, a combined federal rate of 40.8%.⁵

Because of these rates, trustees of non-grantor trusts typically distribute income to beneficiaries so it is taxed at their personal rates. The trust takes a corresponding deduction and reports each beneficiary’s share on Schedule K-1 of Form 1041.⁶

No Step-Up in Basis at Death

Annuities do not receive a step-up in basis when the owner dies. The accumulated gain remains taxable as ordinary income to whoever receives distributions, whether that is the trust or the individual beneficiaries. The IRS classifies these deferred earnings as income in respect of a decedent, which by design does not qualify for the Section 1014 basis adjustment.

For grantor trusts not included in the grantor’s taxable estate, such as intentionally defective grantor trusts, Revenue Ruling 2023-2 confirmed that assets held at the grantor’s death receive no step-up at all. That ruling doesn’t change the annuity analysis, since annuities never got a step-up, but it removes any temptation to think grantor trust status alone creates a basis adjustment.

Trustee Options That Preserve Deferral

In-Kind Distribution of the Contract

A non-grantor trustee can, in many cases, distribute the annuity contract itself rather than surrender it and distribute the cash. In several private letter rulings, the IRS has concluded that an in-kind distribution of an annuity from a non-grantor trust to a natural-person beneficiary is not a taxable transfer under Section 72(e)(4)(C), on the reasoning that the trust as a non-individual falls outside the scope of that transfer rule. The beneficiary becomes the new owner, takes the trust’s cost basis, and continues the deferral. The trust document needs to expressly authorize this kind of in-kind distribution for the trustee to have the power to use it.

1035 Exchanges

A trust that owns an annuity can exchange it for another annuity under Section 1035 without recognizing gain, on the same terms available to individual owners. The exchange must be annuity for annuity, and the owner on both the old and new contracts must be identical. If the trust uses the exchange to move ownership from the trust to a beneficiary, the trade is not a qualifying 1035 exchange and the gain becomes taxable.

Drafting Points That Decide the Outcome

A handful of choices in the trust document control whether any of the above works.

Restrict all beneficiaries, current and remainder, to natural persons. This is the single most important drafting point for preserving Section 72(u) deferral in a non-grantor trust. A contingent charitable beneficiary added “just in case” can disqualify the contract.³

Name a specific natural person as the primary annuitant, and make the annuity contract and the trust instrument match on that point. Because a change in annuitant is a deemed death under Section 72(s)(7), the trust should limit annuitant succession to situations where the original annuitant has actually died rather than treating it as a routine administrative power.¹

Give the trustee explicit authority to buy and hold non-qualified annuities, execute 1035 exchanges, and distribute annuity contracts in-kind. Without those powers spelled out, state fiduciary law may block a trustee from doing what the tax rules would otherwise allow.

For irrevocable trusts, address how annuity income is allocated between accounting income and principal, and give the trustee discretion over distributions. That flexibility is what keeps the trust from being trapped at 37% plus NIIT on retained earnings.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Private Letter Ruling 202031008
3
Internal Revenue Service. Private Letter Ruling 199933033
4
Internal Revenue Service. Revenue Procedure 2025-32
5
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
6
Internal Revenue Service. Instructions for Schedule K-1 (Form 1041)