Tax-free buildup within the contract is allowed only to natural persons. If an annuity contract is held by a person who is not a natural person, then the annuity contract is not treated as an annuity and the income on the contract is treated as ordinary income received or accrued by the owner during that taxable year.
Corporations are not natural persons. Neither is the typical trust, although a trust acting as the agent for a natural person would itself be considered a natural person. But if an employer is the agent for its employees, the contract will be considered as if owned by the employer. The employer will therefore be taxed on the inside build-up. This means that annuities are no longer appropriate tax-advantaged investments for nonqualified deferred compensation agreements. Exceptions from the natural persons rules allow tax-free buildup of the following annuities:
Annuities received by the executor of a decedent at the decedent’s death;
Annuities held by a qualified retirement plan or IRA;
Annuities considered qualifying funding assets (used to provide funding for structured settlements and by property and casualty insurance companies to fund periodic payments for damages);
Annuities purchased by an employer on termination of a qualified plan and held until all amounts under the plan are distributed to the employee or his beneficiary; and
Annuities which are immediate (i.e., those which have a starting date no more than one year from the date the annuity was purchased and provide for a series of substantially equal periodic payments to be made at least annually over the annuity period).
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM