IRC 72(u): Entity-Owned Annuity Tax, Exceptions, and Trust Rules

When a corporation, partnership, LLC, or trust owns a deferred annuity, IRC Section 72(u) generally treats the contract as if it were not an annuity for federal income tax purposes and requires the entity to report the contract’s annual growth as ordinary income, even without any withdrawal.¹ Five categories of contracts are carved out, and trusts holding the annuity for an individual can preserve deferral. Everything else loses it.

What Section 72(u) Does to an Entity-Owned Annuity

The statute triggers two consequences at the same time when an annuity is held by a “person who is not a natural person.” The contract loses its classification as an annuity contract for purposes of Subtitle A of the Code, and the annual increase in the contract’s value is treated as ordinary income received by the owner that year.¹

A non-natural person is any entity that owns 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 distributions begin. When an entity owns one outside the statutory exceptions, that deferral is gone.

The income is ordinary. A corporation reports it on Form 1120. A partnership reports it on Form 1065 and passes it through to each partner on Schedule K-1. The entity cannot defer by leaving the money inside the contract. That is exactly what Congress intended when it enacted 72(u) in 1986 to stop entities from using deferred annuities as tax shelters.

The Five Exceptions That Preserve Tax Deferral

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

An annuity acquired by the estate of a decedent because of the owner’s death.
An annuity held under a qualified retirement plan, a 403(a) plan, a 403(b) program, or an IRA. These arrangements have their own rules on contributions, distributions, and RMDs.
An annuity that is a qualified funding asset for a structured settlement under Section 130(d). These fund periodic payments in personal injury settlements that are themselves tax-free under Section 104(a)(2).²
An annuity purchased by an employer on the termination of a qualified plan and held until all amounts are distributed to the employee or the employee’s beneficiary.
An immediate annuity, defined by three simultaneous requirements: purchased with a single premium, an annuity starting date no later than one year after purchase, and substantially equal periodic payments made at least annually throughout the annuity period.

The immediate annuity exception causes the most confusion. All three prongs must be satisfied. A contract funded with multiple premiums over time fails the single-premium requirement even if payments begin promptly.

When a Trust Can Still Preserve Deferral

The statute provides that “holding by a trust or other entity as an agent for a natural person shall not be taken into account.”¹ If a 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 a 2020 private letter ruling, the IRS drew an important distinction. A trustee owes fiduciary duties that differ fundamentally from those of an agent, so the word “agent” in the statute applies only to “other entity,” not to “trust.” For trusts, the question is whether the trust is holding the contract for a natural person, not whether the trustee is technically the natural person’s agent.³

Grantor Trusts

A grantor trust is the clearest path to preserving deferral. Because the grantor is treated as the owner of trust assets for federal income tax purposes under the grantor trust rules, the IRS concluded that a grantor trust holds the annuity for the grantor, who is a natural person. Section 72(u) does not apply. The ruling reached this result even though one trust beneficiary was a charitable organization rather than a natural person.³

Non-Grantor Trusts

Non-grantor trusts are harder. Legislative history from 1986 indicates that if the nominal owner is not a natural person but the beneficial owner is, the contract should be treated as held by a natural person.⁴ When a non-grantor trust names multiple beneficiaries, or when the trust itself holds the beneficial interest instead of acting as a conduit, the exception becomes uncertain. The safest structure identifies one or more natural persons as the beneficial owners with the trust holding 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 poor candidate.

One planning risk worth flagging: a grantor trust often converts to a non-grantor trust automatically when the grantor dies. If an annuity is inside the trust at that point, 72(u) can start applying.

Calculating the Annual Income Inclusion

The amount an entity must recognize each year equals the “income on the contract,” which the statute defines by formula.¹ Start with the net surrender value of the contract at the end of the tax year. Add all distributions received during the current year and all prior years. Then subtract two items: total net premiums paid (premiums paid minus policyholder dividends received) for the current and all prior years, and any amounts already included in gross income under 72(u) in prior years.

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

In Year 2, the net surrender value reaches $112,000. The subtraction side now includes the $100,000 in net premiums and the $5,000 already included in Year 1, totaling $105,000. Year 2 income is $112,000 minus $105,000, or $7,000. Only the new growth is taxed each year because prior inclusions are credited against the current value.

The Treasury has authority to substitute the contract’s fair market value for its net surrender value when necessary to prevent avoidance, targeting contracts structured to keep the surrender value artificially low while economic value grows.¹

How Later Distributions Are Taxed

Because the entity has already paid tax on the annual growth, those already-taxed amounts increase the owner’s investment in the contract. Total basis equals original net premiums paid plus all income previously included under 72(u). When distributions eventually occur, the entity does not pay tax again on amounts already reported.

This inverts the usual annuity ordering. An individual who owns a non-qualified annuity is taxed on an earnings-first basis: every dollar withdrawn is taxable until all gain has been distributed, and only then does basis come back tax-free. An entity subject to 72(u) has already been taxed on the growth, so distributions come out as a recovery of the inflated basis until that basis is exhausted. Only distributions exceeding total adjusted basis produce additional taxable income.

Suppose an entity paid $100,000 in premiums and recognized $50,000 under 72(u) over five years. Its basis is $150,000. A $60,000 withdrawal is entirely a tax-free return of basis, dropping remaining basis to $90,000. For an individual with an identical contract, the first $50,000 of the same withdrawal would have been taxable earnings.

Track every year’s inclusion. Without records, there is no way to prove how much of a later distribution should be tax-free.

Transferring an Existing Annuity Into 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 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 exception is a transfer between spouses or incident to divorce under Section 1041.

After the transfer, the entity’s basis equals the prior owner’s basis plus any gain the transferor had to recognize. Section 72(u) then applies going forward, requiring annual income recognition on future growth. The 10% early distribution penalty under Section 72(q) may also apply to the gain triggered on transfer if the transferor is under age 59½. Gain on the transfer plus loss of future deferral makes gifting or contributing an annuity to an entity an expensive decision.

Reporting Failures and Penalties

The most common mistake is not recognizing that 72(u) applies at all. An entity buys a deferred annuity, the insurer issues no 1099 because no distribution was made, and the tax preparer never picks up the growth as reportable income. Years of unreported income build up, and the correction often arrives as an IRS notice with penalties and interest.

The IRS imposes a 20% accuracy-related penalty on underpayments attributable to negligence or a substantial understatement of income.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.

If your entity owns an annuity and you have not been reporting the annual growth, 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 contract should be surrendered or transferred to a natural person going forward. Correction is almost always cheaper than an audit.

Should the Entity Own the Annuity at All

Before placing an annuity inside an entity, run the math honestly. The main reason to hold an annuity rather than a taxable investment is tax-deferred compounding. If 72(u) eliminates deferral, what remains is an insurance product with typically higher internal costs than a comparable taxable brokerage account. Unless one of the five exceptions applies or the contract is held in a trust for an identified individual, the entity is paying tax on growth every year while also bearing the contract’s mortality and expense charges.

Coordinate ownership with trust design at the outset rather than after the contract is issued. A revocable grantor trust generally preserves deferral. An irrevocable grantor trust can also work, as the 2020 IRS ruling confirmed. Non-grantor trusts require careful structuring to identify natural persons as beneficial owners. And any provision that could flip a grantor trust to a non-grantor trust, including the grantor’s death, needs to be considered while the annuity is still a planning choice, not a fait accompli.

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