Annuities for business owners: where they fit and how they are taxed

An annuity is an insurance contract that converts money into a stream of payments, either immediately or after a deferral period. For a business owner, annuities show up in four places: inside retirement plans, as an owner's personal retirement vehicle, as a way to pay out a buyout or settlement over time, and, rarely, owned by the business itself. The tax treatment differs sharply across these settings, and the biggest trap is an annuity owned by a corporation or other entity. This guide explains the structures and tax mechanics and does not recommend any product.

Basic types

• Immediate annuity: a single premium starts payments within a year. Payments can be for life, for a set period or for joint lives.
• Deferred annuity: premiums accumulate during a deferral period and are then annuitized or withdrawn. These include fixed, fixed-indexed and variable contracts. The contract terms, fees, surrender charges and crediting methods vary widely, so read the contract and prospectus rather than the brochure.
• Qualified versus nonqualified: a qualified annuity sits inside an IRA or employer plan, funded with pre-tax money subject to plan rules. A nonqualified annuity is bought with after-tax money outside a plan.

Insurers back the guarantees. The guarantee is only as good as the insurer's claims-paying ability, and state guaranty associations provide limited protection if an insurer fails, with limits that vary by state. Check the insurer's financial strength rating from a rating agency such as AM Best.

Tax basics under IRC 72

Section 72 governs. Key points that apply to nonqualified annuities:

1. Deferral. Earnings are not taxed until withdrawn or paid.
2. Income first. Amounts received before the annuity starting date are included in income to the extent allocable to income on the contract, and are excluded to the extent allocable to the investment in the contract (72(e)(2)). In plain terms, withdrawals from a deferred annuity are generally treated as earnings first, then basis. Life insurance gets the opposite ordering outside a modified endowment contract.
3. Early withdrawal tax. An additional 10% tax applies to the portion of a distribution that is includible in income, unless an exception applies, such as the taxpayer being age 59½ or older (72(q)(1) and (2)(A)).
4. Annuitized payments. Once payments begin as an annuity, an exclusion ratio spreads the investment in the contract over the payments, so part of each payment is a return of basis and part is taxable.
5. Section 1035 exchanges. An annuity can generally be exchanged for another annuity without current tax, which matters when comparing contracts. Surrender charges and new terms still apply.

The entity-owned annuity trap

IRC 72(u) says that if a person who is not a natural person holds an annuity contract, the contract is generally not treated as an annuity for income tax purposes, and the owner must include the contract's income for each year as ordinary income. Holding the contract as an agent for a natural person does not avoid the rule. The statute's exceptions are narrow. They include a contract that an estate acquires on a decedent's death, a contract held under a qualified plan or IRA, a qualified funding asset, one an employer buys on terminating a qualified plan, and an immediate annuity (a single-premium contract whose payments begin within one year and are substantially equal at least annually).

So a business that buys a deferred annuity with company money, say to informally fund a deferred compensation promise, usually loses the tax deferral. That is a reason employers who informally fund nonqualified deferred compensation and corporate-owned life insurance often use corporate-owned life insurance or taxable investments instead. A deferred annuity owned by a corporation is the one most likely to produce an unwelcome surprise.

Where annuities fit for business owners

In an employer retirement plan. Annuities can be an investment option or distribution form inside a 401(k), 403(b) or other plan. Plan fiduciaries have to select and monitor the insurer prudently, and the plan is subject to ERISA basics for small employers: what the law requires of your benefit plans. The SECURE Act of 2019 added a fiduciary safe harbor for selecting a lifetime income provider, which is ERISA section 404(e). Plan structure is a topic for a benefits attorney or plan adviser.

An owner's personal retirement. An owner who has maxed out available plan contributions may hold a nonqualified deferred annuity personally. It is a personal asset, not a business one, and it is not a substitute for succession planning. See business succession planning and the insurance that funds it.

Paying a buyout or settlement over time. A single-premium immediate annuity is one way to provide installment payments, for example to a retiring partner under a buy-sell. The business or buyer pays one premium to the insurer, and the insurer pays the retiree. The agreement should say who owns the annuity, who is the payee, and what happens if the payee dies. The tax result depends on the structure. An annuity that is a funding asset for an installment obligation can raise constructive receipt questions. Involve a CPA before purchase. See Funding a buy-sell agreement with life insurance after Connelly.

Spending down life insurance cash value. Some owners with older permanent policies move the cash value into an annuity by a Section 1035 exchange, which can be tax-free. Check surrender charges, loss of the death benefit, and the carrier's rules first.

Questions to ask about any contract

• What are the total annual costs, including mortality and expense charges, rider fees and investment fees?
• What is the surrender charge schedule, and is there a free-withdrawal allowance?
• Which guarantees are backed by the insurer and which depend on investment results?
• How are fixed-indexed crediting rates, caps and participation rates set, and can the insurer change them?
• What are the payout options and the treatment of the remaining value at death?
• Is the contract being bought with plan money, personal money or company money, and what does IRC 72(u) mean for that owner?

Hypothetical example

Say a 62-year-old sole owner of a design firm sells the business to an employee for $900,000, payable over ten years. The buyer takes out a loan and the owner prefers a guaranteed stream instead of the buyer's promise. The buyer purchases a single-premium immediate annuity naming the owner as payee. The deal is documented, a CPA confirms the timing of income, and the owner reports the payments under the installment-sale rules. The facts are invented, and a different structure can change the result.

Underwriting and suitability

Most annuity sales involve less medical underwriting than life insurance, except for impaired-risk immediate annuities that pay more to shorter-life applicants. Instead, the insurer and the agent apply suitability or best-interest standards under state law, which differ by state. Annuity sellers must be licensed, and variable annuities are also securities regulated by the SEC and FINRA.

Key takeaways

• Annuities appear in retirement plans, personal retirement, buyout payments and, rarely, business ownership.
• Deferred annuities are taxed income first, with a 10% additional tax on early gains unless an exception applies.
• A deferred annuity owned by a corporation or other non-natural person generally loses annuity tax treatment under IRC 72(u).
• Immediate annuities and qualified plan annuities are exceptions to 72(u).
• Read costs, guarantees and surrender terms, and involve a CPA before using annuities in a buyout.