A taxpayer was permitted to defer capital gain when he transferred appreciated capital assets in exchange for a private annuity. The Tax Court held the arrangement met the requirements of Revenue Ruling 69-74, 1969-1 C.B. 43, and thus the capital gain could be deferred until the taxpayer began receiving payments under the annuity contract.
Code § 72(b) permits taxpayers to exclude a percentage of an annuity payment received equal to the ratio of the taxpayer’s investment in the annuity to its expected return. When an appreciated capital asset is exchanged for a private life annuity, Revenue Ruling 69-74 permits the deferral of capital gain until the taxpayer begins to receive annuity payments. (However, note proposed regulations described below that, if adopted as final, generally would curtail this deferral.) As payments are received, each payment consists of three components: return of investment, capital gain and ordinary income. The basis of the capital asset becomes the investment in the annuity, which is recovered tax-free evenly over the expected life of the annuitant. The capital gain portion (measured as the difference between the asset’s basis and its fair market value on the date of the exchange) is recognized evenly over the taxpayer’s life expectancy. Once this capital gain has been recognized, any reportable income is ordinary.
Marcus Katz formed a student loan business, Educational Loan Administrative Group Inc. (ELA), in 1993. When ELA merged with UICI Acquisition Corp. in 1997, Katz exchanged his ELA shares for 470,708 shares of UICI, the parent company of UICI Acquisition. In 1998 Katz purchased 200,000 UICI common stock put options and sold 200,000 UICI common stock call options, both exercisable on Feb. 3, 2000. On Feb. 3, 2000, Katz then transferred 200,000 UICI shares and the put options to SJA Co. Ltd. in exchange for a private annuity contract. On Feb. 8, 2000, SJA exercised the put options and sold the 200,000 UICI shares to Merrill Lynch.
As a result of an assignment agreement with Katz and SJA, Merrill Lynch settled the transaction with SJA for $4,617,841, which it erroneously deposited into Katz’s account. Under the terms of the annuity contract, Katz should have received $800,000; thus Merrill transferred $3,817,841 from Katz’s account into RJA’s. Merrill issued Katz a 1099-B in the amount of $4,617,841.
Believing the gain should be deferred, Katz reported no income on his 2000 tax return, by using $4,617,841 as the basis of the UICI shares, although the basis was actually $150,650. The IRS issued a deficiency notice for taxes and penalties totaling more than $1.1 million. The taxpayer agreed that the gain from the UICI shares for which he received $800,000 should be taxed but petitioned the Tax Court for relief from the remaining tax and related penalties.
The IRS argued that the entire gain should be taxed under the substance-overform doctrine because Katz had designed the stock sale and private annuity purchase to unlawfully defer gain. The court was not convinced, since the IRS had previously stipulated the following: The private annuity was a valid agreement that met the requirements of Revenue Ruling 69-74; Katz transferred the options to SJA before their exercise; SJA was the owner of the proceeds from the UICI stock sale; and the transactions were not an attempt to unlawfully avoid federal taxes. The IRS also cited Harry C. Usher Sr. and Myrtis C. Usher, 45 TC 205, where a taxpayer was taxed on the gain from the sale of stock that funded a private annuity. In that case, the taxpayer arranged a stock sale and then had her husband transfer the stock to a trust with their sons as its beneficiaries. The trust agreed to sell the stock to the prearranged party, receive the proceeds and then make annuity payments to the taxpayer for life.
The court contrasted Usher with this case, since the Usher trust’s sole purpose was as a conduit for the funds, whereas Katz, SJA and Merrill Lynch were unrelated parties who had entered into a valid transaction and Katz’s actions were supported by an IRS revenue ruling.
Note: Prop. Treas. Reg. §§ 1.72-6(e) and 1.1001-1(j) were released in October 2006, after the tax year at issue in this case. If adopted as final, these regulations may require immediate recognition of gain in such circumstances. See “Watch Out for Private Annuities,” JofA, July 08, page 34.
Marcus A. Katz v. Commissioner, TC Memo 2008-269
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.