Watch Out for Private Annuities
EXECUTIVE SUMMARY
With the release of Prop. Treas. Reg. §§ 1.72-6(e) and 1.1001-1(j) in October 2006, the Treasury and IRS have signaled their intent to recognize gain or loss at the time of exchange of property other than money for an annuity contract. Previously, taxpayers may have recognized such gain over a taxpayer’s remaining life expectancy. The new rules would, if adopted in final form as proposed, require taxpayers to calculate the fair market value (FMV) of property exchanged for an annuity and for any gain or loss to be realized immediately.
Thereafter, annuity payments would be partly excluded from income as a return of the annuitant’s investment and partly taxed as ordinary income.
The FMV of the contract must be determined by the valuation tables under IRC § 7520.
The proposed rules are effective for exchanges after Oct. 18, 2006, with provisions for a delayed effective date of April 18, 2007, for contracts issued by an individual and whose obligations are not secured, and the property exchanged for the contract is not subsequently sold or otherwise disposed of by the transferee for at least two years after the exchange.
The new rules may make alternatives to private annuity contracts more attractive, including installment sales or installment notes that terminate at the obligee’s death.
Stuart R. Josephs, CPA, has a practice in San Diego that specializes in helping practitioners resolve their clients’ tax questions and problems. He can be reached at 619-469-6999 or stuartrjosephs@yahoo.com.
Ataxpayer might find it attractive to exchange property for a private annuity for estate tax purposes because the property’s value is removed from the taxpayer’s gross estate and the annuity terminates at the taxpayer’s death. In the past, if appreciated property was exchanged, there also was an income tax advantage, since the realized gain could be recognized over the taxpayer’s life expectancy. However, on Oct. 18, 2006, the Treasury and the IRS published Proposed Regulation §§ 1.72-6(e) and 1.1001-1(j) in the Federal Register that would change the income tax treatment of an exchange of property for an annuity. These proposals would apply the same rule to such exchanges for both private and commercial annuities.
Caution: It is currently unknown when the final regulations will be published and the extent to which they will differ from the proposed regulations.
The existing treatment is provided by Revenue Ruling 69-74 (described below), which generally postpones income tax on the exchange of appreciated property for a private annuity. However, the IRS believes that this favorable result is inconsistent with the income tax treatment of exchanges for commercial annuities or other kinds of property.
Caution: The proposed regulations’ preamble states that the IRS proposes to declare obsolete Revenue Ruling 69-74, effective with these regulations’ effective dates.
PROPOSED EFFECTIVE DATES
General Effective Date. The proposed regulations would be effective generally for exchanges of property for an annuity contract after Oct. 18, 2006, except an annuity contract that is either:
A debt instrument subject to the original issue discount rules of IRC §§ 1271 through 1275; or
Received from a charitable organization in a bargain sale governed by Treas. Reg. § 1.1011-2.
Delayed Effective Date. The proposed regulations would be effective for exchanges of property for an annuity contract after April 18, 2007, subject to the same exceptions described immediately above—if the following conditions are met:
(1) The contract’s issuer is an individual;
(2) The contract’s obligations are not directly or indirectly secured; and
(3) The property transferred in exchange for the contract is not subsequently sold or otherwise disposed of by the transferee during the two-year period beginning on the exchange date. For this purpose, a disposition includes without limitation a transfer to a trust (whether a grantor trust, a revocable trust or any other trust) or to any other entity—even if solely owned by the transferor.
The Treasury and the IRS believe that this proposed delayed effective date for these transactions provided ample notice of the proposed rules for taxpayers that were planning transactions presenting the least opportunity for abuse.
Comment: It also is presently unknown if these proposed general and delayed effective dates will be changed by the final regulations.
AICPA Urges Narrower Proposed Rules
Proposed regulations regarding exchange of property for an annuity, REG-141901-05, are overly broad and raise new, unaddressed technical problems in applying the installment sale rules to such transactions, the AICPA has said in comments to the IRS and Treasury Department.
While acknowledging the Service’s interest in curbing abusive transactions, the AICPA said the IRS and Treasury Department should continue to allow private annuities in certain situations as an appropriate and time-honored method to transfer assets from one generation to the next without immediate income tax recognition. The letter, dated March 6, 2007, was signed by Jeffrey R. Hoops, chair of the AICPA Tax Executive Committee, on behalf of the committee and other AICPA panels studying the issue.
An unsecured private annuity sale between individuals poses little potential for abuse, the AICPA said, pointing out that the proposed regulations’ preamble notes that such exchanges occur “for valid, nontax reasons related to estate planning and succession planning for closely held business.” Consequently, the AICPA said, the rules could put families in a difficult situation, since they would require a seller, typically a parent, to come up with a large tax payment from a transfer, often to a child, that lacks liquidity. That difficulty could arise especially in situations where the installment sales method prescribed by the regulations is unavailable. Moreover, treating such transactions as installment sales, as the rules propose, does not duly take into account related-party restrictions under IRC § 453 or limitations on certain assets from qualifying for installment treatment.
These considerations demonstrate that the IRS and Treasury Department’s proposed consistent treatment of commercial annuities with private ones and the latter with a cash sale followed by an annuity purchase are not supported by the economic reality of the underlying transaction, the AICPA said. Legitimate reasons for an exchange for an annuity within families include security of assets. When assets are transferred directly, heirs’ direct access to them poses risks to the transferor.
The AICPA recognizes, Hoops wrote, that some taxpayers’ use of “private annuity trusts” (PATs) are potentially abusive, since they typically involve sales of highly appreciated real estate and claimed deferral of gain while a related-party trust continues to have full access to sales proceeds. However, this perceived abuse could be eliminated by full recognition of gain on the subsequent sale of the appreciated property by the PAT, the AICPA said. In general, an annuity sale should be allowed in such situations where there is no resale by the trust within a short period, before any increase in value of the property, the letter said. Other perceived abuses, likewise, could be more effectively and equitably addressed by existing or more closely tailored remedies.
Finally, to the extent that the proposed rules declare Revenue Ruling 69-74 obsolete, they reopen other questions the ruling addressed, such as providing for ordinary-income treatment of annuity payments after capital gain and basis in the contract are recovered.
For these reasons and others, the letter said, the Service and Treasury Department should narrow the proposed regulations and continue to allow legitimate use of annuities without immediate income tax recognition for intrafamily transfer of assets between generations. It was not known by May 2008 whether or to what extent the IRS might modify the proposed regulations.
REVENUE RULING 69-74
In this ruling, a 74-year-old father (F) transferred a capital asset with a $20,000 adjusted basis and a $60,000 FMV to his son (S) in 1966 in exchange for S’s legally enforceable promise to pay F a $7,200-per-year life annuity in equal monthly installments of $600. The annuity’s present value (PV) was $47,713.08.
Revenue Ruling 69-74 concluded that:
(1) F realized capital gain based on the difference between F’s basis in the property and the annuity’s PV.
(2) This gain was reported ratably over F’s life expectancy.
(3) The investment in the contract to compute the exclusion ratio was F’s basis in the property transferred.
(4) The excess of the transferred property’s FMV over the annuity’s PV was a gift from F to S.
(5) The prorated capital gain reported annually was derived from the taxable portion of each payment.
(6) The remaining portion of each taxable payment was ordinary income.
The results obtained under Revenue Ruling 69-74 are illustrated in Exhibit 1.
PROPOSED NEW TREATMENT
Under the proposed regulations, if an annuity contract is received in exchange for property other than money:
1. The amount realized attributable to the annuity contract is the contract’s FMV (as determined under IRC § 7520) at the time of the exchange.
2. The entire amount of the gain or loss, if any, is recognized at the time of the exchange, regardless of the taxpayer’s accounting method.
3. To determine the investment in the contract as of the annuity starting date (under IRC § 72(c)(1)), the aggregate amount of premiums or other consideration paid for the contract equals the portion of the amount realized on the exchange that is attributable to the contract—which is the contract’s FMV at the time of the exchange.
This rule is intended to ensure that no portion of the gain or loss on the exchange is duplicated or omitted by the application of IRC § 72 in the post-exchange years.
The annuitant’s investment in the contract would be reduced in subsequent years (under IRC § 72(c)(1)(B)) for amounts already received under the contract subsequent to the exchange and excluded from gross income when received as a return of the annuitant’s investment in the contract.
Comment: In situations where the FMV of the property exchanged equals the FMV of the annuity contract received, the investment in the contract equals the FMV of the property exchanged for the contract.
To apply these proposed regulations to an exchange of property for an annuity contract, taxpayers must determine the contract’s FMV under the valuation tables prescribed by IRC § 7520.
Note: Since these proposals would require the entire gain or loss to be immediately recognized, each subsequent annuity payment would consist only of an excludible portion and a taxable ordinary income portion.
In the case of an exchange of property for an annuity contract that is part sale and part gift, the proposed regulations apply the same rules that apply to any other such exchange under IRC § 1001.
Observation: Under Treas. Reg. § 1.1001-1(e), where a property transfer is part sale and part gift, the transferor has a gain to the extent that the amount realized exceeds the property’s adjusted basis. Thus, no adjusted basis has to be allocated to the gift portion, but can be used entirely to reduce the gain. However, no loss is sustained on such a transfer if the amount realized is less than the adjusted basis.
The proposed regulations do not distinguish between secured and unsecured annuity contracts or between contracts issued by insurance companies and those issued by other taxpayers. Instead, the proposals provide a single set of rules that leave the transferor and transferee in the same position before tax as if the transferor had sold the property for cash and used the proceeds to purchase an annuity contract.
The same rules would apply whether the exchange produces a gain or loss; however, these proposals would not prevent the application of other provisions, such as IRC § 267 (pertaining to transactions between related taxpayers), to limit deductible losses from some exchanges.
The proposed regulations apply to exchanges of property for an annuity contract, regardless of whether the property is exchanged either for a newly issued contrac or an existing contract.
The results obtained under the proposed regulations are illustrated in Exhibit 2. The previous and proposed treatment of private annuities is compared in Exhibit 3.
PRIVATE ANNUITIES COMPARED WITH ALTERNATIVES
The following alternatives to private annuities should be considered in light of the proposed regulations and in the event that they are finalized as proposed:
1. Installment sales; or
2. Installment notes terminating at the obligee’s death.
Unlike the proposed treatment for private annuities, Alternative 1 allows the gain on the sale of the property to be reported over the term of the installment sale, regardless of when the obligee dies. However, under IRC § 691(a)(4), the remaining gain attributable to post-death payments is reported by the decedent’s estate or beneficiaries.
Alternative 2 allows the gain to be spread over the obligee’s lifetime. However, Revenue Ruling 86-72 requires the gain still deferred at the obligee’s death to be taxed to the obligee’s estate under IRC §§ 691(a)(2) and 691(a)(5). This position was supported by the Eighth Circuit Court of Appeals in 1993 in Janet M. Frane v. Commissioner (998 F.2d 567).
For estate tax purposes, under Alternative 1, the FMV of the installment note receivable would be an asset of the decedent’s gross estate. There is no such asset in the case of a private annuity or under Alternative 2.
In addition, nontax factors also should be compared—such as the total amounts to be received by the property seller and his or her heirs. If the seller dies prematurely, lesser amounts will be received under a private annuity or under Alternative 2 than would be received under Alternative 1, which provides for a sum certain to be received over the installment sale’s term.
The above comparisons reflect only very broad observations. Detailed analysis of all of these points, as well as other items such as any gift tax ramifications, is beyond this article’s scope and must be left to the reader’s further research. 
