Effect of OID final regs. on private annuities.

A private annuity is an exchange of cash or property for the promise of a series of fixed payments over time, by other than an insurance company; it is frequently used for estate planning purposes. How much income is imputed to these payments? Is the imputed interest deductible? Does it matter whether the property exchanged is publicly or nonpublicly traded? This article answers these and related questions.

Private annuities are commonly used in intrafamily sales for estate planning purposes. Until recently, issuers and holders of private annuities generally were not concerned with the original issue discount (OLD) rules; it was believed that private annuities were exempt under Sec. 1275(a)(1)(B)(i). However, in January 1998,(1) the Service published final regulations on the treatment of annuity contracts not issued by insurance companies. This article examines the effect of these regulations on certain private annuities.

Private Annuity

A private annuity is an arrangement under which an individual (the annuitant) transfers cash or other property to another individual or entity (the obligor)in exchange for the latter's promise to make periodic payments in fixed amounts to the former for the rest of his life.

Is it Debt?

An annuity contract resembles a debt instrument in certain respects. Debt instruments as defined by Sec. 1275(a)(1)(A) are generally subject to the OID rules. That provision defines a "debt instrument" as a bond, debenture, note or certificate or other evidence of indebtedness. According to Regs. Sec. 1.1275-1(d), a "debt instrument" is any instrument or contractual arrangement that constitutes debt under general principles of Federal income tax law.

Whether or not a particular instrument constitutes debt for Federal income tax purposes depends on the facts and circumstances and hinges on a number of factors,(2) including (1) the right to receive a sum certain; (2) a fixed maturity date; (3) the right to receive fixed interest or dividends; (4) the right of a holder to enforce payment in the event of default; (5) subordination to general creditors; (6) the parties' intent; and (7) thin capitalization.(3)

For example, a private annuity subject to a term may constitute a debt instrument under general principles of Federal income tax law. A private annuity subject to a term differs from a conventional private annuity; payments due under the former cease at the earlier of a stated term (which may equal or exceed the seller's actuarial life expectancy) or the annuitant's death. If the maximum term is shorter than the seller's life expectancy, the IRS has expressed the view in GCM 39503(4) that the annuity is properly treated as an installment debt obligation, subject to Sec. 453 and the rules governing debt instruments issued for property. A deferred annuity is the same as a conventional private annuity, except that the annuity stream does not start until a stated number of years in the future.

Exceptions

Sec. 1275(a)(1)(B) carves out an exception from the definition of "debt instrument" for annuity contracts that either (i) depend (in whole or in substantial part) on the life expectancy of one or more individuals or (ii) are issued by insurance companies in a variety of situations.

Thus, if a private annuity not issued by an insurance company constitutes debt for Federal income tax purposes, it would be subject to the OID provisions if it does not qualify under Sec. 1275(a)(1)(B)(i). If, on the other hand, such a private annuity either does not constitute debt for Federal income tax purposes or qualifies for the exception, it generally would be accounted for under Sec. 72.

The reason for the Sec. 1275(a)(1)(B)(i) exception could be that any contract that calls for payments to continue only for the period of a life without guarantee that the premium will be recovered is not a debt instrument. For debt to exist, there generally must be an obligation to make a payment of a fixed amount at some date in the future. When payment is wholly contingent on the occurrence (or nonoccurrence) of an event, arguably, there is no "debt."

Final Regs.

In January 1998, the IRS published final regulations on the treatment of annuity contracts not issued by insurance companies as debt instruments subject to the OID provisions. The general rule under Regs. Sec. 1.1275-1(j)(2) is that an annuity contract qualifies for the exception in Sec. 1275(a)(1)(B)(i) (relating to certain annuity contracts that depend on the life expectancy of one or more individuals) only if it (1) provides for periodic distributions at least annually for the life (or joint lives) of an individual (or a reasonable number of individuals) and (2) contains no terms or provisions that can significantly reduce the probability that total distributions will increase commensurably with longevity. Examples of such reducing terms or provisions include (1) the availability of a cash surrender option or a loan secured by the contract, (2) minimum or maximum payout provisions and (3) provisions that allow decreasing payouts. This list is not exclusive. This article discusses issues related to maximum payout provisions (as they are more commonly seen in the personal financial planning context).

Maximum Payout Provisions

Regs. Sec. 1.1275-1(j)(6)(ii) states that a maximum payout provision is a contractual provision providing that no distributions under the contract may be made after the termination date, even if the terminating death has not yet occurred. The existence of a maximum payout provision may cause an annuity contract that constitutes debt to be subject to the OID rules. An exception in Regs. Sec. 1.1275-1(j)(6)(iii) provides that the termination date can be set at two times (or greater) the life expectancy of the annuitant (2 x life) as of the annuity starting date.

The remaining discussion assumes that a private annuity is issued in exchange for property, and the annuity has a maximum payout provision that violates the 2 x life rule. Such an annuity would be subject to the OID rules if it constitutes debt under general principles of Federal income tax law. If subject to the OID rules, these annuities generally would constitute contingent payment debt instruments, because all payments cease if the annuitant dies before the maximum payout is reached.

OID Calculation

Generally under Kegs. Sec. 1.1273-2(c)(1), the issue price of a debt instrument issued for publicly traded property is the property's fair market value (FMV). The issue price of a debt instrument issued for nonpublicly traded property is determined under Sec. 1274; according to Sec, 1274(a)(1), the issue price of a debt instrument that provides adequate stated interest (based on the applicable Federal rate (AFR)) is the instrument's stated principal amount. On the other hand, under Sec. 1274(a)(2) and Regs. Sec. 1.1274-2(b)(2), the issue price of a debt instrument that does not provide for adequate stated interest is its imputed principal amount. The imputed principal amount is determined by discounting all payments due (both principal and interest) to the issue date at the "test rate" (i.e., the AFR for the instrument's term).

For a contingent payment debt instrument issued in exchange for nonpublicly traded property, the issue price under Regs. Sec. 1.1274-2(g) is the lesser of the instrument's noncontingent principal payments and the sum of the present values of the noncontingent payments. However, Regs. Sec. 1.1274-2(g) further provides that if a debt instrument is issued in a potentially abusive situation (as defined in Sec. 1274(b)(3)(B)), its issue price is the FMV of the noncontingent payments,

Sec. 1273(a)(1) defines "OID" as the excess (if any) of the stated redemption price at maturity over the issue price. Under Sec. 1273(a) (2), the stated redemption price at maturity means the amount fixed by the last modification of the purchase agreement, and includes interest and other amounts payable (other than qualified stated interest).

A typical private annuity contract specifies only the amount of the annuity without stating an interest rate; hence, there is no "stated" interest. Even if a specific percentage is stated in the contract, the interest still needs to meet the definition of "qualified stated interest" under Regs. Sec. 1.1273-1(c)(1)(i) to avoid being treated as OID.

Generally, OID is accrued on a current basis and included in the income of the holder under Sec. 1272 and deducted by the issuer under Sec. 163(e). However, special rules apply in the case of contingent payment debt instruments. As stated previously, private annuities subject to the OID rules will, in many cases, be contingent payment debt instruments, because the annuity payments often are, in part, contingent on the annuitant's life.

Issued for Nonpublicly Traded Property

If the private annuity to which the contingent payment debt instrument rules apply is issued for nonpublicly traded property, under Regs. Sec. 1.1275-4(c)(2) the annuity contract is bifurcated into a noncontingent debt instrument and a contingent debt instrument. Regs. Sec. 1.1275-4(c)(3) applies to the noncontingent portion; a "wait and see" approach under Regs. Sec. 1.1275-4(C)(4) applies to the contingent portion. Under the wait-and-see approach, interest is calculated as each payment becomes fixed (in the case of most private annuities, presumably at the time of actual payment). Each payment is discounted at the appropriate AFR from the date the payment is made to the issue date. The excess of the payment over the present value is interest. The appropriate discount rate is the AFR for the term that began on the issue date and ended on the payment date.

Under Regs. Sec. 1.1275-4(c)(3), the issue price of the noncontingent portion is the issue price of the overall debt instrument, determined under Regs. Sec. 1.1274-2(g). No interest payments on the separate noncontingent debt instrument are qualified stated interest payments (within the meaning of Regs. Sec. 1.1273-1(c)); the de minimis rules of Sec. 1273(a)(3) and Regs. Sec. 1.1273-1(d) do not apply to the separate noncontingent debt instrument. OID accruals on this portion of the annuity will be accounted for on a current basis by the holder and issuer.

Issued for Publicly Traded Property

If the private annuity is issued for publicly traded property to which the contingent payment debt instrument rules apply, the noncontingent bond method under Regs. Sec. 1.1275-4(b) applies. This method involves four steps under Regs. Sec. 1.1275-4(b)(3): (1) determining the comparable yield of an equivalent fixed-rate instrument; (2) determining the projected payment schedule; (3) determining the daily portions of interest; and (4) adjusting the amount of income or deductions for differences between projected and actual contingent payments. Under the noncontingent bond method, the test rate is not provided by Sec. 7872; rather, under Regs. Sec. 1.1275-4(b)(4)(i)(A), it depends on the rate of an equivalent fixed-rate instrument that can be estimated by the banking community and may not be the same rate as the Sec. 7520 rate. (Under Sec. 7520(a)(2), the Sec. 7520 rate is 120% of the mid-term AFR in effect for the month in which the valuation date falls.) In addition, there are infinite number of alternative projected payment schedules with a private annuity.

There are a number of exceptions to the application of the contingent debt payment instrument rules, under Regs. Sec. 1.1275-4(a)(2). For example, a debt instrument is not treated as a contingent payment debt instrument if, based on all the facts and circumstances as of the issue date, a single payment schedule is significantly more likely than not to occur. Thus, if a private annuity is significantly more likely than not to be paid through its stated term, the contingent payment debt instrument rules may not apply. Similarly, under Kegs. Sec. 1.1275-4(a)(5), a payment is not a contingent payment merely because of a contingency that, as of the issue date, is remote or incidental. Thus, if a private annuity has only a remote chance that the payments will not be made to term, it may not be a contingent payment debt instrument.

Example: In January 1999, S sold an asset with a basis of $1,000 and FMV of $1,000,000 to B. B will pay S a fixed annuity for the shorter of S's life or 20 years. At the sale date, S was 65 years old; his estimated life expectancy was 19.5 years.

Variation 1--Private annuity not subject to OID rules: The January 1999 Sec. 7520 rate was 5.6%.s B will pay S a fixed annuity of $108,978 annually for the shorter of S's life or 20 years. When each annuity payment is received, S will recognize $57,701 of ordinary income, under Rev. Rul. 69-74.6

Variation 2--Nonpublicly traded property sold and private annuity subject to OID rules: In January 1999, the short-term AFR was 4.57%, the mid-term AFR was 4.64% and the long-term AFR was 5.21%.(7) From Year 1 to Year 3, when each annuity payment is received, S will discount the annuity to the issue date at 4.57%; from Year 4 to Year 9, at 4.64% and from Year 10 forward, at 5.21%. The difference between the calculated present value and the $108,978 annuity is the interest S will recognize: in Year 1, $4,763; Year 2, $9,317; Year 3, $13,672; Year 4, $18,081; Year 5, $22,112, etc.

Variation 3--Publicly traded property sold and private annuity subject to OID rules: The comparable yield of an equivalent fixed-rate instrument is 5.6%; the projected payment schedule is an annual payment of $108,978 for 20 years. The issue price of this instrument equals $1,000,000, the FMV of the property sold. In Year 1, S recognizes $56,000 of interest income. In Year 2, the adjusted issue price is $947,022 ($1,000,000 + $56,000 (interest previously accrued) -- $108,978 (projected amount of contingent payments previously made)); thus, the Year 2 interest income is $53,033. The interest income continues as follows: in Year 3, $49,900;Year 4, $46,592;Year 5, $43,098, etc.

Effect of OID on Annuitant

Nonpublicly Traded Property

In a private annuity arrangement, the annuity payment is calculated based on the Sec. 7520 rate (120% of the mid-term AFR). Thus, unless the term certain of the payout provision is more than nine years and the long-term AFR is more than 120% of the mid-term AFR., the OID for each accrual period would be less than the ordinary portion of the annuity payment as calculated under Rev. Rul. 69-74.

If Sec. 72 does not apply to a debt instrument, the annuitant is not required to follow Rev. Rul. 69-74 to determine the tax treatment of the private annuity payments. If the annuity is originally calculated using the Sec. 7520 rate and is a debt instrument subject to OID, the amount attributable to the difference between the Sec. 7520 valuation table rate and the Sec. 7872 below-market interest rate may be recharacterized from ordinary income to capital gain. In the case of a deferred annuity, the wait-and-see approach could avoid phantom income and undesirable cashflow issues during the deferral years. However, the annuity contract will still be subject to Secs. 453 and 453A, relating to the additional interest charge imposed on the deferred tax liability and the restriction on subsequent dispositions by related persons.

Publicly Traded Property

Depending on the comparable yield of the equivalent fixed-rate instrument, the OID for each accrual period may not be less than the ordinary portion of the annuity payment as calculated under Rev. Rul. 69-74. Thus, the effect of income recharacterization may work against the annuitant if the comparable yield is determined to be higher than the Sec. 7520 rate; moreover, Secs. 453 and 453A would apply. For a deferred annuity, the OID calculated under the noncontingent bond method is accrued on a current basis; thus, there would be undesirable phantom income during the deferral years.

Effect of OID on Obligor

Interest Deduction

The obligor cannot deduct as interest the portion of each payment that the annuitant has to treat as ordinary income under Sec. 72 and Rev. Rul. 69-74. The Tax Court has concluded that stating the interest element as a separate part of the annuity agreement does not make the interest obligation sufficiently definite to justify its deductibility under Sec. 163.(8)

Sec. 163(e) (2) (A) provides that"debt instrument" for purposes of deducting OID rules has the meaning provided in Sec. 1275(a)(1). Thus, if a private annuity contract is characterized as a debt instrument under Sec. 1275 and subject to the OID rules, the obligor can deduct the portion of interest attributable to OID under Sec. 163(e). However, other interest deduction limits may still apply.

Basis

Regs. Sec. 1.1012-1(g)(1) provides that a debt instrument is issued for property, the cost of the property attributable to the debt instrument is the issue price of the debt instrument as determined under Regs. Sec. 1.1273-2 or 1.1274-2, whichever applies. As was previously discussed, if the private annuity is issued for nonpublicly traded property, its issue price is the lesser of the instrument's noncontingent principal payments or the sum of the present values of the noncontingent payments. In the case of a private annuity issued for publicly traded property, the issue price is the property's FMV. Under the Regs. Sec. 1.1275-4(c)(4) wait-and-see approach, the obligor can increase his basis in the nonpublicly traded property by the principal imputed to contingent payments (but only as payments are made).(9)

Conclusion

After analyzing the effect of the regulations on private annuities, readers may wonder why the regulations were enacted. The preamble explained that the purpose of the final regulations is to ensure that the life contingency under an annuity contract is both "real and significant." The contingency is "real and significant" only if there is a high probability that total distributions under the annuity contract will increase commensurably with the longevity of the individual over whose life the distributions are to be made. Thus, as was discussed, the IRS and Treasury identify several types of terms and provisions that do not meet the "real and significant" contingency requirement. Nevertheless, as discussed in the preamble, Treasury recognized that in many instances, distributions under private annuities axe entirely contingent on the survival of one or a small number of individuals. Generally, these annuities are not debt under general principles of Federal income tax law and, thus, are not debt instruments under Sec. 1275(a)(1)(A).

On the other hand, private annuities with features such as maximum payout provisions may be subject to the regulations. As discussed above, there could be adverse tax consequences when private annuities fall within the ambit of the OID regulations. Moreover, there are nontax costs, such as the administrative burden of OID reporting requirements and the professional costs of obtaining a comparable rate and a projected payment schedule. Although the final regulations may not affect private annuities not considered debt, they do provide a good overview of Treasury's intent and a reference point for tax practitioners designing private annuities embedded with aggressive features.

To help readers find their way through the maze of the OID rules, Exhibit 1 in the box above summarizes the general steps in determining the possible tax treatment of a private annuity received for noncash property.

Exhibit 1: Treatment of Private Annuity Issued for Noncash Property

Debt vs. Annuity [right arrow] Sec. 127(a)(1)(A), (B); Regs. Sec.
  1.1275-(j)

If annuity [right arrow] Sec. 72

If debt

[right arrow] Is it contingent payment debt? [right arrow] Regs.
  Sec. 1.1275-(4)(a)(1)-(5)

[right arrow] If yes
   Exchange for nonpublicly traded property? [right arrow] Regs.
     Sec. 1.1275-(4)(c)
   Exchanged for publicly traded property? [right arrow] Regs. Sec.
     1.1275-4(b)

   [right arrow] If no [right arrow] Secs. 1271-1275 (OID rules
     applicable to noncontingent debt)

EXECUTIVE SUMMARY

* In a private annuity arrangement, the annuity payment is calculated based on the Sec. 7520 rate (120% of the mid-term AFR).

* The final regulations provide a good overview of Treasury's intent and a reference point for tax practitioners designing private annuities embedded with aggressive features.

* The obligor cannot deduct as interest the portion of each payment that the annuitant has to treat as ordinary income under Sec. 72.

(1) TD 8754 (1/7/98).

(2) See Notice 94-47, 1994-1 CB 357.

(3) See also Sec. 385(b).

(4) GCM 39503 (5/7/86).

(5) Rev. Rul. 99-2, IRB 1999-2, 5, Table 1.

(6) Rev. Rul. 69-74, 1969-1 CB 43.

(7) Rev. Rul. 99-2, note 5, Table 1.

(8) See Rebecca Bell, 76 TC 232 (1981), aff'd, 668 F2d 448 (8th Cir. 1982)(49 AFTR2d 82-538, 1982-1 USTC [paragraph] 9148).

(9) See Regs. Sec. 1.1275-4(c)(7), Example (1).

Author's note: The author wishes to thank Richard G. Larkins, Senior Manager, KPMG LLP, Washington, DC, for his generous assistance and invaluable comments.

For more information about this article, contact Ms. Lee at [phone] or [e-mail].

Shirley K. Lee, CFA, CPA
Manager
KPMG LLP
Washington, DC