Private annuities: proposed regulations would negate income tax benefits.

Regulations [Sec. 1.72-6(e) and 1.1001-1(j)], proposed Oct. 18, 2006, addressed the income tax treatment of property exchanged for an annuity contract.

BACKGROUND

Gross income includes any amount received as an annuity under an annuity contract [IRC Sec. 72(a)]. However, Sec. 72(b) provides that gross income excludes that part of such receipt which bears the same ratio to this receipt as the investment in the contract bears to the contract's expected return.

In Rev. Rul. 69-74, a father (F) transferred a capital asset having a $20,000 adjusted basis and a $60,000 fair market value (FMV) to his son (S) in exchange for S's legally enforceable promise to pay F a $7,200 per year life annuity--in $600 equal monthly installments. The annuity's present value (PV) was $47,713.08.

This ruling 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 property's FMV over the annuity's PV was a gift from F to S; and (5) the prorated capital gain reported annually was derived from the taxable portion of each payment.

The remaining portion of each taxable payment was ordinary income.

POLICY CHANGE

Rev. Rul. 69-74 was partially based on assuming that a private annuity contract's value could not be determined. But this assumption is no longer correct. This ruling was rooted in authorities that applied

the "open transaction doctrine," which has been eroded in recent years.

The proposed regulations' preamble states that the IRS proposes to obsolete Rev. Rul. 69-74, effective with these regulations' effective dates (see below).

Charitable gift annuities would be unaffected by these proposals.

Taxpayers retain the ability to structure transactions as installment sales, provided Sec. 453's requirements are met.

PROPOSED EFFECTIVE DATES

General Effective Date: Exchanges of property for an annuity contract after Oct. 18, 2006 (except an annuity contract that either is a debt instrument subject to Secs. 1271 through 1275 or is received from a charitable organization in a bargain sale governed by Regs. Sec. 1.1011-2).

Delayed Effective Date: 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.

PROPOSED NEW TREATMENT

If an annuity contract is received in exchange for property (other than money):

1. The amount realized attributable to the contract is the contract's FMV (as determined under Sec. 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; and

3. To determine the contract's initial investment [under Sec. 72(c) (1)], "the aggregate amount of premiums or other consideration paid for the contract" equals the amount realized attributable to the contract (the contract's FMV).

Caution: These proposals do not prevent the application of other provisions, such as Sec. 267, to limit deductible losses from some exchanges.

Observations:

1. 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.

2. 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 Sec. 1001.

Note: Under Regs. Sec. 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.

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By Stuart R. Josephs, CPA 

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].