Service issues prop. regs. on exchanges for annuities.

The Service issued proposed regulations (REG-141901-05, 10/18/06) on the taxation of the exchange of property for an annuity contract.

Overview

A heavily promoted, but controversial technique for income and estate tax planning has been the so-called "private annuity trust." It relied in part on the "open transaction doctrine," under which, if the value of the private annuity could not be determined with certainty, the seller would recover the basis of the property sold before realizing any income on the sale. The strategy also relied on Rev. Rul. 69-74, which allowed for ratable recognition of gain over the annuitant's life expectancy.

In a typical situation, a parent would transfer property (such as real estate) to a nongrantor trust in exchange for a private annuity; annuity payments could begin immediately or be deferred for a number of years. Proponents of the strategy maintained that payments to the seller would be taxed under the Sec. 72 annuity rules, thereby spreading the income tax over the seller's life. Meanwhile, the trust would sell the appreciated asset to an unrelated party for cash or an installment note. Because the trust would acquire a basis in the real estate equal to its fair market value (FMV), the sale would presumably result in no gain to the trust. The technique offered the usual wealth transfer (freeze) benefits of the private annuity to the parent/seller.

Perceived Abuse

Treasury and the IRS had become aware that some taxpayers were using these transactions in troublesome circumstances. Both indicated that neither of the concepts noted above clearly reflects the income of the transferor who sells the property in exchange for the annuity. They also expressed concern that transactions were structured to provide security for the seller's payments, which would otherwise preclude taxation under the private annuity roles.

Prop. Regs.

The proposed regulations provide that, if an annuity contract is received in exchange for property other than money, (1) the amount realized attributable to the annuity contract will be its FMV (as determined under Sec. 7520) at the time of the exchange; (2) the taxpayer will recognize gain or loss at the time of the exchange, regardless of accounting method; and (3) in determining the initial investment in the annuity contract under Sec. 72(c)(1), the aggregate premiums or other consideration paid for the contract will equal the amount realized attributable to it. Thus, if the FMV of the property exchanged equaled the FMV of the annuity contract received, the investment in the latter will equal the FMV of the property exchanged for it.

The proposed regulations do not distinguish between secured and unsecured annuity contracts, or between annuity contracts issued by an insurance company and those issued by a taxpayer other than an insurance company. They would leave the transferor and transferee in the same position as if the former 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. They would not prevent the application of other provisions (such as Sec. 267) to limit deductible losses for some exchanges. They would also apply to exchanges of property for an annuity contract, regardless of whether the property is exchanged for a newly issued contract or an existing one.

The proposed regulations would not change Regs. Sec. 1.1011-2, which governs the tax treatment of an exchange of property that constitutes a bargain sale to a charitable organization (including an exchange of property for a charitable gift annuity).They would not prevent the exchange of property for an annuity contract for valid nontax reasons related to estate and succession planning for closely held businesses. However, they would ensure that income from those transactions is accounted for in the appropriate periods. The proposed rules would not bar taxpayers from structuring transactions as installments sales under Sec. 453(b), provided the other Sec. 453 requirements are met.

Effective Date

Generally, the proposed regulations would be effective for exchanges of property for an annuity contract after Oct. 18, 2006. (For a limited class of transactions, the proposed regulations would be effective after April 18, 2007.) The effective date would be delayed for six months for transactions in which the (1) issuer of the annuity contract is an individual; (2) contract obligations are not secured (either directly or indirectly); and (3) property transferred in the exchange is not subsequently sold or otherwise disposed of by the transferee during the two-year period beginning on the exchange date.

Implications

The proposed regulations would eliminate the deferral dement of the private-annuity-trust strategy. In other words, in the prototypical transaction described above, the parent/seller would have to recognize gain in the year of the transaction, as opposed to spreading it out over his or her life. Unfortunately, the seller would not receive any cash above and beyond the annuity payment. While the trust-involved transactions have certainly been affected by these proposed regulations, traditional unsecured private annuities done for estate and succession planning purposes, such as an older parent's sale of a business to his or her child (or other individual) in exchange for an annuity, are hopefully still sound. Charitable gift annuities remain unaffected.

FROM CHARLES RATNER, J.D., CLU, CHFC, CLEVELAND, OH