Big Changes for Private Annuities

The article examines the IRS' recent issuance of proposed regulations cracking down on Private Annuity Trusts used for income tax avoidance. The article looks at why PATs are still a viable tool in estate planning.

  For years the IRS has been attacking the use of Private Annuity Trusts, or PATs   as a means of deferring income taxation on the sale of appreciated property.   Our office has followed the advice of the American Academy of Estate Planning   Attorneys and other commentators in advising our clients to stay away from such   transactions unless they were willing to subject the transaction to the close   scrutiny of the IRS.

One example of the many IRS attacks on PATs is Melnik v. Commissioner,   T.C. Memo 2006-25, in which the Tax Court disregarded a deferred private annuity   for income tax purposes in what should have been a run of the mill bad facts   case. However, in disregarding the transaction the Tax Court interjected the   economic substance doctrine into private annuity sales in a problematic way,   clarified its negative view towards private annuity sales to trusts, and set   forth several “don’ts” that would apply to any taxpayer seeking   to defer income tax through private annuity sales, especially through the so-called   “Private Annuity Trust.”

We will not get into those “don’ts” in this Alert, because   on October 17, 2006, the IRS issued Proposed Reg-141901-05. The Proposed Treasury   Regulation will drastically change the tax treatment of an exchange of property   for an private or commercial annuity contract under Internal Revenue Code Sections   72 and 1001 and will put an end to the claims of income tax deferral using such   transactions.

The IRS states that the doctrine that taxpayers have relied on for tax deferred   treatment of the exchange of appreciated property for a PAT is no longer correct.   According to the IRS, the “open transaction doctrine” (the assumption   that the value of a private annuity contract could not be determined for federal   income tax purposes) “has been eroded in recent years.” The IRS   is very much aware that the concept has been abused in a number of transactions   that are designed to avoid income tax. According to the Service, “Many   of these transactions involve private annuity contracts issued by family members   or by business entities that are owned, directly or indirectly, by the annuitants   themselves or by their family members. Many of these transactions involve a   variety of mechanisms to secure the payment of amounts due under the annuity   contracts.”

The proposed regulations declare Revenue Ruling 69-74, the ruling upon which   the proponents of PATs rely, obsolete. The proposed regulations will generally   be effective for exchanges of property for an annuity contract after October   18, 2006. Thus, the proposed regulations would not apply to amounts received   after October 18, 2006 under annuity contracts that were received in exchange   for property before that date.

For a limited class of transactions, the effective date will be for exchanges   of property for an annuity contract after April 18, 2007. These would be transactions   in which:

1. the issuer of the annuity contract is an individual;
2. the obligations under the annuity contract are not secured, either directly     or indirectly; and
3. the property transferred in the exchange is not subsequently sold or otherwise     disposed of by the transferee during the two-year period beginning on the     date of the exchange.

The proposed regulations 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 effect of these proposed regulations is to treat the transferor as having   realized an amount equal to the fair market value of the PAT, determined under   Internal Revenue Code § 7520 (this provides the actuarial tables which   must be used to compute the present value of an annuity). The proposed regulations   do not distinguish between a PAT and a commercial annuity sold by an insurance   company. So if a PAT or a commercial annuity contract is received by the seller   in exchange for property (other than cash), the entire amount of the seller’s   gain or loss (if any) must be recognized at the time of the exchange.

The proposed regulations do not alter the existing rules governing tax-free   exchanges of annuity contracts under Internal Revenue Code § 1035. They   ONLY address taxable exchanges of other property for an annuity, either private   or commercial.

While proposed regulations will likely put an end to the use of PATs for income   tax planning purposes, the private annuity remains a very viable estate planning   strategy for use in circumstances when a person with a taxable estate (more   than $2 million in 2006) is not expected to live his or her life expectancy   as determined under IRS guidelines, but they are not classified as terminally   ill. A person is not considered to be terminal by the IRS if he or she has at   least a fifty percent chance of living one year.

Contact us at our office to schedule an appointment with one of our estate   planning attorneys to learn more about the use of private annuities, self-canceling   installment notes (SCINs), and other advanced estate planning strategies if   you have any clients with taxable estates.