ALERT: Tax. Background

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1 ALERT: Tax December 2006 Death of Private Annuities? The IRS and Treasury Department Issue Proposed Regulations on the Taxation of Certain Private Annuity Transactions* The new PA regulations, however, apply only to a limited group of private annuity transactions, and many arrangements remain unaffected, such as private annuity transactions involving grantor trusts. On October 17, 2006, the IRS and the Treasury Department issued proposed regulations that dramatically modify the taxation of certain private annuity transactions (the PA regulations ). These changes effectively eliminate the income tax deferral benefits of the regulated transactions and impact their usefulness as a tax deferral strategy. The new PA regulations, however, apply only to a limited group of private annuity transactions, and many arrangements remain unaffected, such as private annuity transactions involving grantor trusts. Background Private Annuities Defined. In general, a private annuity involves an agreement between two parties where one party (the transferor ) transfers ownership of appreciated property to a transferee (the obligor ) in exchange for the obligor's unsecured promise to make fixed, periodic payments to the transferor, typically for the transferor s life. A variation of this structure is the private annuity trust, where the transferor establishes an irrevocable, non-grantor trust and funds it with a minimal amount of seed money. The transferor sells appreciated property to the trust in exchange for a private annuity with a current fair market value ( FMV ) equal to that of transferred property. The trust then sells the property, at its FMV, to a third party. Since the trust s basis in the property is its FMV, the trust recognizes little or no gain on the sale. The trust invests the sale proceeds in assets that produce an income stream sufficient to support the trust s annuity payments. Income Taxation. Prior to the PA regulations, Revenue Rulings and governed the income taxation of private annuities. Rev. Rul outlines how the obligor in a private annuity transaction determines the basis of the property received in the exchange. In general, the obligor s basis in the property equals the total annuity payments made to the transferor up to the date of the transferor s death, or, if the obligor disposed of the property prior to the transferor s death, then the basis equals the total annuity payments made to the transferor up to the disposition date, plus the value of any prospective payments GREENBERG TRAURIG, LLP ATTORNEYS AT LAW

2 remaining as of the disposition date (determined under the life expectancy tables then designated by the Code). Rev. Rul complements Rev. Rul by discussing the tax consequences to the transferor upon receipt of each annuity payment. In general, Rev. Rul provides that the transferor realizes gain on the transferred property equal to the FMV of the annuity, (determined under the 7520 tables), less the transferor s adjusted basis in the property (i.e., the transferor s investment in the property, or his/her cost). The nature of the gain realized (either ordinary income or capital gain) depends on the type of property transferred. The transferor recognizes this gain ratably over his or her life expectancy, dividing and reporting each annuity payment received into three parts: 1. a tax-free recovery of basis (i.e., the transferor's adjusted basis in the property divided by his or her life expectancy); 2. capital gain (the capital gain realized on the sale (if any) divided by the transferor s life expectancy); and 3. the remainder as ordinary income. Under the Rev. Rul , the above tax treatment applies only if the annuity is unsecured, and the obligor under the annuity does not routinely issue or sell annuity contracts. Benefits. Based on the above, the major benefits of a private annuity transaction included the following: Deferring income tax on the transferor s gain over his or her life expectancy; Potentially transferring income producing property to a family member in a lower tax bracket, with the transferor receiving partially excludable annuity income. Removing estate assets and shifting future appreciation to family members. Diversifying family assets with little or no current gain recognition. Reasons for Change. In recent years, several tax planning firms have massmarketed private annuity strategies, causing both the popularity of these strategies and the IRS scrutiny of them to increase. In reviewing these transactions, the IRS determined that taxpayers were manipulating the tax treatment of private annuities in an abusive manner. Specifically, in the preamble to the PA regulations, the IRS stated that some taxpayers were inappropriately avoiding or deferring gain on the exchange of highly appreciated Page 2

3 property for the issuance of annuity contracts, by using intra-family transactions involving a variety of mechanisms to secure the annuity contract payments and assure control of the PAT by the annuitant or a related family member. In News Release IR , the IRS stated that Rev. Rul was outdated, because it was based, in part, on the incorrect assumption that the value of a private annuity contract could not be determined for federal income tax purposes.... The ruling has its roots in authorities that applied the open transaction doctrine, which has been eroded in recent years. Furthermore, the IRS stated that developments since the issuance of the above revenue rulings in connection with the treatment and valuation of payments made over time indicated that private annuities did not require special tax treatment. In News Release IR , the IRS stated that Rev. Rul was outdated, because it was based, in part, on the incorrect assumption that the value of a private annuity contract could not be determined for federal income tax purposes.... The ruling has its roots in authorities that applied the open transaction doctrine, which has been eroded in recent years. Proposed Regulations. In order to eliminate the perceived abuses and to update the tax rules applicable to private annuities, the IRS issued proposed regulations (j) and (e). These regulations generally provide that a private annuity transaction will be treated as follows: 1. Amount Realized: The amount realized attributable to the annuity contract is the contract s FMV (determined under 7520) at the time of the exchange. 2. Gain/Loss Recognition: The entire amount of gain or loss on the exchange is recognized at the time of the exchange, regardless of the taxpayer s method of accounting. 3. Initial Investment in Contract: For purposes of determining the initial investment in the annuity contract under 72(c)(1), the aggregate amount of premiums or other consideration paid for the annuity contract equals the amount realized attributable to the annuity contract (the FMV of the annuity contract). Tax Consequences. According to the preamble, 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 bottom line is that the transferor can no longer defer the recognition of gain by using a private annuity transaction. Furthermore, since the transferor recognizes all the gain in the year of the transaction, each annuity payment received will only consist of two parts a return of basis and ordinary income. Note that the PA regulations do not affect the tax-free exchanges of annuity contracts under 1035 or charitable gift annuities under Treas. Reg Effective Dates. The PA regulations apply only to exchanges taking place after the designated effective date, not for payments received from a private annuity Page 3

4 transaction that took place before then. There are two effective dates for the PA regulations: 1. October 18, 2006 for all exchanges that do not meet the requirements below; 2. April 17, 2007 for transactions that meet all the following requirements: a. the issuer of the annuity contract is an individual; b. the obligations under the annuity contract are not secured, either directly or indirectly; and c. the property transferred in the exchange is not subsequently sold or otherwise disposed of by the obligor during the two-year period beginning on the date of the exchange (including any transfer to a grantor trust, revocable trust or any entity solely owned by the transferor). The preamble to the PA regulations indicates that the purpose of the later effective date is to provide adequate notification of the proposed rules for taxpayers currently planning transactions that present the least opportunity for abuse. Arrangements Unaffected by Regulations. The PA regulations do not apply to private annuity transactions involving trusts taxed as grantor trusts under the Code, since any transaction between a grantor and a grantor trust is essentially ignored for Federal income tax purposes. Thus, private annuity transactions involving grantor trusts are neutral for income tax purposes and continue to be viable estate tax planning alternatives. The PA regulations also do not affect tax-free exchanges of annuity contracts under Finally, exchanges of property that are structured as installment sales under 453 or that constitute a bargain sale to a charitable organization under Treas. Reg (c) remain unaffected by the PA regulations. The Treasury Department and the IRS, however, request comments as to when, if ever, an exchange of property for an annuity contract should be treated as an installment sale, and whether changes should be made to the bargain sale treatment of exchanges to charitable organizations. Implications. Although the PA regulations affect the income tax treatment of certain private annuity transactions going forward, taxpayers who completed such transactions prior to October 18, 2006 can continue to rely on the old rules to defer their gain. However, these taxpayers should have their transactions reviewed by competent tax counsel in order to ensure that (1) the transaction complies with the pre-existing requirements of the Code and remains financially viable, (2) the agreement and its terms are properly documented, (3) the parties Page 4

5 fully understand the administration of the transaction and any potential adverse tax consequences (4) the parties have adhered closely to the terms of the agreement and (5) the annuity payments have been made as required. Taxpayers should seek assistance in modifying private annuity transactions that do not comply with existing requirements or that are in financial trouble. If the transaction cannot be saved, then the taxpayer, with the advice of competent counsel, should implement an appropriate exit strategy. Given the heightened IRS scrutiny of many private annuity transactions, the difficulty of administering the transactions properly, and the complex income tax benefit analysis required to determine their viability, advisors and taxpayers may want to focus on other, more traditional tax deferral and wealth transfer strategies, such as 1031 exchanges, charitable remainder trusts, and installment sales to trusts. These techniques provide viable planning options for many taxpayers whose circumstances may have suggested the use of certain types of private annuity transactions. Also, as noted above, the PA regulations do not impact private annuity transactions involving grantor trusts, which, if properly structured, can produce significant estate tax benefits. Thus, such transactions continue to provide advisors with a practical estate planning strategy. *Cites: REG Exchanges of Property for an Annuity, Internal Revenue Service, Treasury, Notice of proposed rulemaking and notice of public hearing; Preamble to Prop. Regs. 10/18/2006. Fed. Reg. Vol. 71, No. 201, p , Treas. Regs , ; Rev. Rul , CB 352; Rev. Rul , CB 43; Treasury and IRS Update Rules on Exchanges for Annuities, IR , Oct. 17, 2006; Jerome M. Hesch, Esq., Intra-Family Sales Using Private Annuities: The House Wins, 30 Tax Mgmt. Est., Gifts & Tr. J. 81, (January 13, 2005); Steve Leimberg s Estate Planning Newsletter #1036 (October 17, 2006) at RIA Newsstand 10/18/06; Stephan R. Leimberg and Leo C. Hodges, The Income Tax and Estate Planning Advantages of Private Annuities, Estate Planning Journal, Vol. 33, No. 2, February 2006; Stephan R. Leimberg and Leo C. Hodges, Maximizing the Planning Opportunities of Private Annuities, Estate Planning Journal, Vol. 33, No. 3, March 2006; Kevin J. McGrath, Private Annuity Trusts -- The Numbers Don't Support the Hype, Tax Notes, Vol. 109, No. 1, October 3, 2005; Edward K. Zollars, Take That, Private Annuities IRS Issues Proposed Regulations, Text of Podcast at October 21, All section references are to sections of the Internal Revenue Code of 1986, as amended. Page 5

6 This Alert was written by Jonathan M. Forster, Rebecca S. Manicone and Jennifer M. Smith in the Tysons Corner office. Please contact Mr. Forster at (703) , Ms. Manicone at (703) , Ms. Smith at (703) or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this GT Alert. Albany Amsterdam Atlanta Boca Raton Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Philadelphia Phoenix Sacramento Silicon Valley Tallahassee Tampa Tokyo Tysons Corner Washington, D.C West Palm Beach Zurich This Greenberg Traurig ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Page 6

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