PRIVATE ANNUITY LEGAL PACKAGE

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1 PRIVATE ANNUITY LEGAL PACKAGE IRS Revenue Rulings Plus Third Party and NAFEP Research Material on The Legality of Private Annuities TM The National Association of Financial and Estate Planning 2001 & 2002, NAFEP (Contains Some NAFEP Copyrighted Material), Revision 3

2 TABLE OF CONTENTS SUBJECT PAGE NO. RIA Research Information 42,913. What is a private annuity? 1 42,912. Taxation of payments under private annuities 2 42,914. Taxation of private annuity payments. 2 42,915. Determining the investment in the private annuity 4 42,916. Investment in a private annuity (w/partial gift amount) 5 42,917. Timing of recognition of gain on the transfer (to private annuity) 5 42,918. Taxation of secured private annuities 6 42,923. Whether the private annuity or installment rules apply 6 Revenue Rulings NAFEP Research Information IRS Affirmation of Private Annuities and Their Deferral 12 Excerpts and Review of IRS Memo GCM of 5/19/86 12 Is it Legal For Trusts to Issue Private Annuity Contracts? 13 Legal Cites for PATs 14 Comparison With Other Annuity Trusts 14 Correct Structure 15

3 Private Annuity Legal Pack Page 1 NOTE: The following commentary and tax opinion on private annuities was written by RIA, the world s largest tax research and information provider. This information was reprinted from RIA s on-line Checkpoint tax and estate planning research system. For more information on RIA, see the below info*, or go to * RIA is a unit of Thomson Tax & Accounting, which is a division of The Thomson Corporation The Thomson Corporation is a leading global e-information and solutions company serving the business and professional marketplace. With $US 2.3 billion in 1999 revenues and over 14,000 employees, Thomson Legal & Regulatory has strong market positions in North America, Europe and Asia-Pacific. RIA was formed with the joining of Research Institute of America (RIA), Computer Language Research (CLR) and Warren, Gorham & Lamont (WG&L). This combined organization brings together great companies with complementary strengths in tax research, tax information and software services. RIA's authors and editors are some of the most respected authorities in the field. From RIA's Federal Tax Coordinator to its CD-ROM service, OnPoint System, to Checkpoint, the first Web-based research and compliance service, RIA has delivered expert research, analysis and practical guidance to tax professionals. RIA is now the world's largest provider of comprehensive and easyto-use solutions to the most complex and challenging tax research, information and compliance questions. RIA is also the only singlesource provider which its clients can turn to for such a wide range of productivity solutions. 42,913. What is a private annuity. A private annuity typically involves the transfer of property to a transferee who promises to make periodic payments to the transferor for the remaining life of the transferor. Or the transferee may agree to make periodic payments until a specific monetary amount is reached or until the transferor's death, whichever occurs first. Private annuity arrangements are often used for intra- family transfers, where an older family member transfers appreciated property to a younger family member. 4 Where property is transferred, or a right to property is surrendered, in exchange for payments for life, the transferor usually is treated as if he had bought an annuity. 5 A private annuity differs from a commercial annuity issued by an insurance company in several respects: (1) In a private annuity, an individual typically transfers property (often appreciated property), rather than cash, in return for the annuity. (2) In an unsecured private annuity where a family member, a corporation or business controlled by the family, or an unrelated purchaser, promises to make the annuity payments, the risk that the promisor will be unable to make the payments throughout the annuitant's life is likely to be greater than in the case of a commercial annuity issued by an insurance company, which is subject to governmental supervision and regulation. (3) The value of the property transferred in a private annuity transaction may not be the same as the value of the annuity received. Private arrangements which may be annuity contracts include transfers of property to members of taxpayer's family, or to a corporation or business controlled by the family, or to an unrelated purchaser in return for a life income, see 42,914 et seq. A transfer made to a charity, or an individual not a family member, also may be treated as a private annuity. 6 For private annuity treatment of transfers of money or property to schools, hospitals, churches, or other eleemosynary institutions in return for life payments, see 42,926 et seq. Settlement of a will contest or other estate distribution difficulties by acceptance of a life income from the estate, heirs or legatees, or renunciation of a legacy in exchange for life payments also involve private annuity issues, see 42,929 et seq. For the treatment of a transaction where a private annuity isn't secured, see 42,914. For the rules that apply to secured private annuities, see 42,918. For whether a transaction is treated as a private annuity or an installment sale, see 42,923. For situations in which a transaction for lifetime payments is treated as other than the purchase of an annuity, see 42,922 and 42,925. Footnotes This Section: 4 GCM Ware, Mary v. Com., (1947, CA5) 35 AFTR 809, 159 F2d 542, 47-1 USTC 9142, affg (1946) PH TCM 46208, 5 CCH TCM 749 ; Steinbach Kresge Co, (1940, DC NJ) 25 AFTR 533, 33 F Supp 897, 40-2 USTC 9682 ; Gillespie, F., (1938) 38 BTA 673, acq ; Steenburg, Edmund, BTA Memo (1941) 43 BTA Ware, Mary v. Com., (1947, CA5) 35 AFTR 809, 159 F2d 542, 47-1 USTC 9142, affg (1946) PH TCM 46208, 5 CCH TCM 749.

4 Private Annuity Legal Pack Page 2 42,912. Taxation of payments under private annuities. Gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract. 1 Any contract that is considered to be a life insurance, endowment, or annuity contract in accordance with customary practice of life insurance companies is taxed under Code Sec. 72 as an annuity contract. It is immaterial whether the contract is entered into with an insurance company. 2 The transfer of property in exchange for a private annuity (see 42,913 ) is not a taxable transaction, see 42,917 (although it may be if the amount of the annuity payments have a determinable value, see 42,918 et seq.). Thus, a taxpayer who exchanges appreciated property for a private annuity can defer the gain that would have been taxed had he either sold the property, or exchanged it for a commercial annuity. The tax treatment of payments under a private annuity contract corresponds to that of a commercial contract. 3 Thus, for the taxation of amounts received as an annuity, see 42,801 et seq. Where a taxpayer transfers appreciated property to a member of the taxpayer's family, a corporation or business controlled by the family, or to an unrelated purchaser in return for a lifetime annuity, the total amount transferred may be a combination of: (1) a gift, see 42,914, and (2) value given in return for the annuity, see 42,914, while the total amount received by the transferor may consist of: (3) gain on the transfer of the property (i.e., to the extent the value of the annuity payments to be received, exceeds the transferor's basis in the property transferred), see 42,917, and (4) annuity income and a return of basis in the annuity, see 42,914. RIA illustration: T transfers property with a fair market value of $300,000 to a corporation owned by T's family, in return for annuity payments for the remainder of T's life. T's basis in the property transferred is $100,000. The present value of the annuity payments to T is $200,000. The taxation of T's private annuity involves the following issues: (1) the timing of T's gain regarding the property ($300,000 $100,000); (2) the portion of the $300,000 (if any) that is a gift; and (3) the amount of T's investment in the annuity contract (i.e., whether the investment in the contract is: (a) the $300,000 given for the annuity, (b) the $200,000 fair market value of what was given for the annuity, or (c) the $100,000 of T's basis in the property given for the annuity). For the timing of the recognition of gain on property given in return for an unsecured annuity, see 42,917. For the timing of gain recognition where the private annuity is secured, see 42,918. Footnotes This Section: 1 Code Sec. 72(a). 2 Reg (a)(1). 3 Code Sec. 72(a). 42,914. Taxation of private annuity payments. The payments under a private annuity (e.g., one received in exchange for the transfer of property) are taxed to the transferor under the annuity rule as they are received. A portion of the payments under the private annuity thus represents that gain, while the balance is regular annuity income. 7 A taxpayer who exchanges appreciated property for an unsecured lifetime private annuity is taxed as follows: 8 A transfer of property for a private annuity is treated as a combination of: (1) a gift (if the value of the property given for the annuity was not given in an arm's-length transaction and the value of the annuity received is less than the value of the property given), (2) gain (if the value of the property given for the annuity, reduced by the amount of the gift, is greater than the transferor's basis in the property), (3) annuity income, and (4) a return of basis in the property transferred: (1) If the transfer is not an ordinary business transaction, it is treated as an immediate gift, to the extent that the value of the property exceeds the present value of the annuity. (2) The transferor has gain to the extent that (a) the amount realized (i.e., where the transfer was not an arm'slength transaction, the present value of the annuity, computed under the IRS estate and gift tax tables, see Appendix to P ), exceeds (b) the transferor's adjusted basis in the transferred property. This gain is included ratably over the transferor-annuitant's lifetime, as he receives payments under the annuity. If the property was a capital asset, the transferor has capital gain (see 42,917 ).

5 Private Annuity Legal Pack Page 3 (3) Amounts received under the annuity that represent annuity payments also are included ratably under the regular annuity rules. The exclusion ratio used to determine the excludable portion of the payments is computed by dividing the total amount expected to be received under the annuity, by taxpayer's basis in the transferred property (i.e., his investment in the contract, see 42,915 ). Payments received after the investment in the contract has been recovered are fully includible in gross income as ordinary annuity income if the annuity starting date is after Dec. 31, '86. For annuities with an annuity starting date before Jan. 1, '87, annuity payments were partially excludable (based on the exclusion ratio) even after the total investment was recovered tax-free. Illustration: W (age 74) transfers property with a fair market value of $60,000 to his son, in exchange for lifetime payments of $7,200 per year. Assume that this transaction occurs after Dec. 31, '86, so that the annuity starting date of the private annuity is after Dec. 31, '86. W's basis in the property is $20,000. Assume that the present value of the private annuity, based on IRS tables, is $47, W is considered to have made a $12, gift ($60,000 property fair market value, minus $47, annuity present value) to his son. He realizes $27, gain ($47, annuity present value, minus $20,000 basis). The computation and application of the exclusion ratio, the gain, and the ordinary annuity income is as follows: $72,720 expected return (annual proceeds multiplied by 10.1, the life expectancy). $20,000 (investment in the contract) divided by $72,720 (expected return) results in an exclusion ratio of 27.5%. (a) Annual proceeds, $7,200. (b) Exclusion (27.5 percent of $7,200), $1,980. (c) Capital gain income ($27,713.08) divided by 10.1 years (the life expectancy), $2, (d) Ordinary annuity income: (a), minus the total of (b) plus (c), $2, Because the annuity starting date is after Dec. 31, '86, the exclusion ratio of 27.5% applies only until the investment in the contract ($20,000) has been recovered tax-free. 9 Where the basis of the property exceeds the present value of the annuity, the annuitant's investment in the contract used to determine the exclusion ratio is limited to the present value of the annuity on the date of the exchange, see 42,915. Thus, where taxpayer transferred assets having a fair market value of $335,000 (in which her basis was $320,000) to an irrevocable trust, which she created in exchange for the payment to her by the trust of a private annuity of $16,502 yearly for her life (present value $176,990), the exclusion ratio was 52.8%. This was computed by dividing the $176,990 investment in the contract by the expected return of $335,000 ($16,502 annual payments 20.3 year life expectancy). Accordingly, $8,713 (52.8% of $16,502) of each year's payment was excludable from the taxpayer's gross income, and the remaining $7,779 was includible in her gross income. The amount by which the value of the transferred assets exceeded the present value of the annuity was a gift. 10 When the annuitant dies before recovering his entire investment in a commercial annuity tax-free, the amount of unrecovered investment can be deducted on his final income tax return. In Rev Rul (footnote 9), for purposes of determining the present value of the annuity, the IRS used Table I, then in effect, in its example. For the taxation of secured private annuities, see 42,918. Footnotes This Section: 7 Rev. Rul , CB Rev. Rul , CB Rev. Rul , CB LaFargue, Esther v. Com., (1986, CA9) 58 AFTR 2d , 800 F2d 936, 86-2 USTC 9715, affg (1985) TC Memo , PH TCM 85090, 49 CCH TCM 839. If the investment in the contract were the lesser of: (a) the fair market value of the property given for the annuity, and (b) the present value of the annuity, under the Tax Court's approach (see 42,915 ), the exclusion ratio in the above Illustration would have been $47, $72,720.

6 Private Annuity Legal Pack Page 4 42,915. Determining the investment in the contract for a private annuity. IRS has said that, in a private annuity transaction involving a transfer of appreciated property for an unsecured life annuity promise, the annuitant's investment in the contract for determining the exclusion ratio is his basis in the property transferred. 11 Illustration: V transfers property with a fair market value of $60,000 to her child, in return for an annuity for the remainder of V's life. V's basis in the property transferred is $20,000. (Assume that the present value of the annuity is greater than $20,000.) In determining the exclusion ratio to find the excludable portion of each payment V receives, under IRS's approach, V's investment in the contract is $20, Unlike IRS, the Tax Court has indicated that, in a private annuity transaction, the annuitant's investment in the contract for determining the exclusion ratio is the fair market value of the property transferred rather than his basis in the property transferred. 13 Under the Tax Court's approach, although the exclusion ratio may be larger, since the fair market value of the property transferred is used as the investment in the contract, the transferor of the property would have a gain: the amount realized less the transferor's basis in the property transferred. For when the gain on the transfer of property in exchange for an unsecured annuity is includible in the transferor's income, see 42,917. For taxation of the gain on the transfer of property in exchange for a secured annuity, see 42,918. RIA illustration: V transfers property with a fair market value of $60,000 to her child, in return for an annuity for the remainder of V's life. V's basis in the property transferred is $20,000. (Assume that the present value of the annuity is greater than $20,000.) In determining the exclusion ratio to find the excludable portion of each payment V receives, under the Tax Court's approach, V's investment in the contract is $60,000. V also has a gain on the transfer in the amount of $40,000 ($60,000 $20,000). Where private annuity payments are secured (see 42,918 ), the Tax Court has held that the investment in the contract is the fair market value of the property transferred for the annuity (or the present value of the annuity, if less, and the transaction was not at arm's length, see below). Taxpayers' basis in stock transferred for an annuity was $21,000, and its value on the date of transfer was $208,000. The present value of the annuity was $126,000 (as measured by the IRS gift and estate tax valuation tables). IRS argued that the taxpayers' investment in the annuity which they could recover taxfree was only $21,000, the cost basis of the stock transferred under the rules of Rev Rul ( 42,914 ) for private annuities. Taxpayers argued that their investment in the contract was the market value of their stock (under the rules of Rev Rul 239, 42,921, which applied under the '39 Code). The Tax Court found that because both Rev Rul and Rev Rul 239 involved unsecured private annuities neither applied. Instead, the investment in the contract was $126, Although the Tax Court used the fair market value of the property transferred as the investment in the contract in cases that involved secured private annuities (i.e., Bell and212 Corp, see 42,918 ), it indicated in 212 Corp that this was its approach regardless of whether the private annuity was secured. It would seem that whether an annuity is secured should not determine the investment in the contract. IRS's use of basis rather than the fair market value of the property transferred to determine cost reflects the gift aspect of these transfers. For determining the investment in the contract where property is exchanged at least in part as a gift, and partly for a private annuity, see 42,916. Footnotes This Section: 11 Rev. Rul , CB Rev. Rul , CB Corp, (1978) 70 TC Bell, Lloyd Est, (1973) 60 TC 469.

7 Private Annuity Legal Pack Page 5 42,916. Investment in the contract in a private annuity where the transfer is intended (at least in part) as a gift. Both IRS 15 and the Tax Court have held that, where the basis of the property transferred in exchange for a private annuity exceeds the present value of the annuity, and the parties were not dealing at arm's length, 16 the annuitant's investment in the contract is limited to the present value of the annuity. 17 Thus, if a transferor intended any part of the transfer to be a gift, he can't include that gift portion (of the property) in the cost of the annuity. 18 Where taxpayer transferred securities with a market value of $371,875 to a trust created by her, in exchange for an annuity with a present value of $177,500, the Tax Court held that her investment in the annuity contract was $177,500 and the excess of $371,875 over $177,500 was a gift to the beneficiaries of the trust. 19 Some evidence of a gift must be present for any amount to be excluded as a gift from the cost of the private annuity. The fact that the value of the property exceeds the present value of the annuity is not conclusive evidence of a partial gift. 20 Some evidence of a gift may appear if the taxpayer filed a gift tax return for the excess value. 21 Evidence of the intent to make a gift appeared from the fact that a transferee was a charity and the transferor was a wealthy person who was not interested solely in buying an annuity, which he could have acquired at substantially less cost from an insurance company. 22 The discount factor in taxpayer's investment in the contract wasn't affected by an agreement in the trust instrument requiring that the interest factor not be used in computing the present value of the annuity. Also, the fact that the right to receive the payments might be modified in a later year, or that the contract itself might be rescinded, didn't affect the amount of investment in the contract. 23 Similarly, a provision in the contract that allocates the first ten years of payment to principal cannot bar the taxability of the payments. 24 Where a husband and wife transferred securities worth one and one-half million dollars to a family corporation in exchange for annuities worth less than a half million, tax on the husband's share of the annuity was based on the value of the property (making the payments taxable in full) because the only proof of a gift was the excessive cost. 25 Tax on the wife's annuity, on the other hand, was based on what her annuity would have cost if bought from an insurance company. The reason for the different result was that there was evidence in the wife's case that she intended part of the stock to be for the benefit of children and grandchildren who then controlled the corporation. 26 Footnotes For This Section: 15 Rev. Rul , CB Corp, (1978) 70 TC LaFargue, Esther v. Com., (1986, CA9) 58 AFTR 2d , 800 F2d 936, 86-2 USTC 9715, affg (1985) TC Memo , PH TCM 85090, 49 CCH TCM 839 ; Benson, Marion, (1983) 80 TC Raymond, Anna, (1939) 40 BTA 244, acq, affd (1940, CA7) 25 AFTR 583, 114 F2d 140, 40-2 USTC 9540, cert den (1940, S Ct) 311 US 710, 85 L Ed 462 ; Kann, Bertha Est, (1947) PH TCM 47226, 6 CCH TCM 913, affd (1949, CA3) 37 AFTR 1434, 174 F2d 357, 49-1 USTC 9271 ; Gillespie, Maud v. Com., (1942, CA9) 29 AFTR 480, 128 F2d 140, 42-1 USTC Benson, Marion, (1983) 80 TC Raymond, Anna, (1939) 40 BTA 244, acq, affd (1940, CA7) 25 AFTR 583, 114 F2d 140, 40-2 USTC 9540, cert den (1940, S Ct) 311 US 710, 85 L Ed 462 ; Trottman, Nelson, (1944) PH TCM 44112, 3 CCH TCM 316 ; Mack, Gordon, (1944) 3 TC 390, affd (1945, CA3) 33 AFTR 876, 148 F2d 62, 45-1 USTC 9201, cert den (1945, S Ct) 326 US 719, 90 L Ed 425 ; Gillespie, F. A, (1938) 38 BTA 673, acq. 21 Steenburg, Edmund, (1941) PH BTA Memo Raymond, Anna, (1939) 40 BTA 244, affd (1940, CA7) 25 AFTR 583, 114 F2d 140, 40-2 USTC 9540, cert den (1940, S Ct) 311 US 710, 85 L Ed Benson, Marion, (1983) 80 TC LaFargue, Esther, (1985) TC Memo , PH TCM 85090, 49 CCH TCM Gillespie, F. A., (1938) 38 BTA 673, acq. 26 Gillespie, Maud, (1941) 43 BTA 399, revd on other issue (1942, CA9) 29 AFTR 480, 128 F2d 140, 42-1 USTC ,917. Timing of the recognition of gain on the transfer of property for an unsecured private annuity. The transfer of property in exchange for an unsecured private annuity is not a taxable transaction. Thus, a taxpayer who turns his property over to a member of his family or other private individual, or to his own corporation or other corporation, which is not a life insurance company or a bank or an organization which issues annuities from time to time, in exchange for payments for life, has no immediate taxable gain. The actual transfer isn't taxable because the promise to make the lifetime payments is considered to have no determinable value. It makes no difference if the obligor under the private annuity arrangement (i.e., the

8 Private Annuity Legal Pack Page 6 transferee) is financially sound at the time of the transfer, since that private transferee is not in the business of granting annuities, his solvency is not subject to the supervision and restrictions of insurance companies and banks, and may change over the payment period. 27 The Claims Court rejected private annuitants' argument that, because of the uncertainty as to how long they would live, and because the obligation to pay their lifetime annuity was unsecured, the amount they would realize from the transaction was uncertain and should be treated as an open transaction (i.e., no gain should be recognized until an annuitant recovered the basis in his property). The Claims Court found that, under the Code, the receipt of the first annuity payment is an event requiring a valuation of the stream of proceeds from the annuity. The law requires an effort wherever possible to separate the gain on the exchange of property for a contract and the ordinary gain from the contract. Code Sec. 72 provides for this separation by excluding from taxation the portion of each receipt that is attributable to the consideration paid for the annuity. 28 Although gain is not taxable immediately, the amount of the gain must be reported ratably over the period of the annuitant's life expectancy, but only from that portion of the annual proceeds which is includible in income under the annuity rules (see 42,914 ) 29 For the timing of the recognition of gain on the transfer of property for a private annuity under which the amount of payments is not uncertain, as when the annuity is secured or the payments are to be made over a term certain, see 42,918 et seq. Private annuities were considered unsecured, so gain was taxed ratably, where: (1) taxpayer transferred stock to two foreign situs trusts in exchange for lifetime private annuities, (2) taxpayer controlled the trusts and the trustee (e.g., taxpayer could have replaced an uncooperative trustee and could have depleted trust assets), and (3) there were no restrictions regarding the disposition of the stock. 30 Where a taxpayer transfers property to a church, school or other organization, corporation, trust, fund or foundation (other than a commercial insurance company) which from time to time issues annuity contracts, so that the transaction approximates the purchase of a commercial annuity, the taxpayer does have taxable gain to the extent that the value of the annuity exceeds his basis in the transferred property. 31 If a taxpayer sells his property and uses the proceeds to buy an annuity, he is immediately taxable on any excess of the proceeds over his basis for the property. He is also taxed on his gain if he turns the property over directly to an insurance company in exchange for an annuity contract. For the taxation of the annuity payments, see 42,914 et seq. Footnotes This Section: 27 Lloyd, Darsie, (1936) 33 BTA 903, acq ; Deering, Frank, (1939) 40 BTA 984 ; Hommel, Bella, (1946) 7 TC 992, acq ; Kann, Bertha Est, (1947) PH TCM 47226, 6 CCH TCM 913, affd (1949, CA3) 37 AFTR 1434, 174 F2d 357, 49-1 USTC Garvey Inc, (1983, Cl Ct) 51 AFTR 2d , 1 Cl Ct 108, 83-1 USTC 9163, affd (1984, CA Fed Cir) 53 AFTR 2d , 726 F2d 1569, 84-1 USTC 9214, cert den (1984, S Ct) 469 US 823, 83 L Ed 2d Rev. Rul , CB Stern, Sidney, (1992) TC Memo , RIA TC Memo 92374, 64 CCH TCM Rev. Rul , CB ,918. Taxation of secured private annuities. The Tax Court holds that the private annuity rules apply only to unsecured private annuities. If a private annuity is secured, any gain on the transfer of property for the secured private annuity is recognized immediately. An annuity is secured if, for example, the property that is transferred also is used as collateral for the payments. 32 Footnotes This Section: 32 Bell, Lloyd Est, (1973) 60 TC ,923. Whether the private annuity or installment sale rules apply. Although a typical private annuity transaction would appear to fit within the definition of an installment sale under the Code Sec. 453 installment sale rules, where a taxpayer transfers property in a private annuity transaction in exchange for an unsecured contractual right to receive payments for the remainder of his life, the tax treatment of the periodic payments received is governed by the Code Sec. 72 annuity rules (as modified for private annuities) rather than by the Code Sec. 453 installment sale rules. 47 The Claims Court rejected the position that a private annuity (taxpayer's promise to make periodic payments of money to his father in exchange for his father's transfer of stock to him) was an installment sale within the meaning

9 Private Annuity Legal Pack Page 7 of Code Sec. 453(b)(1), and therefore that Code Sec. 72, rather than Code Sec. 453, controlled the tax consequences of the transaction. The court concluded that Code Sec. 72, and not Code Sec. 453, governs the tax consequences of a private annuity agreement since the rules of statutory construction provide that a general statute (here, Code Sec. 453 ) does not supersede a previously enacted specific statute (here, Code Sec. 72 ) to the extent that they overlap. 48 Where the stream of payments to which the transferor of property is entitled will continue until a specific monetary amount is reached or until his death (whichever occurs first), the transaction also will be characterized as a private annuity and payments received will be taxed under the Code Sec. 72 annuity rules for a private annuity. However, when the transaction is structured so that there's a stated maximum payout that will be reached in a period of time less than the transferor's life expectancy (as determined at the time of the transaction under Table I of Reg ), then the transaction will be characterized as an installment sale with a contingent sales price and will be taxed under the installment sales rules. 49 Illustration: A transfers property to B in return for B's agreement (unsecured) to make annual payments of $10,000 to A until $100,000 is paid or until A's death, whichever occurs first. A's actuarial life expectancy at the time of the agreement (as determined under Table I of Reg ) is 11 years. Because the maximum payout will be reached in a period of time (10 years) that's less than the transferor's life expectancy (11 years), the transaction is treated as an installment sale rather than an annuity and will be taxed under the installment sales rules. 50 Footnotes This Section: 47 GCM Rye, Jonathan v. U.S., (1992, Cl Ct) 69 AFTR 2d , 25 Cl Ct 592, 92-1 USTC GCM GCM End of RIA Section

10 Private Annuity Legal Pack Page 8 Rev. Rul , CB 352 Headnote: Basis for computing the depreciation allowance and for determining gain or loss upon the disposition of property acquired in exchange for an annuity contract. O. D. 945, C. B. 4, 44 (1921), and S. M. 3141A, C. B. IV-2, 183 (1925), modified. Full Text: Advice has been requested relative to the basis for (1) computing depreciation and (2) determining gain or loss upon the subsequent sale or exchange of property received by a taxpayer in exchange for an agreement to make annuity payments to the annuitant (transferor of the property) for the remainder of the annuitant's life. In O. D. 945, C. B. 4, 44 (1921), the taxpayer received certain land in exchange for a cash payment and his promise to support his mother for the remainder of her life. O. D. 945, as modified by I. T. 2689, C. B. XII-1, 160 (1933), pursuant to the recommendation to that effect in G. C. M , C. B. XII-1, 159 (1933), holds that the basis for determining gain or loss on the sale of such land is the sum of the cash payment plus the discounted value of the support to be furnished. In S. M. 3141A, C. B. IV- 2, 183 (1925), the taxpayer purchased her mother's life interest in property, giving as the consideration therefore her agreement to contribute to the support of her mother for the remainder of her mother's life. S. M. 3141A holds that the total of the payments made and to be made by the taxpayer under the contract will represent the cost of the property acquired. Under the provisions of section 23(e) of the Internal Revenue Code of 1939, one of the requisites of a deductible loss is that such loss must actually be sustained during the taxable period for which the deduction therefore is sought and evidenced by a closed and completed transaction. See section 39.23(e)-1 of Regulations 118. A transaction in which a taxpayer who is not engaged in the business of writing annuity contracts receives property in exchange for his promise to make annuity payments to the transferor is not a closed and completed transaction until the death of the annuitant. It is not until the death of the annuitant that the fixed cost of the property so acquired may be determined. The annuitant having died and payments under the contract having terminated, the cost of the property, for Federal income tax purposes, is the total of the annuity payments made. See Thomas H. Mastin v. Commissioner, 28 Fed. (2d) 748; Citizens National Bank of Kirksville, Mo. v. Commissioner, 122 Fed. (2d) 1011, certiorari denied, 315 U. S. 822; and D. Bruce Forrester v. Commissioner, 4 T. C Of course, if the property acquired in exchange for an annuity contract is depreciable property, or if the property is sold prior to termination of the annuity payments, it is necessary to determine a basis upon which to compute a reasonable allowance for depreciation and upon which the gain or loss from the sale or exchange of the property may be determined. In view of the foregoing and assuming an arm's-length transaction with no intent of a gift on the part of either party, where a taxpayer who is not engaged in the business of writing annuities receives property in exchange for his contract to make annuity payments, the following Federal income tax consequences will result, subject, however, to the provisions of section 24(b) of the Code of 1939, relating to the nondeductibility of certain losses from sales or exchanges of property: 1. The basis (unadjusted) 1 of the property for the purpose of computing the allowance for depreciation prior to the death of the annuitant shall be the value of the prospective payments under the annuity contract (computed as of the date of the transaction in accordance with Table I, section 86.19(f) of Regulations 108 with reference to the life expectancy of the annuitant) until such time as the annuity payments equal the value of the annuity contract at the date of the transaction. Any annuity payments made in excess of the value of the annuity contract at the date of the transaction should be added to the basis of the property for depreciation purposes. However, upon the death of the annuitant, the basis (unadjusted) for computing any subsequent allowance for depreciation becomes the total of the annuity payments made under the contract. In the event depreciable and nondepreciable property is received, an allocation, for the purpose of computing the basis for the depreciable portion of the property, must be made on the basis of the ratio of the respective fair market values of the depreciable and nondepreciable properties at the time acquired. 2. Should disposition of the property occur after the death of the annuitant, the basis (unadjusted) for determining gain or loss shall be the total of the annuity payments made under the contract. See D. Bruce Forrester v. Commissioner, supra. 3. Should disposition of the property occur prior to the death of the annuitant, the basis (unadjusted) for determining gain shall be the total of the annuity payments made under the contract up to the date of disposition plus the value of the prospective payments remaining to be paid at the date of such disposition (computed in accordance with Table I, section 86.19(f) of Regulations 108 with reference to the life expectancy of the annuitant as of the date of disposition of the property). The basis (unadjusted) for determining loss shall be the total of the annuity payments actually made at the time of disposition. Compare section 39.23(e)-1, Regulations 118; Thomas H. Mastin v. Commissioner, supra, and Citizens National

11 Private Annuity Legal Pack Page 9 Bank of Kirksville, Mo. v. Commissioner, supra. Of course, a situation may arise where the selling price is less than the adjusted basis for gain and greater than the adjusted basis for loss. In such a case, neither gain nor loss would be recognized at the time of the sale. Where disposition of property acquired in exchange for a promise to make annuity payments has occurred prior to the death of the annuitant, the taxpayer may realize a gain or loss, for Federal income tax purposes, as a result of events occurring subsequent to such disposition. Whether such events result in a recognized gain or a recognized loss is dependent upon the circumstances in each individual case. If the total of the annuity payments made under the contract (total of payments made before and after disposition of the property) exceeds the basis (unadjusted) of the property used in determining the gain or loss on the disposition, such excess is a loss in the year or years in which paid. In the case of a recognized loss, this will include all payments made after the date of disposition of the property. Where the selling price is such that neither gain nor loss is recognized upon disposition of the property, no loss is sustained until the total of the payments made under the annuity contract (total of payments made before and after disposition of the property) when decreased by depreciation allowed or allowable exceeds the selling price, at which time such excess is a loss in the year in which paid. On the other hand, in the case of a recognized gain upon disposition of the property prior to the death of the annuitant, if the total of the annuity payments ultimately made is less than the basis (unadjusted) for computing such gain, the excess of such basis over the total of the annuity payments will constitute income in the year the annuitant dies. In the case of a recognized loss, there will be no gain as a result of the annuitant's death. In case neither gain nor loss was recognized upon the disposition of the property, if the total annuity payments ultimately made (decreased by depreciation allowed or allowable during the period the property was held and adjusted for capital additions or subtractions) is less than the selling price, the excess of the selling price constitutes income in the year the annuitant dies. The nature of any gain or loss, whether capital or ordinary, which is recognized as a result of events occurring subsequent to the sale of the property involved will depend upon the purpose for which the property was held. Compare F. Donald Arrowsmith et al., executors of the last will and testament of Frederick R. Bauer, deceased, and Ruth R. Bauer et al. v. Commissioner, 344 U. S. 6, Ct. D. 1752, C. B , 136. The principles outlined above may be illustrated by the following examples: (a) Assume the fair market value of the property received is $95,000 (land $15,000 and building $80,000) and the property is used in the taxpayer's trade or business or for the production of income. The remaining life of the building is 50 years and the estimated salvage value of the building at the end of that time is $15,000. The annuity contract provides for annual payments of $10,000 to the annuitant (transferor) for the remainder of his life. At the time of transaction the present value of the annuity contract is $94,785 (at age 69). The annual depreciation would be computed for the period up to the date of the annuitant's death as follows:$80, X$94,785 $15,000 $95, =$1, (b) If the annuitant should die at the end of the eighth year, the annual depreciation for subsequent taxable years would be computed as follows:$80, X$80,000(2)-$15,000-$10,371.04(3) $95, =$ (remaining life of building) (2)Eight annuity payments made. (3)Depreciation for 8 years at $1, (c) Assuming the property was sold at the end of the ninth year and prior to the death of the annuitant, the recognized gain is computed as follows: Selling price $150, Basis: Annuity payments made (9x$10,000) $90, Plus: Value of prospective payments at date of sale (age 78) 63, Unadjusted basis $153, Less: Depreciation (9x$1,296.38) 11, Adjusted basis 142, Recognized gain $7, Losses from annuity payment made after the property is disposed of would be recognized after the aggregate of the annuity payments exceeds $153,705, i. e., $6,295 of the 16th annual payment and all subsequent payments are losses in the year in which paid. However, if the 15th annual payment was the final payment made, there would be a recognized gain of $3,705 ($153,705 minus $150,000).

12 Private Annuity Legal Pack Page 10 (d) Assuming all facts the same as in the preceding example, except that the selling price is $75,000, the recognized loss is computed as follows: Selling price $75, Unadjusted basis (9 annuity payments made) $90, Less: Depreciation (9 x $1,296.38) 11, Adjusted basis 78, Recognized loss $3, In this instance, each annuity payment made after the sale of the property would be recognized as a loss in the year paid. (e) If the selling price were $105,000.00, no gain or loss would be recognized at the time the property is disposed of, since the selling price falls between the basis (adjusted), $142,037.58, for computing a recognized gain and the basis (adjusted), $78,332.58, for computing a recognized loss. In this situation, there would be a recognized loss of $3, on the 12th annuity payment (selling price, $105,000-(total payments, $120,000-- depreciation, $11,667.42). The full amount of each succeeding payment would be a recognized loss in the year paid. If, however, the annuitant died after only 11 payments had been made, there would be a recognized gain in the year of the annuitant's death in the amount of $6, (selling price, $105,000- -(total payments, $110,000--depreciation, $11,667.42)). transferred, as the case may be, is reduced by the value of the prospective annuity payments to be made (computed as of the date of the transaction in accordance with Table I, section 86.19(f) of Regulations 108 with reference to the life expectancy of the annuitant). Where necessary, an allocation of the basis of the portion of the property received as a gift should be made between depreciable and nondepreciable property based on the ratio of the total fair market values of such depreciable and nondepreciable property. See Revenue Ruling 239, C. B , 53, as to the taxability of annuity payments received by an annuitant who has transferred real property in exchange for an annuity contract. To the extent they are inconsistent with the foregoing, S. M. 3141A, C. B. IV-2, 183 (1925), is modified, and O. D. 945, C.B. 4, 44 (1921), as modified by I. T. 2689, C. B. XII-1, 160 (1933), is further modified. 1 When used in this ruling, the term basis (unadjusted) refers to the basis prior to the adjustment for depreciation, and does not contemplate capital additions or subtractions. If, in fact, an element of gift is involved in connection with a transaction where property is acquired in exchange for an annuity contract, such fact must be considered by the recipient of the property in determining his basis for computing the depreciation allowance and for determining gain or loss upon subsequent disposition of such property. Under section 113(a)(2) of the Code the donee's basis for determining gain on the disposition of property received as a gift is the same as it would be in the hands of the donor, or the last preceding owner by whom it was not acquired by gift; the donee's basis for determining loss is the same as the basis for determining gain, or the fair market value of the property at the time of the gift, whichever is lower. The basis for depreciation is the same as the basis for computing gain. Section 114(a) of the Code. Thus, in determining the basis for gain, loss or depreciation the donee's basis of the portion of the property acquired by gift should be added to the basis computed under each of the above-stated rules relating to property received in exchange for an annuity contract only. In determining the basis for gain, loss or depreciation which is attributable to the portion of the property transferred as a gift, the donor's basis or the fair market value of the total property

13 Private Annuity Legal Pack Page 11 Rev. Rul , CB 43, IRC Sec(s). 72 Headnote: Principles to be applied in determining the tax consequences of the transfer of appreciated property for a private annuity contract in an intra- family exchange. Full Text: Advice has been requested relative to the treatment for Federal income and gift tax purposes of monthly payments received under the circumstances outlined below. In the instant case, the taxpayer, age 74, transferred property (a capital asset) having an adjusted basis of $20,000, and a fair market value of $60,000, to his son in 1966, in exchange for the legally enforceable promise of the latter to pay him a life annuity of $7,200 per annum payable in equal monthly installments of $600. Section 72(b) of the Internal Revenue Code of 1954 provides that gross income does not include that part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract bears to the expected return under the contract. Further, section of the Income Tax Regulations states that amounts received under annuity contracts are not to be included in the income of the recipient to the extent that such amounts are excludable from gross income as the result of the application of section 72 of the 1954 Code and the regulations thereunder. Accordingly, the tax consequences of the private annuity transaction in this case are determined by applying the following principles: (1) The gain realized on the transaction is determined by comparing the transferor's basis in the property with the present value of the annuity. Section (e)(1)(iii)(b)(3) of the regulations prescribes the appropriate table to be used for valuing a private annuity contract. (U.S. Life Table 38 contained in paragraph (f) of section of the Estate Tax Regulations.) The gain realized will be capital gain if the transferred property constitutes a capital asset. (2) The excess of the fair market value of the property transferred over the present value of the annuity acquired constitutes a gift for Federal gift tax purposes where the transaction is not an ordinary business transaction within the meaning of sections (g)(1) and of the Gift Tax Regulations. (3) The gain should be reported ratably over the period of years measured by the annuitant's life expectancy and only from that portion of the annual proceeds which is includible in gross income by virtue of the application of section 72 of the 1954 Code. This will enable the annuitant to realize his gain on the same basis that he realizes the return of his capital investment. (4) The investment in the contract for purposes of section 72 of the 1954 Code is the transferor's basis in the property transferred. Since the amount of the gain is not taxed in full at the time of the transaction, such amount does not represent a part of the premiums or other consideration paid for the annuity contract. Applying the foregoing principles, the transaction in the instant case is taxable as follows: (1) Based on U.S. Life Table 38, with interest at 3 1/2 percent, the present value of the right of a person age 74 to receive a life annuity of $7,200 per annum is $47, (2) The excess of the fair market value of the property transferred over the value of the annuity received as a gift to the son from the father. ($60,000 minus $47, is $12,286.92, the gift made by the father to his son.) (3) The basis of the property is $20,000. (4) The excess of the value of the annuity received over the basis in the property transferred represents the gain realized. ($47, minus $20,000 is $27, the gain realized.) See section (e)(1) of the Income Tax Regulations. (5) The computation and application of the exclusion ratio, the gain, and the ordinary annuity income is as follows: $72,720 expected return (annual proceeds multiplied by 10.1, the life expectancy). $20,000 (investment in the contract) divided by $72,720 (expected return) equals exclusion ratio of 27.5 percent. (a) Annual proceeds, $7,200. (b) Exclusion (27.5 percent of $7,200), $1,980. (c) Capital gain income ($27,713.08) divided by 10.1 years (the life expectancy), $2, (d) Ordinary annuity income: (a), minus the total of (b) plus (c), $2, The exclusion ratio of 27.5 percent is applicable throughout the life of the contract. After the capital gain of $27, has been fully reported, subsequent amounts received (after applying the exclusion ratio) are to be reported as ordinary income. Revenue Ruling 239, C.B , 53, which was issued under different provisions of prior law, is not determinative under section 72(b) of the Code.

14 Private Annuity Legal Pack Page 12 NOTE: The following three topics are NAFEP Research Material. IRS Affirmation Of Private Annuities And Their Deferral Treasury Decision TD-8754 affirmed the validity of private annuities and the deferral of private annuity payments. On February 9, 1998 the IRS and the Treasury Department issued final regulations for Code Section 1275(a)(1)(B)(i) and (ii), under decision TD Prior to this date the IRS and Treasury had published the regulations in a proposed form. These proposed regulations would have, if adopted, eliminated the ongoing practice of deferring private annuity contracts. However non-deferred private annuities would have continued to be legal. As announced in TD- 8754, the IRS and the Treasury reversed their proposed deferral elimination position when they adopted the final regulations. Sections 163(e) and 1271 thru 1275 of the federal tax code contain tax laws known as "original issue discount" rules. These rules relate to the tax treatment of debt instruments which have original issue discount. Section 1275(a)(1)(B)(i) exempts (private) annuity contracts from these rules if they meet certain parameters. Section 1275(a)(1)(B)(ii) exempts commercial annuities, those issued by an insurance company. Under TD-8754 (private) annuities were deemed to qualify for this exemption provided that they followed certain other rules (rules which NAFEP has always observed in the preparation of private annuity contracts). This left private annuity contracts to be regulated as they always were, primarily Section 72 of the code, Revenue Rulings and 69-74, and GCM (see elsewhere in this package). In addition to generally confirming the continued legality of private annuities, there was a very important side aspect of the regulations. This was the affirmation that private annuities may have their payment stream deferred. Quoting from TD-8754: "After a careful review of this issue, the IRS and the Treasury have modified the regulations to eliminate the requirement that the annuity distributions begin within one year of the date of the initial investment in the contract." "Several commentators expressed concerns that the proposed regulations, if finalized, would alter the tax treatment traditionally afforded private and charitable gift annuity contracts. Private annuity contracts are typically issued as consideration in intra-family transfers of property. In many cases, distributions under private and charitable gift annuity contracts are entirely contingent on the survival of one individual (or a small number of individuals). These contracts are not indebtedness under general principles of federal income tax law and, therefore, are not within the definition of debt instrument in section 1275(a)(1)(A). For almost all other private and charitable gift annuities, the final regulations address the concern by removing the requirement that the distributions begin within one year of the date of the initial investment in the contract." The final regulations do address several concerns that the IRS and the Treasury had regarding whether a private annuity is based on sound annuity factors and actuarials. If the annuity deviates from being a real annuity it will be treated as a debt instrument with original issue discount and taxed accordingly. The rules that the final regulations lay down prevent private annuities from having the following provisions: 1. Cash surrender options. 2. Loans to the annuitant which are secured by the private annuity contract itself (though presumably loans which are adequately secured by other property and which are made at market interest rates are legal). 3. Minimum payouts. 4. Maximum payouts. 5. Decreasing payouts. 6. Any other provision that can significantly reduce the probability that sound life time annuity factors and actuarials are followed. (The actual language used in TD-8754 is "any other term or provision that can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity".) NAFEP private annuity contracts have never included these prohibited provisions and should continue to qualify for private annuity treatment, either with or without deferral of the annuity payment stream. Excerpts And Review Of IRS Memo GCM of 5/19/86 NAFEP NOTE: The IRS' GCM concerns whether a certain transaction under review should be treated as an installment sale or private annuity. The effect in distinguishing between private annuities and installment sales is far reaching because a properly structured private annuity has significant tax advantages over an installment sale. Further, this IRS Memo makes it clear that private

15 Private Annuity Legal Pack Page 13 annuities escape estate taxes. The following are key excerpts from this GCM: Distinction Between Installment Sale and Private Annuity. "We believe that when property is transferred in exchange for a transferee's promise to make periodic payments to the transferor until his death, the transaction should be considered a private annuity...if the stated monetary amount would be received by the transferor before the expiration of his or her life expectancy (as determined actuarially at the time of the sale agreement), then the transaction will be characterized as an installment sale." "This brings us to the question of whether the installment sales rules of section 453 of the Code or the annuity rules of section 72 govern the treatment of periodic payments received by a taxpayer...we believe that where the conveyor of property receives a right to periodic payments for the remainder of his life, with no monetary limit provided...the payments represent an annuity and should be governed by section 72. A stream of payments for life is squarely within the accepted concept of an annuity in our opinion, so the annuity rules in the Code, at section 72, are logically applicable. The Service already appears to have so recognized in Rev. Rul 69-74, CB 43, which applies section 72 where appreciated property is exchanged for a right to periodic payments for life." Legal to Use Private Annuity for Estate Tax Planning "Private annuity arrangements are often used for intrafamily transfers whereby an older family member transfers appreciated property to a younger family member in order to gain tax advantages, e.g., removal of the property from the transferor's gross estate." "A private annuity also should not be included in the transferor's gross estate for Federal estate tax purposes. " "Related Party" Rules Are Inapplicable, Quick Sale Is Legal "The related party resale rules outlined above are inapplicable to private annuity transactions. Thus the transferee in a private annuity situation could quickly dispose of the property, and no accelerated recognition of gain would be charged to the original seller/transferor." Section 72 plus Revenue Rulings and Control Private Annuities "The Service already appears to have so recognized in Rev. Rul 69-74, CB 43, which applies section 72 where appreciated property is exchanged for a right to periodic payments for life" "The income tax treatment afforded unsecured private annuity payments is set forth in Revenue Ruling which applies the provisions of section 72 to private annuity transactions." "Rev. Rul , CB 352, prescribes the method for calculating a taxpayer's basis in property received in exchange for a private annuity." Is It Legal For Trusts To Issue Private Annuity Contracts? Note: For clarification purposes, the private annuity/trust arrangement which is discussed below, and in this whole document package, is referred to as a PAT (private annuity trust). Throughout the history of the use of the private annuity they often have been issued by a family trust. If a trust or other legal entity isn t used to issue the contract, the annuitant must enter into the arrangement directly with individuals, usually children or other heirs. When property owners are planning a private annuity transaction it is desirable for them to use a trust to issue the annuity for several reasons: 1. The annuitant s children or other heirs may be underage and not legally able to enter into the transaction. 2. The annuitant s children or other heirs may not be skilled or trustworthy enough to manage the assets exchanged for the annuity, especially when the assets are liquidated. 3. For privacy reasons, the annuitant may not wish to involve his children or other heirs directly in the transaction. 4. The children or other heirs may get into legal difficulties, such as lawsuits, tax liens or divorces, which would result in the annuity assets being attached in a resulting legal action. Without an intermediary entity (such as a trust) to hold the assets, the individual s legal difficulties can directly attach to the assets. 5. The trust provides a formal, written and legal arrangement to administer the private annuity transaction, so there will be no questions or misunderstandings on what and how things are to happen. Much greater control is effected. There definitely are court cases where private annuity (PAT) transactions in a trust have been disallowed, with Lazarus v. Commissioner, 58 TC 854, 8/17/1972, being the most often cited example. Some practitioners, without looking beyond this and/or a couple of other cases, then go so far as to say that the IRS does not allow the use of a

16 Private Annuity Legal Pack Page 14 trust with a private annuity. However, more thorough research reveals that the mere incorporation of a trust into the private annuity transaction does not make the transaction any more prone to IRS disallowance when the structure is created and operated correctly. The IRS can and will challenge any defective or illegal structure, whether it is a trust, corporation, pension plan or whatever. A private annuity utilizing a trust (PAT) is no more and no less vulnerable than other, mainstream tax planning. In some cases the IRS, upheld by the Tax Court, has disallowed the trust and the private annuity (PAT) transaction. This was usually done by declaring the trust to be a sham, to be non existent for tax purposes. But the reasons that the Tax Court disallowed the PAT arrangement were due to the trust being handled either or both in a defective or fraudulent manner. In one important case where the Tax Court disallowed a properly structured trust, the decision was reversed on appeal to Ninth Circuit Court. In several other cases, trusts were specifically allowed to issue the private annuity where the trust was properly structured and operated (see Legal Cites below). Legal Cites for PATs. 1. Treasury Regulation (a)(1), For the purposes of Section 72, however, it is immaterial whether such contracts (life insurance, endowments and annuities) are entered into with an insurance company. The Treasury Regs have left the issuance of annuity contracts unlimited to any specific entity. For example, a type of private annuity is issued by charities and religious organizations (charitable gift annuities), and other types of private annuities are issued by charitable remainder trusts (CRT), grantor retained annuity trusts (GRAT) and grantor retained unitrusts (GRUT). From the other material in this information package, it is clear that this Section 72 quoted above includes the PAT type private annuity under its regulatory control. 2. Treasury Regulation , and the several examples which accompany this section, is totally devoted to explaining certain life expectancy rules which apply when private trusts issue (private) annuities. This section imposes a special life expectancy when a trust or other limited source of funds issues an annuity, if the annuity is based on an interest rate which is greater than the AFMR (applicable federal mid-term rate). So this whole Treasury Regulation Section and its accompanying examples was written with the specific expectation that private trusts would issue private annuities. These private annuities include the PAT variety which is the subject of this legal package, but also include CRTs, GRATs and GRUTs, all of which are private annuities issued by private trusts, and all must use the same annuity factors, life expectancy table, AFMR interest rate and certain other factors and formulas. 3. Revenue Ruling approved the use of a trust in a private annuity (PAT) transaction without any restrictions beyond the proper valuation and calculation issues and the treatment of an undervalued amount as a gift (standard procedure). 4. LaFargue v Commissioner, 689 F.2d 845 (1982). This is arguably the most important legal precedent for the ability of trusts to issue a private annuity (PAT variety) in exchange for property, and for understanding what is legal and what isn t (see the below list of eight, NAFEP developed rules). In this case, the Ninth Circuit U.S. Court of Appeals reversed a Tax Court decision, 73 T.C. 40, where the Tax Court had disallowed a private annuity transaction using a trust, even though the trust appeared to be properly structured. Any doubt about the legal ability of a PAT type trust to be a party to the private annuity transaction should be removed upon reviewing this case. 5. Sidney B. Stern, TC Memo This important case reflects both a Ninth Circuit Court of Appeals and a Tax Court decision to allow a private annuity trust (PAT) transaction to stand, even though there were some questionable provisions allowed to the annuitants in the trust structure. 6. Weigl v. Commissioner, 84 TC 1192 (1985). In this Tax Court Case, the private annuity/trust transaction was held to be invalid because the annuitant retained effective control. But this case outlined six rules for determining whether a private annuity trust was independent of the grantor, or whether the trust was grantor owned. The Tax Court cited Stern and LaFargue (listed above) as part of the basis for the rules. Following these six rules, as all NAFEP PATs are designed to do, makes the trust legal for private annuity purposes (an independent entity). Even though the PAT in this case was illegal, it was made clear what would constitute a legal PAT. Comparison With Other Annuity Trusts. In regards to Treasury Regulation , referred to in Legal Cite Number 2 above, an important correlation to PATs is revealed. In addition to PATs, also regulates charitable remainder trusts (CRT), grantor retained annuity trusts (GRAT) and grantor retained unitrusts (GRUT). CRTs, GRATs and GRUTs are other examples of private trusts issuing private annuities. The private annuities from these three other

17 Private Annuity Legal Pack Page 15 trusts may use different terms of duration and payment schemes than PATs do, but all the same they are just variations of a private annuity. CRTs, GRATs and GRUTs all use trusts to issue their variation of private annuities, there is no other way for them to work. These other three annuity trust types are well known, mainstream planning vehicles. They are readily acceptable to the IRS and supported by tax laws and regulations. The private annuities which these trusts issue are taxed a little differently than the standard PAT type private annuity (in some cases the differences are very minor). Nevertheless, the effect, structure, operation and usage of CRTs particularly is virtually indistinguishable from PATs. CRTs, GRATs and GRUTs are subject to many of the same annuity calculation factors (life expectancy table, AFMR interest rate, annuity factors, and certain other factors and formulas). It makes no sense to argue that a PAT cannot issue a private annuity when that is the only IRS accepted mode of operation for CRTs, GRATs and GRUTs, and when much of their governing law is the same. Correct Structure. It is clear that the issuance of private annuities by private trusts (the PAT variety) has been accepted by the Tax Court and federal courts, the IRS and by the Treasury Regulations. When the trust transaction was disallowed, it was due to a fraudulent abuse or a defective structure. A correct PAT structure, with formalities adhered to, is legal according to all the information discussed in this topic. What are the correct structure and formalities? These rules must be adhered to: 1. The trust must be designed to be independent of the annuitant, with either an independent trustee or an adult beneficiary acting as trustee. Therefore the trust is a non-grantor type under federal tax law. 2. The annuitant has no control over the trust or the management of its assets. Neither the annuitant nor the spouse of the annuitant may be either a trustee or a beneficiary of the trust. 3. The trust must receive and take full legal title to the appreciated assets before the assets are liquidated if there is to be a deferral of capital gains. The trustee, acting for the trust, must be in full control of the liquidation of the assets and the trust must directly receive the cash proceeds if there is to be a deferral of capital gains. 4. The trust must have some capital above the private annuity face amount to provide a reserve, so that the trust has more asset value than what it owes on the annuity contract. Without this reserve the trust would have a net worth of zero (asset value transferred to the trust, minus an annuity obligation of the same value, equals zero). NAFEP private annuities are usually structured so that the annuity face amount is 93% of the exchanged asset value, leaving 7% for this capital reserve. 5. The annuitant s only connection with the trust is his/her receipt of annuity payments. 6. Annuity payments are based only on IRS actuarial tables, interest rates, annuity factors and formulas. The annuity payment is a fixed, flat amount for the life of the annuitant. There must be a formal annuity contract signed between the annuitant and the trust which sets out the flat payment terms and provisions and is based on the correct IRS factors. 7. The annuitant receives only his/her fixed, flat annuity payment, and never receives the trust income or any trust earnings which are in excess of that which is needed to make the annuity payments. 8. The trust must never issue a K-1 tax report to the annuitant to report the annuity payment to the IRS. K-1 treatment of the payment will invalidate the independence of the trust from the annuitant; the K-1 will turn the trust into a grantor trust. The correct tax report is a 1099R. NAFEP s legal counsel structures all private annuity trusts to strictly adhere to these rules. NAFEP requires the trustee(s) and the grantor(s) to sign a 10 point disclaimer, signed point by point, to confirm that they individually understand each of the rules. NAFEP then furnishes the grantor and the trustee each with a Set Up and Operating Guide which is a comprehensive educational and reference tool to explain all the necessary details. TM FAX: (801) * PH. (801) nafep@nafep.com

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