PRIVATE ANNUITIES A VERSATILE

AMERICAN COLLEGE OF TRUST AND ESTATE COUNSEL NOVEMBER 10, 2002 PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PRESENTED BY: STEPHEN H. GARIEPY Stephen H. Gariepy Hahn Loeser + Parks, LLP 3300 BP Tower, 200 Public Square Cleveland, OH 44114 Direct Phone: 216.272224 Direct Fax: 216.242824 E-mail: sgariepy@hahnlaw.com

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 1 I. OVERVIEW OF TRADITIONAL PRIVATE ANNUITY Typical Transaction. Seller. The parent in failing health. Buyer. The children. Asset. Stocks, bonds, real estate, closely-held business. Contract. The parent sells the asset to the children in exchange for their unsecured promise to pay the parent an annuity for life based on standard life expectancy tables and applicable federal rate. Tax Advantages. No gift tax. The present value of the annuity payments that would be expected under the standard life expectancy tables equals the fair market value of the asset sold to the children. Section 7520. Reduced estate tax. Asset sold to children is removed from parent s gross estate. Annuity payments cease at parent s death. Only those annuity payments received by parent prior to death are included in parent s gross estate. (i) Estate reduced to the extent parent receives fewer annuity payments than would be expected under the standard life expectancy tables. Even as to annuity payments received, works an estate freeze to the extent the appreciation/income on the transferred asset outperforms the Section 7520 rate (and parent does not outlive the standard life expectancy). No immediate income tax. No gain recognized at the moment of sale (assuming sale is unsecured and no depreciation recapture). C. Tax Disadvantages. As annuity payments are received by parent, they are subject to income tax (as gain, interest and tax-free return of basis). Children cannot deduct the interest portion of the annuity they pay to the parent (even though the interest is taxable income to the parent).

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 2 Children do not obtain a step-up in basis for the asset on the parent s death. Rather, on the parent s death, their basis is the sum of the annuity payments they have made. D. Overall Objectives. The hoped-for tax result is that the estate tax savings surpass the income tax costs. This requires: A parent with a life expectancy much shorter than expected under the standard life expectancy tables; and/or An asset that is deeply discounted and/or has high potential appreciation/income. Achieve business or family goals, such as succession and management. II. USUAL INCOME TAX RESULTS Income Tax Consequences to Parent. Annuity payments received by parent are composed of three elements. Rev. Rul. 69-74, 1969-1 CB 4 A tax-free return of basis, allocated over the parent s standard life expectancy. A gain element, allocated over the parent s standard life expectancy. Taxable interest. 5. It is uncertain whether recaptured depreciation under Sections 1245 and 1250 is recognized in full in the year of sale or over the parent s standard life expectancy. If the parent outlives the standard life expectancy, the full amount of all subsequent payments are ordinary income. If the parent dies earlier than the standard life expectancy (i.e., before recovering the entire basis), no further gain is recognized, and the parent may be entitled to a loss deduction on the final individual income tax return for the unrecovered basis. Section 72(b)(3). The above income tax treatment is available only if the private annuity sale is unsecured. If the sale is secured, the parent immediately recognizes the full gain. Bell v. Commissioner, 60 TC 469 (1973); 212 Corp. v. Commissioner, 70 TC 788 (1978).

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 3 Income Tax Consequences to Children. No interest deduction. No part of the annuity payment is deductible by the children as interest expense (even though the parent must report part of each annuity payment as taxable interest). Bell v. Commissioner, 76 TC 232 (1981), aff d 668 F.2d 448 (8th Cir. 1982). The children must therefore use after-tax income to make annuity payments which are taxable to the parent. This means the income used to generate a private annuity is subject to double-income tax. However, the nondeductible interest expense is not entirely lost because it is added to the children s basis. Income tax basis. Rev. Rul. 55-119, 1955-1 CB 35 The children initially obtain a tentative basis in the asset. During the parent s lifetime, the children s basis, for purposes of depreciation and determining gain on a sale or exchange, is the present value of the annuity obligation (which is the fair market value of the asset if there is no gift element in the transaction). The children s tentative basis is increased if and when their actual annuity payments exceed their tentative basis. (i) This can happen before the parent attains the standard life expectancy because the full amount of the children s payments are capitalized, including the interest portion. d. If the parent dies before the annuity payments equal the tentative basis, the children s basis is then reduced to the total payments they actually made. If the children sell the asset before the parent s death, the children s gain is determined using the tentative basis (and loss is determined using the total payments actually made); and any annuity payments after the total payments exceed the tentative basis are deductible losses. (i) If the parent dies before the children s payments equal the tentative basis used to compute the children s gain, the children will recognize income in the year of the parent s death equal to the difference between the tentative basis and total payments. C. Not an Installment Sale. Private annuities are not treated as installment sales under IRC Section 45

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 4 Although the definition of an installment sale under Section 453(b) is broad enough to cover a private annuity, the legislative history of the Installment Sales Revision Act of 1980 states that Section 453 does not apply directly to private annuity transactions. Consequently, the Section 72 annuity rules rather than the Section 453 installment sale rules apply to private annuity sales. GCM 39503 (1985); PLR 900906 Because a private annuity is not an installment sale under Section 453, a private annuity can be used for publicly-traded stock without triggering the full amount of the gain in the year of the sale. III. USE OF ACTUARIAL TABLES Valuation Tables. The amount of the private annuity payments are generally determined under Treas. Reg. Section 20.7520. The regulations set forth valuation tables that are based on standard life expectancies and an interest factor equal to 120% of the mid-term applicable federal rate, rounded to the nearest 2/10 of one percent. The Treasury issued new actuarial tables effective July 1, 1999. The rate for November 2002 has plummeted to 6%. Disqualifying Health Condition. The standard actuarial tables may be used unless the parent suffers from a known incurable illness or other deteriorating physical condition such that death is imminent. Section 20.7520-3(b)(3)(i). Death is considered imminent if there is at least a 50% probability that the parent will die within one year. A parent who lives for at least 18 months is presumed not to have been terminally ill unless the IRS establishes the contrary by clear and convincing evidence. When a parent s life expectancy is significantly less than normal, but more than one year, a private annuity may be a viable technique. C. Marshalling Evidence of Parent s Health Condition. Opinion letter from parent s attending physician. Opinion letter of medical specialist.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 5 IV. SPECIAL PROBLEMS WITH PRIVATE ANNUITY SALES TO TRUSTS Avoiding Section 2036. Poor design or administration of a private annuity sale to a trust can result in the transaction being recharacterized as a gift to the trust with a retained income interest, resulting in inclusion of the transferred asset under Section 2036(a). The tax court has listed six factors it has examined in several cases determining whether a transaction that takes the form of a private annuity sale is in substance a transfer with retained interest in the asset. Weigl v. Commissioner, 84 TC 66 (1985). d. e. f. The relationship between the creation of the trust and the transfer of property to the trust. [Part of same transaction?] The relationship between the income generated by the transferred property and the amount of the annuity payments. [Precisely equal?] The degree of control over the transferred properties exercised by the annuitant. [Retained control?] The nature and extent of the annuitant s continuing interest in the transferred properties. The source of the annuity payment. [Trust has no other assets?] The arms-length nature of the annuity/sale arrangement. [Formalities observed?] When properly planned and implemented, private annuity sales to trusts have been upheld. Estate of Fabric v. Commissioner, 83 TC 50 (1984); Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984), rev g 77 TC 614 (1981). Impact of Chapter 1 If the IRS recharacterizes a private annuity transaction as a transfer to a trust with a retained interest, Section 2702 may apply. If a donor transfers property to a trust and retains an annuity interest in the trust, the annuity must be a qualified annuity in order to be subtracted from the value of the gift to the trust. An annuity is qualified only if it is an irrevocable right to receive a fixed amount for a definite period.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 6 5. 6. In Private Letter Ruling 9253031, the taxpayer transferred $5 million of marketable securities to a $19 million trust created in 1933 by the taxpayer s father, in exchange for the trust s agreement to pay the taxpayer a private annuity. The IRS ruled that the private annuity was a retained, qualified interest under Section 270 A bona fide private annuity should not be subject to Section 2702 because there is no retained interest in the transferred asset. The deferred payment obligation is debt and not an interest in the transferred property. The private annuity is a sale in exchange for an annuity obligation, not a gift with a retained interest as in the case of a grantor retained annuity trust (GRAT). If the annuity is treated as a retained interest, the parent would have to survive the term of the retained interest in order to remove the transferred property from the gross estate (as is required for a GRAT). Private Letter Ruling 9436006 took a more favorable view of an installment sale of a partnership interest to a trust for a 25-year promissory note. The IRS ruled that Section 2701 did not apply because the note was not a retained interest in the partnership, and that Section 2702 did not apply because the note was not an interest in the trust. The same rationale should apply to a private annuity sale. C. Specter of Superfunding Requirement. In order to use the annuity tables to value a lifetime annuity, the Treasury Regulations require the trust to have sufficient resources to be able to continue paying the annuity until the parent attains age 110. See Treas. Reg. 20.7520-3(b)(2)(i), 25.7520-3(b)(2)(v), example Are these regulations invalid? Avoid issue through use of a PATY? Prior to purchasing assets in a private annuity transaction, a trust should be sufficiently funded to give it independent economic significance. Consider personal guarantee of annuity payments by trust beneficiaries. V. PRIVATE ANNUITY SALES OF INTERESTS IN FAMILY LIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES Discounted Asset Value. Assets may be significantly discounted through use of a Family Limited Partnership or Limited Liability Company. Discounts available for lack of marketability and lack of control.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 7 Tax Results. By discounting the asset value: The burden of the annuity payments required from the children is reduced. The taxable gain and interest to the parent are reduced. The parent s gross estate is reduced. If the level of discount is reduced on IRS audit, the transaction will be recast as part gift/part private annuity sale. VI. PRIVATE ANNUITY SALE TO AN INCOME TAX DEFECTIVE TRUST Intentionally Income Tax Defective Trust. A trust may be defective for income tax purposes, yet effective for gift and estate tax purposes. See, e,g., IRS Letter Ruling 903701 If the grantor is treated as the owner for income tax purposes, all transactions between the grantor and the trust are ignored for income tax purposes. Section 67 Use of An Income Tax Defective Trust May Have Several Advantages for a Private Annuity. In a traditional private annuity, a portion of the annuity payment is taxable interest to the parent (while no portion of the annuity payment is deductible interest by the children). But in a private annuity sale to an Income Tax Defective Trust, no portion of the annuity payment is taxable interest to the parent. This avoids what otherwise is a double income tax on the income used to generate the transaction. In a traditional private annuity sale, a portion of the annuity payment is taxable gain to the parent. But in a private annuity sale to an Income Tax Defective Trust, no portion of the annuity payment is taxable gain to the parent. In a traditional private annuity sale, the children pay income tax on the income generated by the asset transferred to them. So they use after-tax income to fund the annuity payments. But in a private annuity sale to an Income Tax Defective Trust, the parent (the grantor) pays the income tax on income of the asset transferred to the trust, thereby allowing the trust to use pre-tax income to fund the annuity payments. The Income Tax Defective Trust may acquire a carryover of the parent s basis, which might be higher than the total annuity payments made by the trust.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 8 VII. BACK-LOADED ANNUITIES Estate Tax Objective. For a parent in failing health, a back-loaded annuity can significantly reduce the amount of the annuity payments received prior to death. For example, an annuity which increases by 20% per year will in the first couple years result in annual payments which are only a small fraction of the traditional, level annuity payments. Income Tax Consequences. Treasury Regulations 1275-1(d) as proposed April 7, 1995, would have subjected back-loaded private annuities to the original issue discount (OID) rules. The final regulations deleted level payments as a requirement for exemption from the OID rules. The regulations now provide that the annuity payments cannot decrease from year to year. Treas. Regs. 1275-1(j). VIII. PRIVATE ANNUITY FOR A TERM OF YEARS (PATY) Description. A PATY is a private annuity in which the payments continue until the earlier of the parent s death or a certain term of years. The purpose of a PATY is to terminate the annuity payments required to be paid by the children in the event the parent outlives the term of years. The amount of annuity payments must be somewhat higher to reflect the possibility of the early termination. Income Tax Consequences. If the term of years is not at least twice as long as parent s remaining standard life expectancy, the PATY is taxed under the original issue discount rules. Treas. Reg. 1275-1(d)(2). If the OID rules apply, the annuitant is taxed on the contract earnings as they accrue, regardless of when they are received. If the term of years is at least twice the parent s remaining standard life expectancy, then the PATY is taxed under the private annuity rules.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 9 C. Gift and Estate Tax Consequences. A PATY should generally achieve the same gift and estate tax results as a traditional private annuity. See GCM 39503 (1986). A PATY may be appropriate where the parent s health is poor but not failing. A PATY may avoid the superfunding requirement. IX. ANNUITIES PER AUTRE VIE Selecting the Measuring Life. In the traditional private annuity, the parent sells an asset to the children in exchange for their promise to pay an annuity to the parent for the parent s own lifetime. However, a parent may sell assets to the children in exchange for their promise to pay an annuity to the parent for the lifetime of some other individual. Tax Advantage. A parent in good health may select as the measuring life an individual in failing health (provided that the probability that the selected individual will live one year is more than 50%). The standard actuarial valuation tables should apply even where the payments are made to a person other than the measuring life. Treas. Reg. 25.2512-5(d)(2)(iv). Note new anti-ghoul rule applicable to charitable lead trusts. Upon the death of the measuring life, the children s payments to the parent cease. In the event the parent dies before the measuring life ends, the value of annuity as of the parent s date of death is included in the parent s gross estate. X. CASH TRANSACTIONS FOR LOW BASIS ASSETS Description. An income tax disadvantage of a traditional private annuity is that a low basis asset removed from the parent s gross estate does not obtain a step-up in basis on the parent s death. However, a parent may retain ownership of the low basis asset, use the asset as collateral to borrow cash from a third party, and transfer cash to the children in exchange for the annuity.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 10 Tax Results. The asset will obtain a step-up in basis on the parent s death. The cash transferred to the children is removed from the parent s gross estate (and only the annuity payments received prior to death are included in the parent s gross estate). The debt owed to the third party is deductible from the parent s gross estate. However, IRS could contend that on the parent s death the children recognize gain to the extent their tentative basis is reduced to reflect the actual annuity payments made. XI. STOCK REDEMPTION BY FAMILY CORPORATION Stock Redemption as Private Annuity. A family corporation may redeem stock from a shareholder in exchange for the corporation s promise to pay the shareholder an annuity for life. See e.g., PLR 78021 If the parent and children own stock in a family corporation, and the corporation redeems the parent s stock, the children are left as the only remaining shareholders. Waiver of Family Attribution. If the family corporation is a C corporation with earnings and profits, or a S corporation with pre-s election earnings and profits, a redemption may be treated as a taxable dividend (rather than a sale or exchange) to the redeemed shareholder. In order to qualify for capital gain treatment rather than dividend treatment, the parent may file an election to waive the family attribution rules under Section 318. This requires a complete termination of the parent s interest in the corporation, including the parent s resignation as a director, officer and employee. If the parent s life expectancy under the standard actuarial tables exceeds 15 years, the IRS may contend that the annuity constitutes a retained equity interest (rather than a creditor s interest) in the corporation, therefore precluding waiver of family attribution. See PLR 8503058, Rev. Pro 98-3, 1978-1 IRB 100.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 11 XII. POST-MORTEM PRIVATE ANNUITIES Following Death of First Spouse. Sellers. Surviving Spouse Marital Trust Non-Exempt GST Marital Trust Buyers. Credit Shelter Trust Irrevocable Insurance Trust Irrevocable Gift Trust Purpose. To remove assets from gross estate of surviving spouse. To leverage the generation-skipping tax exemption. Examples. Annuity transaction between the surviving spouse and the Credit Shelter Trust. Annuity transaction between the Marital Trust and the Credit Shelter Trust. Annuity transaction between the Marital Trust and the Irrevocable Insurance Trust. Annuity transaction between the Non-Exempt GST Marital Trust and a GST Exempt Irrevocable Gift Trust. XIII. GENERATION-SKIPPING AND DYNASTY TRUSTS Application of GST Tax to Private Annuities. Subject to GST tax if the transaction involves a gift element and the buyer is a skip person under Section 2613(a). If no gift element (i.e., the present value of the annuity payments equals the fair market value of the asset sold), then not subject to GST tax even if the buyer is a skip person.

PRIVATE ANNUITIES A VERSATILE ESTATE PLANNING TOOL PAGE 12 Leveraging the $1,000,000 GST Exemption. Sale to grandchildren. Sale to a Dynasty Trust an irrevocable gift trust having a zero inclusion ratio under Section 2642(a). Sale to an irrevocable trust grandfathered from the GST tax. Sale to a Credit Shelter Trust having a zero inclusion ratio.