Private annuities: proposed regulations would negate income tax benefits.

• Author: Josephs, Stuart R.
• Position: Federaltax

Regulations [Sec. 1.72-6(e) and 1.1001-1(j)], proposed Oct. 18, 2006, addressed the income tax treatment of property exchanged for an annuity contract.

BACKGROUND

Gross income includes any amount received as an annuity under an annuity contract [IRC Sec. 72(a)]. However, Sec. 72(b) provides that gross income excludes that part of such receipt which bears the same ratio to this receipt as the investment in the contract bears to the contract's expected return.

In Rev. Rul. 69-74, a father (F) transferred a capital asset having a $20,000 adjusted basis and a $60,000 fair market value (FMV) to his son (S) in exchange for S's legally enforceable promise to pay F a $7,200 per year life annuity--in $600 equal monthly installments. The annuity's present value (PV) was $47,713.08.

This ruling concluded that: (1) F realized capital gain based on the difference between F's basis in the property and the annuity's PV; (2) this gain was reported ratably over F's life expectancy; (3) the investment in the contract to compute the exclusion ratio was F's basis in the property transferred; (4) the excess of the property's FMV over the annuity's PV was a gift from F to S; and (5) the prorated capital gain reported annually was derived from the taxable portion of each payment.

The remaining portion of each taxable payment was ordinary income.

POLICY CHANGE

Rev. Rul. 69-74 was partially based on assuming that a private annuity contract's value could not be determined. But this assumption is no longer correct. This ruling was rooted in authorities that applied

the "open transaction doctrine," which has been eroded in recent years.

The proposed regulations' preamble states that the IRS proposes to obsolete Rev. Rul. 69-74, effective with these regulations' effective dates (see below).

Charitable gift annuities would be unaffected by these proposals.

Taxpayers retain the ability to structure transactions as installment sales, provided Sec. 453's requirements are met.

PROPOSED EFFECTIVE DATES

General Effective Date: Exchanges of property for an annuity contract after Oct. 18, 2006 (except an annuity contract that either is a debt instrument subject to Secs. 1271 through 1275 or is received from a charitable organization in a bargain sale governed by Regs. Sec. 1.1011-2).

Delayed Effective Date: Exchanges of property for an annuity contract after April 18, 2007 (subject to the same exceptions described immediately above)--if the following conditions are met:

(1) The...