Effect of OID final regs. on private annuities.

• Author: Lee, Shirley K.
• Position: Original issue discount; IRS final regulations

A private annuity is an exchange of cash or property for the promise of a series of fixed payments over time, by other than an insurance company; it is frequently used for estate planning purposes. How much income is imputed to these payments? Is the imputed interest deductible? Does it matter whether the property exchanged is publicly or nonpublicly traded? This article answers these and related questions.

Private annuities are commonly used in intrafamily sales for estate planning purposes. Until recently, issuers and holders of private annuities generally were not concerned with the original issue discount (OLD) rules; it was believed that private annuities were exempt under Sec. 1275(a)(1)(B)(i). However, in January 1998,(1) the Service published final regulations on the treatment of annuity contracts not issued by insurance companies. This article examines the effect of these regulations on certain private annuities.

Private Annuity

A private annuity is an arrangement under which an individual (the annuitant) transfers cash or other property to another individual or entity (the obligor)in exchange for the latter's promise to make periodic payments in fixed amounts to the former for the rest of his life.

Is it Debt?

An annuity contract resembles a debt instrument in certain respects. Debt instruments as defined by Sec. 1275(a)(1)(A) are generally subject to the OID rules. That provision defines a "debt instrument" as a bond, debenture, note or certificate or other evidence of indebtedness. According to Regs. Sec. 1.1275-1(d), a "debt instrument" is any instrument or contractual arrangement that constitutes debt under general principles of Federal income tax law.

Whether or not a particular instrument constitutes debt for Federal income tax purposes depends on the facts and circumstances and hinges on a number of factors,(2) including (1) the right to receive a sum certain; (2) a fixed maturity date; (3) the right to receive fixed interest or dividends; (4) the right of a holder to enforce payment in the event of default; (5) subordination to general creditors; (6) the parties' intent; and (7) thin capitalization.(3)

For example, a private annuity subject to a term may constitute a debt instrument under general principles of Federal income tax law. A private annuity subject to a term differs from a conventional private annuity; payments due under the former cease at the earlier of a stated term (which may equal or exceed the seller's actuarial life expectancy) or the annuitant's death. If the maximum term is shorter than the seller's life expectancy, the IRS has expressed the view in GCM 39503(4) that the annuity is properly treated as an installment debt obligation, subject to Sec. 453 and the rules governing debt instruments issued for property. A deferred annuity is the same as a conventional private annuity, except that the annuity stream does not start until a stated number of years in the future.

Exceptions

Sec. 1275(a)(1)(B) carves out an exception from the definition of "debt instrument" for annuity contracts that either (i) depend (in whole or in substantial part) on the life expectancy of one or more individuals or (ii) are issued by insurance companies in a variety of situations.

Thus, if a private annuity not issued by an insurance company constitutes debt for Federal income tax purposes, it would be subject to the OID provisions if it does not qualify under Sec. 1275(a)(1)(B)(i). If, on the other hand, such a private annuity either does not constitute debt for Federal income tax purposes or qualifies for the exception, it generally would be accounted for under Sec. 72.

The reason for the Sec. 1275(a)(1)(B)(i) exception could be that any contract that calls for payments to continue only for the period of a life without guarantee that the premium will be recovered is not a debt instrument. For debt to exist, there generally must be an obligation to make a payment of a fixed amount at some date in the future. When payment is wholly contingent on the occurrence (or nonoccurrence) of an event, arguably, there is no "debt."

Final Regs.

In January 1998, the IRS published final regulations on the treatment of annuity contracts not issued by insurance companies as debt instruments subject to the OID provisions. The general rule under Regs. Sec. 1.1275-1(j)(2) is that an annuity contract qualifies for the exception in Sec. 1275(a)(1)(B)(i) (relating to certain annuity contracts that depend on the life expectancy of one or more individuals) only if it (1)...