Service issues prop. regs. on exchanges for annuities.

• Author: Ratner, Charles L.

The Service issued proposed regulations (REG-141901-05, 10/18/06) on the taxation of the exchange of property for an annuity contract.

Overview

A heavily promoted, but controversial technique for income and estate tax planning has been the so-called "private annuity trust." It relied in part on the "open transaction doctrine," under which, if the value of the private annuity could not be determined with certainty, the seller would recover the basis of the property sold before realizing any income on the sale. The strategy also relied on Rev. Rul. 69-74, which allowed for ratable recognition of gain over the annuitant's life expectancy.

In a typical situation, a parent would transfer property (such as real estate) to a nongrantor trust in exchange for a private annuity; annuity payments could begin immediately or be deferred for a number of years. Proponents of the strategy maintained that payments to the seller would be taxed under the Sec. 72 annuity rules, thereby spreading the income tax over the seller's life. Meanwhile, the trust would sell the appreciated asset to an unrelated party for cash or an installment note. Because the trust would acquire a basis in the real estate equal to its fair market value (FMV), the sale would presumably result in no gain to the trust. The technique offered the usual wealth transfer (freeze) benefits of the private annuity to the parent/seller.

Perceived Abuse

Treasury and the IRS had become aware that some taxpayers were using these transactions in troublesome circumstances. Both indicated that neither of the concepts noted above clearly reflects the income of the transferor who sells the property in exchange for the annuity. They also expressed concern that transactions were structured to provide security for the seller's payments, which would otherwise preclude taxation under the private annuity roles.

Prop. Regs.

The proposed regulations provide that, if an annuity contract is received in exchange for property other than money, (1) the amount realized attributable to the annuity contract will be its FMV (as determined under Sec. 7520) at the time of the exchange; (2) the taxpayer will recognize gain or loss at the time of the exchange, regardless of accounting method; and (3) in determining the initial investment in the annuity contract under Sec. 72(c)(1), the aggregate premiums or other consideration paid for the contract will equal the amount realized attributable to it. Thus, if the FMV of the...