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Big Changes for Private Annuities

The article examines the IRS’ recent issuance of proposed regulations
cracking down on Private Annuity Trusts used for income tax avoidance.
The article looks at why PATs are still a viable tool in estate

  For years the IRS has been attacking the use of Private Annuity Trusts, or PATs
  as a means of deferring income taxation on the sale of appreciated property.
  Our office has followed the advice of the American Academy of Estate Planning
  Attorneys and other commentators in advising our clients to stay away from such
  transactions unless they were willing to subject the transaction to the close
  scrutiny of the IRS.

One example of the many IRS attacks on PATs is Melnik v. Commissioner,
  T.C. Memo 2006-25, in which the Tax Court disregarded a deferred private annuity
  for income tax purposes in what should have been a run of the mill bad facts
  case. However, in disregarding the transaction the Tax Court interjected the
  economic substance doctrine into private annuity sales in a problematic way,
  clarified its negative view towards private annuity sales to trusts, and set
  forth several “don’ts” that would apply to any taxpayer seeking
  to defer income tax through private annuity sales, especially through the so-called
  “Private Annuity Trust.”

We will not get into those “don’ts” in this Alert, because
  on October 17, 2006, the IRS issued Proposed Reg-141901-05. The Proposed Treasury
  Regulation will drastically change the tax treatment of an exchange of property
  for an private or commercial annuity contract under Internal Revenue Code Sections
  72 and 1001 and will put an end to the claims of income tax deferral using such

The IRS states that the doctrine that taxpayers have relied on for tax deferred
  treatment of the exchange of appreciated property for a PAT is no longer correct.
  According to the IRS, the “open transaction doctrine” (the assumption
  that the value of a private annuity contract could not be determined for federal
  income tax purposes) “has been eroded in recent years.” The IRS
  is very much aware that the concept has been abused in a number of transactions
  that are designed to avoid income tax. According to the Service, “Many
  of these transactions involve private annuity contracts issued by family members
  or by business entities that are owned, directly or indirectly, by the annuitants
  themselves or by their family members. Many of these transactions involve a
  variety of mechanisms to secure the payment of amounts due under the annuity

The proposed regulations declare Revenue Ruling 69-74, the ruling upon which
  the proponents of PATs rely, obsolete. The proposed regulations will generally
  be effective for exchanges of property for an annuity contract after October
  18, 2006. Thus, the proposed regulations would not apply to amounts received
  after October 18, 2006 under annuity contracts that were received in exchange
  for property before that date.

For a limited class of transactions, the effective date will be for exchanges
  of property for an annuity contract after April 18, 2007. These would be transactions
  in which:

  1. the issuer of the annuity contract is an individual;
  2. the obligations under the annuity contract are not secured, either directly
        or indirectly; and
  3. the property transferred in the exchange is not subsequently sold or otherwise
        disposed of by the transferee during the two-year period beginning on the
        date of the exchange.

The proposed regulations provide a single set of rules that leave the transferor
  and transferee in the same position before tax as if the transferor had sold
  the property for cash and used the proceeds to purchase an annuity contract.
  The effect of these proposed regulations is to treat the transferor as having
  realized an amount equal to the fair market value of the PAT, determined under
  Internal Revenue Code § 7520 (this provides the actuarial tables which
  must be used to compute the present value of an annuity). The proposed regulations
  do not distinguish between a PAT and a commercial annuity sold by an insurance
  company. So if a PAT or a commercial annuity contract is received by the seller
  in exchange for property (other than cash), the entire amount of the seller’s
  gain or loss (if any) must be recognized at the time of the exchange.

The proposed regulations do not alter the existing rules governing tax-free
  exchanges of annuity contracts under Internal Revenue Code § 1035. They
  ONLY address taxable exchanges of other property for an annuity, either private
  or commercial.

While proposed regulations will likely put an end to the use of PATs for income
  tax planning purposes, the private annuity remains a very viable estate planning
  strategy for use in circumstances when a person with a taxable estate (more
  than $2 million in 2006) is not expected to live his or her life expectancy
  as determined under IRS guidelines, but they are not classified as terminally
  ill. A person is not considered to be terminal by the IRS if he or she has at
  least a fifty percent chance of living one year.

Contact us at our office to schedule an appointment with one of our estate
  planning attorneys to learn more about the use of private annuities, self-canceling
  installment notes (SCINs), and other advanced estate planning strategies if
  you have any clients with taxable estates.

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