The use of private annuities to shelter gain on appreciated property has come to an abrupt halt, if the Internal Revenue Service has its way.Whether the IRS can withstand pressure to withdraw or substantially amend new proposed regs before they are made final, or whether the final regs can withstand judicial challenge, remains to be seen. For now, however, effective for annuity transactions after Oct. 18, 2006 (subject to a relatively brief six-month "estate planning" exception), the division between "old rule" and "new rule" is dramatic.

* Old rule: An unsecured promise to pay by a family member or corporation that is not in the business of issuing annuities has no ascertainable value, so no gain is currently recognized on the transfer of appreciated property to such an obligor.

Instead, capital gain - defined as the difference between the present value of the annuity and the transferor's adjusted basis in the property - is recognized ratably on each payout over the life expectancy term of the annuity. The adjusted basis of the property is ratably returned tax-free as part of each annuity payment. The balance of any payment, which is the portion in excess of the capital gain and the basis recovery, represents interest and is ordinary income. Payments received after the life expectancy are fully includable in income.

* New rule: The same as the old rule, with one dramatic exception: The gain representing the difference between the present value of the annuity and the transferor's adjusted basis in the property is all taxed immediately upon the exchange. What's more, the present value of the annuity is deemed generally to be the fair market value of the appreciated property.

Open-transaction approach

Rev. Rul. 69-74, the IRS's only published position on this issue before the release of the proposed regs on Oct. 17, 2006, used the ratable recognition approach to defer gain on the exchange of appreciated property for a private life annuity. That approach allowed gain to be pro-rated evenly over the annuitant's life expectancy. It had its roots in the related judicially created open-transaction doctrine, under which no gain was recognized until basis was fully recovered, since the amount realized could not be determined with certainty at the time of the initial transaction.

The IRS now says that the open-transaction doctrine has been eroded, the valuation assumption underlying ratable recognition is no longer correct, and Rev. Rul. 69-74 should be declared obsolete as a result.

Sweeping application

The new regs provide a single set of rules purporting to leave the transferor and the 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.

This blanket rule applies whether in exchange for a new or existing annuity, whether the annuity contract is secured or unsecured, or even whether it is a commercial or a private annuity. Its universal application is tempered only by a narrow six-month rule and two exceptions that the IRS states it is not beyond removing when it considers them in more detail.

It also should be noted that while the same rules would apply whether the exchange produces a gain or a loss, the new rule on recognition does not have a silver lining for loss property. The IRS has been careful to provide that other provisions, such as the related party rules, can limit the loss.


The IRS correctly observed that the application of the open-transaction doctrine has been eroded. It points to abuses that principally involve related parties to justify its abandonment. It also reported that "a variety of mechanisms have been employed to secure the payment of amounts due under the annuity contracts." The question remains, however, whether the IRS is killing the proverbial fly with a sledgehammer.

While the IRS states that "the proposals are designed to combat the problem of some taxpayers who have been inappropriately avoiding or deferring gain on the exchange of highly appreciated property for the issuance of annuity contracts," in point of fact it catches all taxpayers in its net, including those who "appropriately" have been deferring gain.

Essentially, the proposed rules ignore the continuing uncertainties of the annuitant dying early and the obligor being unable to continue funding the payment stream. Under the theory of the new rules, the present value of the annuity already should take all those uncertainties into account.


The tone of the preamble in terms of harbingering more bad news for private annuities is ominous. Clearly, the IRS believes that the giant step against private annuities has been taken at this time, principally to stop the hemorrhaging of revenues caused by strategies that press the limits of the open-transaction doctrine.

Nevertheless, the IRS also implies that clean-up work, involving what to do with charitable annuities, installment sales, legitimate estate planning concerns and other loose ends, will be done next year ... and that such efforts won't foreclose applying the same new blanket rule to them, too.

In the meantime, however, practitioners have at least a short window of opportunity to enter into private annuity arrangements before the door shuts tight on any possible gain deferral.

* Charitable annuities. In the case of an exchange of appreciated property for a charitable gift annuity, the benefits of spreading out the gain on the bargain-sale portion of the transaction remain ... at least for now.

Reg. Sec. 1.1011-2 provides that any gain on such an exchange is reported ratably, rather than entirely in the year of the exchange. The IRS assured donors and charities that the new proposals are not intended to change the existing rule in this reg, but in the next breath announced that "comments are sought on whether a change should be made in the future to conform the tax treatment in the proposals."

* Installment sales/estate planning. Property is sometimes exchanged for an annuity contract, including a private annuity contract, for valid non-tax reasons related to estate planning and succession planning for closely held businesses. The proposals would continue to allow taxpayers to use these transactions, such as the installment-sale rules.

However, as with charitable annuities, the IRS plans to look into any changes to the installment-sale regulations "that might be required."

Six-month cushion

In general, the new rules would be effective for exchanges of property for annuity contracts after Oct. 18, 2006, and for annuity contracts received in such exchanges after Oct. 18, 2006.

However, the effective date would be delayed for six months until April 19, 2007, for certain transactions that, according to the IRS, "pose the least likelihood of abuse." That temporary angel's list includes transactions in which:

* The issuer of the annuity contract is an individual;

* The obligations under the annuity contract are not secured, either directly or indirectly; and,

* 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.

That leaves a significant window of opportunity for many related-party transactions to defer gain, as long as the uncertainties contained within the required two-year holding period can be endured. Action must be taken quickly, in any event, before the April 18, 2007, deadline.

Two other effective date matters also deserve mention. First, while the proposal does offer some hope in asking for comment on whether any additional transactions should come under the six-month delayed effective date, the public hearing is not scheduled until Feb. 16, 2007 - already four months into that grace period. Second, while the proposed regs were released on Oct. 17, they were not made effective until after Oct. 18, an odd two-day grace period given to those practitioners especially fleet of foot in accessing new developments from the IRS.

Transition planning

The abrupt change in the IRS's position on private annuities is mitigated only somewhat by the six-month transition rules and the requirement that a hearing take place before the regs are made final. Clearly, its new position is open to litigation.

A strategy of beating the six-month deadline or the probable tightening of the bargain-sale and installment-sale rules has its risks. Accelerating plans to exchange highly appreciated property with a private annuity is likely worth a try by certain wealthy clients, especially if they are prepared to shoulder immediate capital gain if things go awry. However, participants should tread cautiously in using either the Oct. 18, April 19 or later deadlines as bright-line cutoff dates.

Although the IRS does have its old position still outstanding in the form of Rev. Rul. 69-74, it also made it clear in a recent news release that "the ruling has been relied upon inappropriately in a number of transactions." Without being clear on what is "inappropriate," its audit position on examining past annuity exchanges and exchanges within the current deadlines may come as much of a surprise to some practitioners as the new proposed regs proved to be to most everyone.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a WoltersKluwer company.

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