In a prior column I wrote extensively on the usage of private annuities to sell one’s business, real estate or any large assets with the current incurrence of income tax. IRC §72 and Rev. Rul. 69-24, 1969-1 C.B. 43. Case law supported this view point and there had not been much if any current litigation on this issue. Bell v. Comr., 60 T.C. 469 (1973), 212 Corp. v. Comr., 70 T.C. 788 (1978).
To recap form the prior column
An annuity is a contract, generally with an insurance company, where you provide the company a sum of money. The insurance company agrees to make payments back to you over a set time frame. You would decide when the payments to you, would start and how the long the time period the payments would continue for. You would also decide if the payments would be measured by your life span, or by the life of an another, such as your spouse.
You would first select a starting date for the annuity payments to begin. If the payments begin immediately this type of annuity is called an immediate annuity. The payments however, could began at any point in time you agree to, such as in five years, ten years, next week, or next month.
Second you would select how long the payments would continue for. If you want the payments to continue for your life, the term is referred to as a life annuity. If you selected the measuring period for payments to be you and a spouse, the term is referred to as a joint life annuity. You could also select a specific time period, or a term certain, such as ten years, twenty years or whatever term of years you require.
Each variable as to the starting date, the amount of time the annuity will be paid for, a certain term, versus a life time, a guaranteed return versus a variable term all will affect the amount of each payment you receive.
Annuities are approved within IRC §72. It allows a person to transfer property to another and receive back a stream of payments. Each payment that you receive from the annuity company will contain two or sometimes three components. The components are:
return of principal, (your cost basis)
capital gain, (depending on the property transferred) and
interest or investment income.
Now that you know this exists, why does this device allow your to incur no immediate income tax?
What makes this work is two factors:
- The creation of an annuity usually is not a taxable event.
- Every payment of the annuity has a fixed fractional component that consists of your taxable gain, a portion that is your return of capital, and a portion that is ordinary income.
As you have not yet received any payments, you would therefore not yet have incurred any tax. At the time the assets were transferred to the annuity the transfer was not capable of precise valuation, no determination of the selling price had yet occurred. Therefore a tax computation was not possible.
Though, this planning tool, may be aggressive in its nature it has been widely regarded for over 27 years, since the 1969 revenue ruling. Unfortunately, its practice became highly commercialized in the past few years with many “planners” offering their clients an inexpensive tool, dubbed the “PATS”, or private annuity trusts. With this tool, almost anyone could buy an inexpensive kit and arguable have a private annuity set up to sell assets to a trust. The trust would offer the asset’s seller a private annuity in exchange for the assets. The underlying assets, would then be sold by the private annuity trust to a third party for the amount the annuity interest was valued at. The result would be no current taxation for the initial sale of assets and no current taxation for the annuity trust’s sale of assets. The mass marketing of this type of concept into a product left the IRS in a position where it had to stop the practice before it became out of hand and significant tax revenue was lost.
What to do???
A simple solution for the government was developed. On October 16, 2006 the Internal Revenue Service and the Department of Treasury issued proposed regulations that became effective on October 18, 2006 addressing the tax treatment for all annuities, both private and commercial or public. The proposed regulations change the interpretation of prior revenue rulings, ending the capital-gains and income tax deferrals on such transactions and instead taxing a seller on the full, fair-market value of the annuity, when the transaction initially occurs. Hence, no current tax benefit would occur from using the structure. Therefore, with no tax deferral, there would be no reason to use the structure, or if used, no savings would result.
The major change in the proposed regulation is that the transfer of the underlying assets to the annuity are now deemed capable of valuation, whereas as all prior case has ruled that such transfer is not subject to valuation. As the asset was not deemed subject to valuation, until you were actually paid by the annuity payments, no current tax could be incurred, as an unknown existed, as to the amount of your selling price of the assets to the annuity structure.
Even though the IRS has changed their interpretation of the rules, no court case has changed nor has any court considered this change of interpretation. A major question looming is whether the court will accept the IRS viewpoint and overrule all their prior cases based upon the IRS proposed regulation? Yet, the regulation is only proposed, with public hearings scheduled for February 16, 2006. There is yet no specific time frame for this proposed regulation to become a final regulation. Yet to ignore such a regulation if it becomes final, or even in its proposed form is fraught with danger from penalties that could be assessed.
Also, lets make this a bit more confusing on the IRS’s rule. If a private annuity transaction is pending, or proposed, then an exception may exist within a six month window, until April 18. 2007. If such transaction closes, and the underlying property is not sold for two years, then annuity treatment, no current taxation on the sale to the annuity structure and no current taxation on the annuity’s sale of the underlying property may still occur. Other restrictions on usage of a private annuity structure are contained in the IRS proposed regulations. Proposed Treas. Reg. Sec. 141901-05, 2006 IRB 47.
So if private annuities are on their way out what is on their way in to postpone taxation on a the sale of your closely held stock?
That is for next month’s column, but there is another Code Section that may work!
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.