Private Annuity Trusts: New Rules

Just as last month’s discussion of private annuity trusts was mailed, the government issued proposed regulations restricting the strategy. Though intended to stop transactions considered by the IRS to be abusive of the tax law, the regulations go further and make private annuity trusts generally unattractive.

Recall from last month’s discussion that a private annuity is an estate planning transaction. The owner of highly appreciated property such as a business or real estate sells it, usually to his children or a trust for the children’s benefit. The property is transferred in exchange for an annuity. The trust promises to pay the owner a fixed amount each year for life.

The private annuity allows the owner to spread the tax burden over many years, provides income from the property for life, and keeps the property and its future appreciation out of his estate.

Private annuities sprang from an IRS ruling many decades ago. In that ruling the IRS said that at the time it was assumed that a private annuity could not be valued, so when property was exchanged for an annuity taxes could be delayed until cash was received. Now the IRS says there are mechanisms for valuing the transaction, so there is no reason to allow deferral of taxes. Along with issuing the proposed regulations, the IRS withdrew the old ruling.

The new regulations provide that when property is exchanged for an annuity, the transferor of the property is treated as selling the property for the fair market value of the annuity. IRS regulations are used to determine the value of the annuity. The annuity’s value depends on the value of the property, current interest rates, and the life expectancy of the seller (or the payout period for the annuity). The valuation rules are the same ones used for vehicles such as grantor annuity trusts and charitable remainder trusts.

Taxes from the transaction are due on the date the property is transferred, as though the property were sold for cash equal to the value of the annuity.  In addition, the regulations provide that there is no difference between secured and unsecured annuities or between private annuities and those issued by insurance companies.

The IRS did say that the new regulations affect only annuity transactions. Taxpayer can achieve many of the same results by using an installment, and the IRS specifically stated that installment sales are not affected by the proposed regulations.

In an installment sale, the owner sells property in exchange for the buyer’s promise to make a series of payments over time. Taxes are due only as each payment is received if the sale is structured correctly. Each payment is treated partly as a tax-free return of principal, part as capital gains, and part as interest income. We will provide more details about installment sales as an estate planning tool in a future issue.

Some estate planners were concerned that the proposed regulations also would disrupt charitable gift annuities. But the IRS stated that the regulations do not apply to charitable gift annuities. The IRS did say that regulations directed at charitable gift annuities are possible in the future.

The proposed regulations apply to exchanges for annuities that occur after Oct. 17, 2006. There is a six-month grace period after that date for transactions that the IRS does not consider abusive. The strategies the IRS considers abusive are those in which the promised payments under the annuity are secured in some way, usually by the property transferred.