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The following article was taken from the January 2012 issue of Estate Planner's Alert.

1/30/12 -- Ruling untangles tax consequences of unwinding of a private annuity

In a private letter ruling, IRS has explained the tax consequences of when an obligor of a private annuity contract sells property (a partnership interest) in exchange for termination of the contract and cash. As explained in the ruling, which involves a fairly complicated series of transactions, the obligor (a trust) will recognize gain or loss in an amount equal to the difference between (a) its basis in the property transferred and (b) the sum of the annuity value (value of the remaining payments), cash, and the trust's share of the partnership liabilities under Code Sec. 752(d). (IRS Letter Ruling 201149005)

Background. Private annuities historically have offered many tax advantages, for both income and transfer taxes, as well as the opportunity to save estate administration expenses. One income tax advantage has been the opportunity to spread capital gain over several years. A private annuity typically involves a parent's transfer of property to a child in return for the child's promise to pay the parent a fixed income.

RIA observation: This can save estate tax for the parent because it removes the subject property and any later appreciation in it from the parent's gross estate. However, payments received from the child will be included in the parent's gross estate to the extent not consumed during life.

A private annuity transaction works as follows. A person (the annuitant) transfers complete ownership of property to a transferee (the obligor) in exchange for the obligor's unsecured promise to make periodic payments to the annuitant. In the typical case, these payments are structured to continue for the rest of the annuitant's life. Generally, this type of arrangement is an isolated transaction between private parties who normally don't write annuities.

A portion of each annuity payment is subject to income tax and a portion of each payment is tax-free as a return of capital. The amount that may be excluded is determined by multiplying the annual payment by the "exclusion ratio." The exclusion ratio is calculated by dividing the annuitant's investment in the contract by the expected return under the annuity contract. The expected return is the product of the annuitant's life expectancy as determined from Reg § 1.72-9 and the amount of the annual payment.

The portion of each year's payment that is subject to tax may consist entirely of ordinary income or may consist in part of capital gain and in part of ordinary income. The latter occurs where the annuitant transfers appreciated capital gain property in exchange for the annuity. In such a case, the investment in the contract is the annuitant's basis in the appreciated assets, and the difference between the basis in the property and the present value of the annuity is treated as capital gain. The portion of the capital gain amount reported each year is determined by dividing the total capital gain amount by the life expectancy factor from Reg § 1.72-9. Once all capital gain has been reported, the balance of the taxable portion of each payment is ordinary income. (Rev Rul 69-74, 1969-1 CB 43)

RIA caution: IRS has issued proposed regs that would knock out the income tax advantages of selling appreciated property in exchange for a private annuity. They would do this by causing the property seller's gain to be recognized in the year the transaction is effected rather than as payments are received. The regs generally would apply for transactions entered into after October 18, 2006.

Under Rev Rul 55-119, 1955-1 CB 352, if property is exchanged for an annuity, and such annuitized property is disposed of before the death of the annuitant, the basis for determining gain is the total of the annuity payments made under the contract up to the date of disposition plus the value of the prospective payments remaining to be paid at the date of such disposition. The basis for determining loss is the total of the annuity payments actually made at the time of disposition. If the selling price is less than the adjusted basis for gain and greater than the adjusted basis for loss, neither gain nor loss is recognized at the time of the sale.

Facts. An individual (Grantor) established two Trusts, each benefitting a different beneficiary. Trusts purchased common stock from Grantor in exchange for unsecured Annuity Contracts (private annuities). These Annuity Contracts require Trusts to make a fixed annual payment to Grantor for his life.

The present value of the annuity payments required to be made under the Annuity Contracts equals the value of the stock received by the Trusts. As a result, no gift arose on the transaction under Code Sec. 2512.

Later, Trusts exchanged the stock for stock of another company in a tax-free merger. Trusts sold some of the new stock to unrelated parties and eventually exchanged the remaining new stock for stock in a third corporation that was received in a second tax-free merger. Trusts later sold all of their stock in the third corporation to unrelated third parties. After that, Trusts acquired interests in two partnerships. They later merged into Partnership 3.

Grantor is assigning his rights under Annuity Contracts to Buyer, a grantor trust. Thereafter, Trusts will sell their Partnership Interests to Buyer in exchange for (1) the termination of the Annuity Contracts and (2) cash.

The fair market value of the Partnership Interest of each Trust at the time of the sale will equal the sum of (1) the present value of the future annuity payments due under the Annuity Contracts (Annuity Value), plus (2) the Cash Payment. The Annuity Value was to be computed as of the closing date using the appropriate table identified in Reg. Sec. 2031-7T and the applicable Code Sec. 7520 interest rate as of the closing date and the age of the Grantor.

RIA observation: The taxpayer apparently sought the ruling before August 9, 2011, when IRS finalized Reg. Sec. 2031-7T.

Taxpayer requested two rulings.

First ruling. The taxpayer sought a ruling that the transfer by each Trust of a portion of its Partnership Interest to Buyer in exchange for the termination of the Annuity Contracts is treated as an annuity payment made under each of the Annuity Contracts in an amount equal to the Annuity Value for purposes of Rev. Rul. 55-119, and each Trust will recognize gain or loss as a result of such transfer in the tax year that includes such transfer as provided therein.

IRS said that the transfer by each Trust of a portion of its Partnership Interest to Buyer in exchange for the termination of the Annuity Contracts is treated as an annuity payment in an amount equal to the Annuity Value made under each of the Annuity Contracts under Code Sec. 72. IRS further concluded that the termination of the Annuity Contracts ceases the deferral treatment set forth in Rev. Rul. 69-74 and causes recognition of any remaining gain.

RIA observation: This statement concerning recognition of the remaining gain seems to affect the tax treatment to Grantor or to Buyer, as Grantor's assignee.

In addition, IRS stated that the disposition of the property that was exchanged for the Annuity Contracts may be relevant in determining the gain or loss realized. IRS said that each Trust shall recognize gain or loss as a result of such transfer in the tax year that includes such transfer in accordance with Rev. Rul. 55-119. RIA observation: Although it is not crystal clear, it sounds like IRS is saying that Trusts' gain or loss on the stock sales to the third parties should have been determined under Rev. Rul. 55-119 and that those gains or losses may be relevant in determining the gain or loss on the sale of the Partnership Interests.

Second ruling. IRS agreed with the taxpayer's second ruling request that each Trust will recognize gain or loss as a result of the sale of its Partnership Interest to the Buyer in the tax year that includes such sale in an amount equal to the difference between each Trust's basis in its Partnership Interest and the sum of (i) the Annuity Value, (ii) the Cash Payment, and (iii) the Trust's allocable share of the Partnership's liabilities immediately before the sale under Code Sec. 752(d).

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