AICPA Comments to IRS on Annuities - March 6, 2007

AICPA Comments to IRS on Annuities - March 6, 2007

March 6, 2007

The Honorable Mark W. Everson

Commissioner

Internal Revenue Service

CC:PA:LPD:PR (REG-141901-05)

Courier’s Desk

1111 Constitution Avenue, NW

Washington, DC20044

Mr. James Polfer

Internal Revenue Service

CC:PA:LPD:PR (REG-141901-05)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

RE:REG-141901-05,Notice of Proposed Rulemaking Regarding Exchanges of Property for an Annuity (

Dear Commissioner Everson and Mr. Polfer:

The American Institute of Certified Public Accountants is pleased to provide comments on the proposed regulations that were issued and effective October 18, 2006,regarding the taxation of the exchange of property for an annuity contract. Our Trust, Estate, and Gift Tax Technical Resource Panel’s Private Annuities Task Force developed these comments, which were approved by boththe AICPA’s Trust, Estate, and Gift Tax Technical Resource Panel and Tax Executive Committee.

The AICPA is the national, professional association of CPAs, with approximately 350,000 members, including CPAs in business and industry, public practice, government, and education; student affiliates; and international associates. Our members advise clients on federal, state, and international tax matters and prepare income and other tax returns for millions of taxpayers. They provide services to individuals, not-for profit organizations, small and medium-sized businesses, as well as America’s largest businesses. It is from this broad perspective that we offer our thoughts today.

The AICPA believes that these proposed regulations are overly broad in nature and attempt to curb perceived abuses that could be managed in a much less intrusive manner. The proposed regulations should be narrowed to correct the perceived abuses and allow the private annuity estate planning toolto continue to allow the non-abusive, legitimate intra-family transfer of assets to lower tier generations, without immediate income tax recognition. Our attached comments discuss our concerns with the regulations and suggest the regulations be changed.

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The Honorable Mark W. Everson and Mr. James Polfer

March6, 2007

Page 2

We welcome the opportunity to discuss our comments further with you or others at the IRS and Treasury Department. Please contact me at (212) 773-2858, or ; Steven A. Thorne, Chair of the AICPA Trust, Estate, and Gift Tax Technical Resource Panel, at (312) 486-9847, or ; Jacqueline A. Patterson, Chair of the AICPA Private Annuity Task Force, at (213) 228-6500, or ; or Eileen Sherr, AICPA Technical Manager at (202) 434-9256, or .

Sincerely,

Jeffrey R. Hoops

Chair, AICPA Tax Executive Committee

cc: Eric Solomon, Assistant Secretary (Tax Policy), Treasury Department, Room 3104 MT (fax 202-622-0605)

Donald L. Korb, Chief Counsel, IRS, Room 3026 IR (fax 202-622-4277)

Heather C. Maloy, Associate Chief Counsel - Passthroughs & Special Industries, IRS, Room 5300 IR (fax 202-622-4524)

Catherine V. Hughes, Attorney Adviser, Tax Legislative Counsel, Treasury Department, Room 4212 MT (fax 202-622-9260)

James Hogan (Senior Technical Reviewer, CC:PSI:B09, Room 4107 (fax 202-622-4451)

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AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on REG-141901-05,Notice of Proposed Rulemaking Regarding Exchanges of Property for an Annuity

March 6, 2007

Executive Summary

The AICPA believes that these proposed regulations are overly broad in nature and attempt to curb perceived abuses that could be managed in a much less intrusive manner.The proposed regulations provide harsh tax treatment of private annuity sales and suggest using the installment sale rules instead. However, the applicability of the installment sales rules for private annuities is highly questionable due to important differences between the two transactions. Furthermore, to the extent that the installment rules are not available, these rules put families, and others, who legitimately are trying to pass property in return for an income stream in a difficult situation, since the seller will have to come up with a large tax payment in a situation in which neither side of the transaction has acquired any liquidity. (We note that an abuse could occur when the buyer does acquire liquidity, such as by selling the property for cash to an outsider.)

Private annuities are used for many reasons, including: (a) to transferan asset from the transferor to an(often related) transferee, (b) to provide ongoing cash flow to the transferor, and (c) to defer the gain from the sale over the annuity payments. The proposed regulations disable the third objective and make the second more difficult to achieve. These regulations should only target abusive private annuity transactions, one of which is where the owner of appreciated property attempts to defer gain recognition on a pending sale by creating a nongrantor trust, selling the appreciated property to the trust in exchange for an annuity, and then having the trust immediately sell the appreciated property to a third party. The proposed regulations should be narrowed to correct the perceived abuses and permanently (not just for the six months noted in the proposed regulations) allow the private annuity estate planning tool to continue to allow the non-abusive, legitimate intra-family transfer of assets to lower tier generations and allow the use of trusts in such situations without immediate income tax recognition.

Specific Comments

  1. Certain private annuity transactions have little potential for abuse and should be allowed and excluded from the prohibition in the proposed regulations. In fact, the Treasury Department and the IRS have acknowledged in the preamble to the proposed regulations that unsecured sales of annuities between individuals are “legitimate” and used in estate planning for “valid, non-tax reasons related to estate planning and succession planning for closely held businesses.” Further, they state that “the proposed regulations are not intended to frustrate these transactions….” In addition to transactions between individuals, we support the use of trusts in certain transactions and note that the transferor often faces risks when assets are transferred directly to heirs who have direct access to the property and cash, and where the assets are subject to poor handling, lawsuits, divorce settlements, etc.These arelegitimate reasons to allow transfers to a trust as long as there is no resale by the trust within a short period of time prior to any increase in the value of the property, as discussed in 2 below. Therefore, thetransactions described in the preamble to the proposed regulations as “plain vanilla” private annuity sales (between individuals, unsecured, and where the property is not subsequently disposed of within two years), which were given a six month extension period under the proposed regulations,should at a minimum be granted a permanent exception to the new rules and allowed to continue. For example, taxpayers using the traditional unsecured private annuity in succession planning, such as an older parent’s sale to a child in exchange for an annuity, should be allowed to continue to receive favorable tax treatment if the transaction is not abusive, irrespective of when the transaction occurs (not just for transactions that occur on or before April 18, 2007).

REG-141901-05, which currently proposes to tax all private annuity sales at inception, isoverly broad in nature and has effectively disabled an estate planning tool that has a long history of use and effectiveness. The new regulations will severely curtail many taxpayers’ ability to use this tool in legitimate estate planningfor valid nontax reasons. Private annuity sales have been used in estate planning for many years, and the deferral of the gain component in these transactions has been with the blessing of the Internal Revenue Service (IRS) since 1950. Private annuity transactions are often used in isolated family transactions to allow older generation family members to pass businesses and other assets to lower tier memberswhile maintaining a cash flow for the transferor. Such transactions are already subject to countless taxation rules and other requirements. These transactions will not be possible if the transferor has to pay income tax on the full gain without any cash from the transaction to pay the tax.

  1. The proposed regulations clearly attempt to correct perceived abusesthat include private annuity trusts (PATs)where the “Treasury Department and the IRS have learned that some taxpayers are inappropriately avoiding or deferring gain on the exchange of highly appreciated property for the issuance of annuity contracts.” PATs are a term coined by those marketing the combination of private annuities and trusts for deferral of gain from the specific sale of highly appreciated real estate.In particular, abusive private annuity transactions involve a trust “promoter” who targets a taxpayer, who is selling property (often real property) and has already found a buyer. The promoter directs the taxpayer to create a trust. The parties fully intend to have the trust buy the asset and sell it to the buyer. The trust’s involvement amounts to tax avoidance. Several judicial doctrines could be applied (sham transaction, step transaction, substance over form, and assignment of income).The PAT strategy has allowed the deferral of gain while the related party trust has full access to the proceeds of the underlying property sales. Correction of this abuse can be achieved in a much less intrusive manner by specifically targeting the PAT rather than adversely impacting all private annuity sales. Full recognition of gain on the subsequent sale of the appreciated property by the PAT would eliminate the perceived PAT abuse. Other perceived abuses, such as those that may occur in the foreign area, should be isolated and corrected in the same manner. There are many situations in which combining a trust with a private annuity is not abusive. It is the resale by the trust in a short period of time, before there has been any appreciation in the property that the IRS considers abusive, so only that situation should it be treated as abusive.
  1. REG-141901-05 does constitute a “significant regulatory action” and deserves a full coordinated review by the Office of Management and Budget. It dramatically revises the timing of gain in a private annuity transaction and overturns sixty years of both judicial and non-binding precedent. It also contradicts Congressional intent behind the taxation rules of Internal Revenue Code (IRC) section 72, which instructs that a portion of each annuity payment be treated as an annuity payment with the balance being treated as a return of basis.
  1. Declaring Rev. Rul. 69-74 obsolete creates additional questions that were resolved when the compromise ruling was issued. Rev. Rul. 69-74 put to rest many questions regarding the taxation of private annuity payments and represented an integration of installment sale concepts with annuity concepts. It set forth a reasonable reporting method reflected in prior court decisions that the “realization” (collection) of cash was the appropriate point for taxation. It recognized that annual payments consisted of an annuity amount resulting in ordinary income and a capital amount that is further divided between a recovery of basis and a capital gain. Once all the capital gain and basis are recovered, Rev. Rul. 69-74 provides that annuity payment will be taxed as ordinary income for the rest of the annuitant’s life. Declaring Rev. Rul. 69-74 obsolete resurrects the question regarding the character as ordinary or capital of the annuity payments made after the annuitant recovers the investment in the contract. It also raises questions regarding the deductibility of the interest portion by the transferee.
  1. The consistency argument put forth in the proposed regulations to tax private and commercial annuities in the same manner is not supported by the economic reality of the underlying transaction. To tax a private annuity transaction as if the asset were sold and the proceeds used to purchase a commercial annuity is unreasonable. At the transaction’s inception, there are no sales proceeds received by the transferor with which to either pay the tax or purchase a commercial annuity. A typical rationale for entering into a private annuity transaction is to prevent the forced sale of a family business or other asset that is intended to flow to children, grandchildren or trusted employees, upon the death of the transferor.

Additionally, commercial annuities differ greatly from private annuities. For instance, commercial annuities are sold by professionals, while private annuity transactions are generally between family members, close friends or employees. Commercial annuities are generally purchased for cash, while private annuities are exchanged for in-kind property. Commercial annuity companies develop their own actuarial models based on many factors personal to the annuitant, while private annuities rely solely upon the IRS actuarial valuation tables that ignore many risk factors. There is state regulation of annuity company investments, as well as state requirements for maintaining sufficient reserves and evidence that purchasers of commercial annuity contracts have significantly varied life expectancies than the average person represented by the IRS tables.

  1. Recognizing the full gain at the time of the annuity sales transaction simply does not reflect the underlying economics. The sales proceeds subject to gain have not been received but are simply the “present value” or projected economics in the transaction. Judge Simpson in his dissent in Bell v. Comr., 60 T.C 469, 477 (1973) stated, “a cash basis taxpayer does not include in the computation of the ‘amount realized’under section 1001(b) the right to receive future income unless that right is readily transferable in commerce”. Because the total annuity payments depend entirely on how long the annuitant lives and are completely unsecured, the annuity promise is not readily transferable in commerce and hence not the equivalent of cash.If the annuitant dies prematurely, he or she will not have received the full economic benefit of the transaction upon which he or she has been taxed. The ability to take a loss on the unrecovered tax basis at the death of the transferor in no way compensates for the upfront taxation required by the new rules.
  1. In many respects a private annuity is similar to aself-canceling installment sale or SCIN. Gain is deferred in a SCIN transaction under the rules of IRC section 453 and the “contingent sales doctrine” because the duration of the payments depends upon the individual’s life [reg. section15a.453-1(c)(4)]. The contingency does not lie in the amount of the maximum sales price but whether the buyer will make all of the payments before the seller’s death. A similar contingency exists in the private annuity sale along with the possibility that the transferor will outlive his or her life expectancy and the transferee will be obligated to continue to make payments. These contingencies warrant deferred gain tax treatment. An exchange of property for a private annuity has been taxed in a manner similar to a SCIN, and such treatment should continue.

Further, there are significant differences in the taxation of private annuities and installment sales. These include limitations under the installment rules that prevent certain assets from qualifying for installment sale treatment. Additionally, there are differences in the two transactions that include the ability of the transferor to secure an installment note, the transferee’s right to adjust the cost basis to the sale price, and the ability of the transferee to deduct the interest portion of the payments if allowed under IRC section 163. There are also related party rules under IRC section 453 that apply to installment sales. Thus, the availability of the installment sales rules in situations that would traditionally have used a private annuity instead, as suggested by the preamble to the proposed regulations, is highly questionable given the uncertainty of the amount that will ultimately be paid and the relationships between the parties. Furthermore, to the extent that the installment rules are not available, these rules put families, and others, legitimately trying to pass property in return for an income stream in a difficult situation, since the seller will have to come up with a large tax payment in a situation in which neither side of the transaction has acquired any liquidity. (We note that an abuse may occur when the buyer does acquire liquidity, such as by selling the property for cash to an outsider.) Because of these differences, private annuity transactions should continue to be taxed under their own rules.

  1. The new proposed regulations ignore prior rulings, regulations and case law that have long monitored private annuities purchased either by individuals or trusts. These include the basis adjustment rules under Rev. Rul. 55-119 for both depreciation and subsequent sale by the transferee in a private annuity transaction. These floating basis rules recognize the contingencies apparent in the private annuity transaction and clearly fix the cost of the property acquired at death, not at the time the annuity commences. The ruling states: “A transaction in which a taxpayer who is not engaged in the business of writing annuity contracts receives property in exchange for his promise to make annuity payments to the transferor is not a closed and completed transaction until the death of the annuitant. It is not until the death of the annuitant that the fixed cost of the property so acquired may be determined.”
  1. Theexhaustion test or calculation under section 7520 directly impacts the use of private annuities with trusts.The trust as obligor of the annuity must have sufficient assets or funding to pay the annuity until the transferor reaches age 110. Because of these requirements, valid private annuity transactions,as opposed to many abusive ones, meet these rules. The proposed regulations add another layer of complexity and cost to create and monitor the transactions.

Conclusion