Private Annuity Sales and the Exhaustion Test

Private Annuity Sales and the Exhaustion Test

The exhaustion test presents a significant obstacle to successful implementation of a private annuity sale to an irrevocable trust. Ignoring the exhaustion test can result in gift and income tax, but meeting the exhaustion test is extremely difficult. Finally, whatever their merits, arguments against the validity of the exhaustion test are not a wise bet.

The Exhaustion Test

The regulations contain two limitations on the use of the annuity tables under section 7520 that may apply to private annuity sales to trusts.[1] One is the so-called “exhaustion test,” which states:

A standard section 7520 annuity factor may not be used to determine the present value of an annuity for a specified term of years or the life of one or more individuals unless the effect of the trust, will, or other governing instrument is to ensure that the annuity will be paid for the entire defined period. In the case of an annuity payable from a trust or other limited fund, the annuity is not considered payable for the entire defined period if, considering the applicable section 7520 interest rate on the valuation date of the transfer, the annuity is expected to exhaust the fund before the last possible annuity payment is made in full. For this purpose, it must be assumed that it is possible for each measuring life to survive until age 110. For example, for a fixed annuity payable annually at the end of each year, if the amount of the annuity payment (expressed as a percentage of the initial corpus) is less than or equal to the applicable section 7520 interest rate at the date of the transfer, the corpus is assumed to be sufficient to make all payments. If the percentage exceeds the applicable section 7520 interest rate and the annuity is for a definite term of years, multiply the annual annuity amount by the Table B term certain annuity factor, as described in Section 25.7520-1(c)(1), for the number of years of the defined period. If the percentage exceeds the applicable section 7520 interest rate and the annuity is payable for the life of one or more individuals, multiply the annual annuity amount by the Table B annuity factor for 110 years minus the age of the youngest individual. If the result exceeds the limited fund, the annuity may exhaust the fund, and it will be necessary to calculate a special section 7520 annuity factor that takes into account the exhaustion of the trust or fund. This computation would be modified, if appropriate, to take into account annuities with different payment terms.[2]

Example 5 of Treas. Reg. section 25.7520-3(b)(2)(v) (“Example 5”) explains how to calculate the special section 7520 factor. If a trust will exhaust prior to the annuitant’s attainment of the age of 110, then Example 5 requires that the annuity must be valued as an annuity payable for a term of years or until the prior death of the annuitant, with the term of years determined by when the annuity payments will exhaust the fund. Example 5 is reprinted in the Appendix.

The other limitation on the use of section 7520 is contained in Treas. Reg. section 25.7520-3(b)(1)(ii). It states that “A restricted beneficial interest is an annuity, income, remainder, or reversionary interest that is subject to any contingency, power, or other restriction, whether the restriction is provided for by the terms of the trust, will, or other governing instrument or is caused by other circumstances. In general, a standard section 7520 annuity, income, or remainder factor may not be used to value a restricted beneficial interest.” This is referred to herein as the “governing instrument” requirement. The governing instrument requirement is not analyzed herein.

II. The Exhaustion Test

A. What is at stake?

Failing the exhaustion test means that the annuity payable to the seller will be worth less than desired, potentially resulting in gift and income tax.

Example: a 65-year old desires to sell an asset worth $10,372,800 to an irrevocable trust[3] in exchange for a private annuity at a time when the section 7520 rate is 5.2%. Ignoring the exhaustion test, a $1 million life annuity will equal $10,372,800.[4]

Failing the exhaustion test means a gift will necessarily result. For example, assume that the irrevocable trust is funded with a seed gift of $1 million. Under Example 5, the trust will be assumed to run out of funds when the annuitant is 83. The $1 million annuity for life is accordingly valued as if it were an annuity for a term or life annuity. The value of the annuity under section 7520 is approximately $9,276,307, resulting in a gift of approximately $1.1 million.

Additionally, if the trust is relying on Rev Rul 55-119[5] to get basis in the purchased asset, then its basis in the asset will be only $9,276,307,[6] so that upon its subsequent sale of the asset, some capital gain (likely short-term) will result.

B. Historical Background

1. Rev. Rul. 77-454

The starting point for the discussion of the current exhaustion test is Rev. Rul. 77-454.[7] Rev. Rul. 77-454 interpreted former Treas. Reg. section 25.2512-9, which laid out valuation tables that were then applicable to annuities, terms for years, remainders and reversions. In Rev. Rul. 77-454, the Service claimed that annuity factors set forth in section 25.2512-9 are based upon the assumption that payments can actually be received for each year even if the annuitant survives to age 109.

The Service offered this example to support its point: “For example, an annuity payable only from a fund of $200 cannot be valued by using a factor from Table A(1) if an annuitant aged 51 years is to receive annual payments of $100 for life. In such a situation, the annuitant's right to payments is not worth $1,113 (the value produced through the use of a factor of $11.1308 from Table A(1).) On the contrary, it is worth something less than $200, due to the possibility that the annuitant may die before the fund is exhausted.”

The Service then concluded that an annuity from a fund that will exhaust prior to age 109 is to be valued as annuity for a term of years or the death of an individual, whichever occurs first. The term of years equals the number of years until the trust will exhaust.

From this revenue ruling comes the truism that an annuity cannot be worth more than the fund from which it will be paid. Economically, this is an irrefutable point. In other words, the Service is correct that the annuity in the above example is not worth $1,113, because it is payable out of a $200 fund. The annuity cannot be worth more than $200. Second, the Service claims that the annuity cannot be worth $200, because there is a risk that the 51 year old will die prior to receiving the entire corpus of the trust back. Again, economically, this is difficult to refute. At best, the annuitant will receive $200 (in today’s value), and at worst, he will receive nothing. Therefore, the annuity has to be worth less than $200.

Third, the revenue ruling establishes a method for valuing the annuity. The Service’s method is to treat the annuity as a short of term or life annuity, with a term equal to the length of time until the trust runs out of money, determined by assuming that the trust grows at an assumed growth rate (then 6%).

Fourth, the Service set forth the circumstances in which annuities must be valued under this method: if the trust doesn’t have sufficient funding the pay the annuity through age 109, then this special valuation method must be used. This is probably the most controversial point in the ruling.

The assumption that the annuitant must receive the annuity through age 109 does not in any way follow from the $200 example. The Service used an example in which the tables value an annuity at an amount well in excess of the fund from which the annuity would be paid to not only prove an easy point (that naked application of the tables is inappropriate in that circumstance), but to prove a different, unrelated point altogether: if the tables value an annuity at an amount LESS than the fund from which the annuity would be paid (so that the $200 example above is NOT on point), the tables are nevertheless inapplicable if there is a risk that the annuitant does not receive the benefit of the bargain inherent in an annuity contract (i.e., payments under the contract in the event the annuitant lives past his life expectancy).

While the age 109 assumption has little to do with the $200 example, it does in fact follow from the Service’s premise that the tables are based upon the assumption that payments can actually be received for each year even if the annuitant survives to age 109. Instead of illustrating the exhaustion test through the $200 limited fund example, the Service should have made its point by illustrating that the value of an annuity is simply equal to the present value of each year’s annuity payment multiplied by the chances of the annuitant living to receive each payment. Such an illustration would show that a portion of the assumed value of any annuity lies in the value of the potential payments beyond the annuitant’s life expectancy.

This Service’s exhaustion argument was tested in Estate of Shapiro v. Commissioner, T.C. Memo 1993-483.

2. Estate of Shapiro

In Shapiro, the taxpayer argued that the tables under section 20.2031-7(f) applied in valuing a $350,000 annuity payable to the 91-year old decedent out of a trust fund of $1,005,000. Application of the regulations resulted in the life annuity having a value of $943,425, and it was on this value that the decedent’s estate calculated a credit for tax on prior transfers under section 2013.

The IRS argued that, due to the trust’s limited funding, the annuity should be valued as a term or life annuity. Although Rev. Rul. 77-454 was not cited by the Tax Court, the valuation method urged by the IRS in Shapiro was identical to the method prescribed by Revenue Ruling 77-454. Under the IRS’ approach, the annuity had a value of only $680,896, thus reducing the tax on prior transfers credit. The IRS argued that the annuity should not be valued as a life annuity, but should be valued as an annuity for a term certain concurrent with one life because (i) the annuity was payable out of a depleting corpus and (ii) the trust was "underfunded" in that the corpus was not large enough to support the annuity obligation in case decedent had lived to be age 109.

The Tax Court addressed both arguments as if made in the alternative, but the second argument (that the corpus will fully deplete prior to age 109) is the real issue - the first argument (that the annuity is payable from a depleting corpus) has no consequence unless the second argument (that the corpus will fully deplete prior to age 109) is true; and the second argument (that the corpus will fully deplete prior to age 109) cannot be true unless the first argument is also true (that the annuity is payable from a depleting corpus).[8]

The Tax Court sided in favor of the taxpayer, making several observations:

• “The actuarial tables, such as Table A of section 20.2031-7(f), Estate Tax Regs., are an administrative convenience in that they provide a "bright line" approach to valuation making it unnecessary to hypothesize as to the facts and circumstances surrounding each case.”
• “It is well established that the actuarial tables generally are to be respected unless the established facts show that the result under the tables is unrealistic or unreasonable, or that the result ignores common sense.”
• “Respondent confuses a TERM CERTAIN with a property interest that is TERMINABLE. In most cases, it is impossible to immediately ascertain the time at which a trust fund will exhaust with the certainty and specificity sufficient to equate the duration of the trust to a term certain. Although decedent's interest in the trust may have been TERMINABLE by virtue of the possibility of corpus depletion, the bequest of his interest was not definitively limited to a TERM CERTAIN. If respondent, in drafting this regulation, intended the meaning of term certain to comprise that period of time after which a property interest might be extinguished by the possible exhaustion of a trust fund, she should have set forth a special definition of "term certain" in the regulation. Because she did not, we are reluctant to transform "term certain" into a term of art in this case.”
• “The fact that respondent, in section 20.2031-7, Estate Tax Regs., did not specify "terminable" interests, when she could have, further convinces us that a TERM CERTAIN is to be distinguished from an interest that is merely TERMINABLE DUE TO POSSIBLE DEPLETION OF THE CORPUS.”
• With regard to the age 109 requirement, the Tax Court stated: “Taking respondent's argument to its theoretical conclusion, ANY TRUST created with corpus funds equivalent to the present value of a lifetime annuity obligation as computed under Table A would be deemed to be "underfunded" in that it would have insufficient funds to sustain the annual payments should the annuitant live beyond his or her average life expectancy. In this regard, respondent's argument contravenes the fundamental purposes and presumptions underlying the actuarial tables… The fair market value of an obligation to make future payments is deemed to be a sufficient amount to meet the entire obligation. Thus, by deduction, one of the fundamental presumptions underlying Table A is that the PRESENT VALUE of a lifetime annuity obligation is sufficient to sustain the stream of annuity payments as they come due over the course of an annuitant's expected life span.”
• “A person, at any given age, is assumed to die within a time consistent with the average mortality rate for that age. Sec. 20.2031-7(f), Estate Tax Regs. Table A does not expect or presume that a 91-year-old person will live for 18 more years; to the contrary, the table implicitly recognizes the possibility of any person reaching 109 years of age is extremely remote.”
• “In essence, respondent argues that unless an annuity is "guaranteed" throughout an annuitant's extreme life expectancy, just as a commercial annuity is guaranteed, the computation of the annuity's present value must be made on a case-by-case basis using a special actuarial factor supplied by the Internal Revenue Service; any computation of an unguaranteed, private annuity under Table A would be deemed invalid in respondent's view. Respondent's position, if it were correct, would vitiate the use of Table A as an administrative convenience and bright-line approach to valuation. Table A could not be used to determine the present values of all sorts of unguaranteed, privately funded annuities; they would all be subject to individual analysis under a facts-and-circumstances test.”

The Tax Court in Shapiro not once, but twice, suggested that the Commissioner could promulgate its argument as a regulation. Not long thereafter, amendments to the Section 7520 regulations were proposed, codifying the exhaustion test of Rev. Rul. 77-454. In the preamble to the regulations, the Service noted that it was rejecting the ruling of Shapiro.

3. Final Regulations

When Treasury finalized the exhaustion test regulations, it rejected comments suggesting that the exhaustion rule should be ignored in the case of less severe under-funding of trusts (apparently, there were no comments to the effect that the Service had no authority to overrule Shapiro, or if there were, the Service failed to address them). The Service stated that the method described in the proposed regulations for determining the value of the annuity is consistent with fundamental principles for determining present value and long-standing IRS position. The Service cited not only Rev. Rul. 77-454 (1977-2 C.B. 351), but Rev. Rul. 70-452 (1970-2 C.B. 199), Moffett v. Commissioner, 269 F.2d 738 (4th Cir. 1959) and United States v. Dean, 224 F.2d 26 (1st Cir. 1955).

These citations are somewhat disingenuous. While Rev. Rul. 77-454 was in fact the Service’s position, the Tax Court in Shapiro essentially shot it down. Rev. Rul. 70-452 and the Dean case are not remotely on point (they involve the deductibility for estate tax purposes of a contingent gift to charity). In Moffett, the government and the taxpayer stipulated on the valuation of the annuity (apparently employing an exhaustion-type test that benefited the taxpayer), but did so in a case the issue of which was the deductibility of a contingent bequest to charity. Nonetheless, the validity of the regulation is unlikely to hinge on the Service’s sloppy citations.

III. Validity of Regulation

Section 7520(a) states that the value of any annuity shall be determined under tables prescribed by the Secretary. Section 7520(b) provides that section 7520 shall not apply for purposes of any provision specified in the regulations. Section 7520(e) provides that the term “tables” includes formulas. In Chevron v. Natural Resources Defense Council[9]the Supreme Court stated: “If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute.”[10] Because Congress expressly delegated the responsibility to enact tables to the Secretary, and because the statute has no meaning without the tables, the regulations under section 7520 are legislative regulations, and should be upheld unless arbitrary or capricious.