The Department of the Treasury and the Internal Revenue Service issued proposed regulations under Code Sections 72 and 1001 that would drastically change the tax treatment of an exchange of property for an annuity (private or commercial) contract in which taxpayers have been avoiding or deferring gain. This proposed regulation would end tax deferral on such transactions by causing the property seller's gain to be recognized in the year the transaction is effected rather than as payments are received. However, the technique is still available for savings of estate and gift taxes.

Background

A private annuity transaction typically works as follows. A person (the annuitant) transfers complete ownership of appreciated 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 is an isolated transaction between private parties who normally do not write annuities.

Private annuities historically have offered many tax advantages, both income and transfer, as well as the opportunity to save estate administration expenses. The primary income tax advantage has been the opportunity to spread capital gain over several years, as payments are received. A private annuity can also save estate tax because the 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 which 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.

The proposed regulations focus on the income tax benefits of the transaction. A decades-old IRS ruling generally postpones tax on the exchange of appreciated property for a private annuity. This ruling was originally based in part on the assumption that the value of a private annuity contract could not be determined for federal income tax purposes.

Now the IRS has declared such a result is inconsistent with the tax treatment of exchanges for commercial annuities or other kinds of property and that the rationale behind the ruling upon which this tax treatment is based is no longer correct. According to the IRS, the doctrine has been abused and relied upon inappropriately in numerous transactions that are designed to avoid U.S. income tax. According to the Service, the typical transactions involve private annuity contracts (intra family transactions) which involve a variety of mechanisms to secure the payment of amounts due under the annuity contracts.

Summary of the Impact of the Proposed Regulations

The proposed regulations: (i) provide a single set of rules that leave the transferor and transferee in the same position before tax as if the transferor had sold the property for cash and used the proceeds to purchase an annuity contract;
(ii) effectively treat the seller-annuitant as having realized an amount equal to the fair market value of the contract determined under Code Section 7520 (this provides the actuarial tables which must be used to compute the present value of an annuity); (iii) require that if a private annuity promise or a commercial annuity contract is received by the seller in exchange for property (other than cash), the entire amount of the seller's gain or loss (if any) must be recognized at the time of the exchange; and (iv) render Rev. Rul. 69-74 obsolete effective contemporaneously with the effective date of these regulations.

These proposed regulations do not: (i) distinguish between private annuities and annuities issued by commercial insurance companies; (ii) alter the existing rules governing tax-free exchanges of annuity contracts under section 1035  they only address taxable exchanges of other property for an annuity contract; (iii) distinguish between secured and unsecured annuity contracts; and (iv) prevent the application of other provisions, such as section 267, to limit deductible losses in the case of some exchanges.

Effective Date

The proposed regs will generally be effective for exchanges of property for an annuity contract after October 18, 2006. Thus, the regulations would not apply to amounts received after October 18, 2006 under annuity contracts that were received in exchange for property before that date. The effective date will be for exchanges of property for an annuity contract after April 18, 2007, for transactions in which: (i) the issuer of the annuity contract is an individual; (ii) the obligations under the annuity contract are not secured, either directly or indirectly; and (iii) the property transferred in the exchange is not subsequently sold or otherwise disposed of by the transferee during the two-year period beginning on the date of the exchange.

Conclusion

Taxpayers will no longer be able to defer recognition of gain on an exchange involving a private annuity, however, there is still an opportunity to use the private annuity transaction for savings of estate and gift taxes.

Question
Dear Mr. Bloshinsky,

I am moving to Florida to be closer to my kids. I updated my estate plan just last year. Do I need a new estate plan once I move?

Sincerely,
Heading South

Answer
Dear Heading South,

Estate and probate laws vary from state to state. Consequently, if you are relocating to Florida you should review the peculiarities of Florida law with a qualified Florida estate planner in order to determine the appropriateness of your current estate plan. Although you may not need to rewrite your estate plan, there may be good reasons for considering a revision.

1. Is Your Out-of-State Will or Trust Effective in Florida?
Florida recognizes out-of-state Wills and Trusts if executed according to the requirements of the state in which it was signed. However, even if your document was validly executed, its effectiveness should always be reviewed by a Florida licensed attorney.

2. Taking Advantage of Gifting Under Florida Law
Florida, unlike many other states, does not have a gift tax. Relocating to Florida may make it worthwhile to consider a lifetime gift program that reduces Federal estate taxes payable upon your death.

3. Review The Choice of Your Fiduciary
If your Will names an out-of-state institution as Personal Representative or Trustee, you should confirm they will be permitted to qualify and exercise fiduciary powers in Florida. If your Will names a nonresident individual as Personal Representative, he or she will not be allowed to qualify in Florida unless he or she is related to you in the manner provided by Florida statute. If your Trust Agreement names an individual residing far from Florida as Trustee, it may be impractical to expect such individual to carry out their responsibilities.

4. Are Provisions of Your Will Subject to Different Legal Interpretations Under Florida Law?
Laws governing the interpretation of Wills vary from state to state. Your Will should be reviewed to determine whether Florida law varies from the law of your former state in any substantive way that defeats your estate planning goals. For example, you may have a provision attempting to convey your Florida homestead property in an impermissible manner. Provisions of this type are unenforceable and of no effect in Florida.

5. Are You Prior Residents of a Community Property State?
Many states, unlike Florida, are community property states. Whether property is community or separate affects your and your spouse's rights in determining your income and death tax liabilities and property rights. If you are relocating to Florida from a community property state, your assets should be reviewed to determine their character so that unanticipated and undesirable tax consequences can be avoided.

6. Have You Adequately Provided for the Management of Your Assets if You Become Incapacitated?
In some states, Powers of Attorney lose their validity when the principal becomes incapacitated. In Florida they do not - if properly drafted. Consequently, it is usually advisable to sign a "Durable" Power of Attorney that appoints an individual as your agent to manage your assets in the event you can no longer do so. If you executed a Power of Attorney in your former domicile or many years ago, it should be reviewed to determine whether it is valid in Florida and whether it will survive your incapacity.

7. Have You Signed a "Living Will" and Health Care Surrogate?
Florida has enacted a law encouraging physicians and hospitals to follow the wishes of a terminally ill patient who earlier has signed a Declaration, often referred to as a "Living Will," requesting his or her doctor to withhold or withdraw extraordinary life support measures in the event of a terminal illness. Florida law provides that you may designate a "Health Care Surrogate" to make health care decisions, including whether to remove life support systems, in the event you are unable to make such decisions yourself. So, if you have signed a Living Will and Health Care Surrogate in your prior state, you should consult your Florida attorney to determine whether it complies with Florida law.

8. Is Your Estate Plan Current?
The last decade has seen continual and substantial changes in the estate and gift tax laws and the laws relating to the administration of estates and trusts that may make your current estate plan obsolete. Changes in your personal, financial and family circumstances may also require a revision of your estate plan. Accordingly, you should carefully review your estate plan with a qualified Florida attorney on a periodic basis, regardless of any change in state residence.

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