Dec 1, 2006 12:00 PM, Rorie M. Sherman Editor in Chief

By: Rorie M. Sherman Editor in Chief

David A. Handler, partner in the Chicago office of Kirkland & Ellis LLP, reports:

• Technical background on proposed regulations for tax treatment of annuity contracts sales. Let's also take a look at the legal underpinnings to what the Treasury has done with its proposed regulations addressing the tax treatment of an exchange of property for an annuity contract. See IR-2006-161.

  Under Internal Revenue Code Section 1001(b), the amount realized from the sale or other disposition of property is the sum of any money received plus the fair market value (FMV) of any property (other than money) received. In Lloyd v. Commissioner, 33 B.T.A. 903 (1936), acq. 1950-2 CB 3, the Board of Tax Appeals considered the taxation of gain from a father's sale of property to his son for an annuity payable for the father's lifetime. The board applied the “open transaction doctrine” articulated by the U.S. Supreme Court in Burnet v. Logan, 283 U.S. 404 (1931), which holds that if an amount realized from a sale cannot be determined with certainty, the seller recovers the basis of the property sold before any income is realized on the sale. Because the amount realized from the sale would depend on how long the father lived, it could not be determined with certainty. The board concluded that the annuity contract had no FMV within the meaning of the predecessor of IRC Section 1001(b). As a result, the gain from the sale was not required to be recognized immediately, but would be included in income when the annuity payments exceeded the property's basis.

  In Revenue Ruling 69-74, 1969-1 CB 43, a father transferred an asset having an adjusted basis of $20,000 and an FMV of $60,000 to his son in exchange for the son's legally enforceable promise to pay him a life annuity of $7,200 per year, in equal monthly installments of $600. The present value of the life annuity was $47,713.08. The ruling concluded that: (1) the father realized capital gain based on the difference between the father's basis in the property and the present value of the annuity; (2) the gain was reported ratably over the father's life expectancy; (3) the investment in the contract for purposes of computing the exclusion ratio was the father's basis in the property transferred; (4) the excess of the FMV of the property transferred over the present value of the annuity was a gift from the father to the son; and (5) the prorated capital gain reported annually was derived from the portion of each annuity payment that was not excludible.

  But, in Estate of Bell v. Comm'r, 60 T.C. 469 (1973), acq. in part and nonacq. in part, 1974 WL 36039 (Jan. 8, 1974), acq., AOD No. 1979-184 (Aug. 15, 1979), and in 212 Corp. v. Comm'r, 70 T.C. 788 (1978), the Tax Court held that the entire amount of gain realized from the exchange of appreciated property for an annuity contract was fully taxable in the year of the exchange — when the annuity contract was secured by the property sold.

  In the announcement issuing the proposed regulations, the Treasury and the Internal Revenue Service stated that they believe that neither the open transaction approach of Lloyd nor the ratable recognition approach of Rev. Rul. 69-74 clearly reflects the income of the transferor of property in exchange for an annuity contract. “Contrary to the premise underlying these authorities, an annuity contract — whether secured or unsecured — may be valued at the time it is received in exchange for property… The Treasury Department and the IRS believe that the transferors should be taxed in a consistent manner regardless of whether they exchange property for an annuity or sell that property and use the proceeds to purchase an annuity.”

  The proposed amendments provide that, if an annuity contract is received in exchange for property (other than money), (1) the amount realized attributable to the annuity contract is the FMV (as determined under IRC Section 7520) of the annuity contract at the time of the exchange; (2) the entire amount of the gain or loss, if any, is recognized at the time of the exchange, regardless of the taxpayer's method of accounting; and (3) for purposes of determining the initial investment in the annuity contract under IRC Section 72(c)(1), the aggregate amount of premiums or other consideration paid for the annuity contract equals the amount realized attributable to the annuity contract (the FMV of the annuity contract).

  The proposed regulations do not distinguish between secured and unsecured annuity contracts, or between annuity contracts issued by an insurance company and those issued by a taxpayer that is not an insurance company.

  The proposed regulations are not intended to affect the tax treatment of a contribution of property to charity in exchange for a “charitable gift annuity.” Example 8 of Treasury Regulations Section 1.1011-2(c) provides that any gain on an exchange of property that constitutes a bargain sale to a charitable organization (including an exchange of property for a charitable gift annuity) is reported ratably, rather than entirely in the year of the exchange.

  The proposed regulations are to be effective generally for exchanges of property for an annuity contract after Oct. 18. Thus, the regulations would not apply to amounts received after Oct. 18, under annuity contracts that were received in exchange for property before that date. However, the effective date is delayed for six months for transactions in which (1) the issuer of the annuity contract is an individual; (2) the obligations under the annuity contract are not secured; and (3) the property transferred in the exchange is not subsequently sold by the transferee during the two-year period beginning on the date of the exchange.

• Second Circuit affirms Tax Court in Rudkin. In William L. Rudkin Testamentary Trust v. Comm'r, No. 05-5151-ag (issued Oct. 18), the U.S. Court of Appeals for the Second Circuit affirmed the Tax Court's decision that investment advisory fees paid by a trust are not fully deductible, but deductible only to the extent they exceed 2 percent of the trust's adjusted gross income. The Fourth Circuit and the Federal Circuit previously reached the same conclusions. However, the Sixth Circuit reversed such a decision by the Tax Court in O'Neill v. Comm'r, 994 F.2d 302 (6th Cir. 1993).

  Notably, the Second Circuit disagreed with the Fourth and Federal Circuits' view that costs “not customarily incurred outside of trusts” are the ones not subject to the 2 percent floor, and went with a more restrictive interpretation of IRC Section 67(e)(1). Instead, the Second Circuit said, only those costs that “could not have been incurred if the property were held by an individual” would not be subject to the 2 percent floor.

• Right to receive IRD assigned to estate beneficiary not included in DNI. In Chief Counsel Advisory 200644016 (issued Nov. 3), the IRS addressed whether property that is “income in respect of a decedent” (IRD) is includible in an estate's or trust's distributable net income (DNI) under IRC Section 643 and an estate's or trust's income distribution deduction under IRC Section 661. The opinion of the U.S. Court of Appeals for the Sixth Circuit in Rollert v. Comm'r, 752 F.2d 1128 (6th Cir., 1985) had been cited previously to support the position that such property should not be included in DNI or the income distribution deduction. In Rollert, the Sixth Circuit held that the assignment by an estate of a right to receive IRD in the future to the estate's beneficiaries was not includible in the estate's income distribution deduction, because the estate had never actually received and distributed the IRD property. The Chief Counsel Advisory agreed with this result, but concluded that the opinion should not be read as holding that IRD property actually received by an estate or trust would not be includible in DNI under IRC Section 643 or the income distribution deduction under IRC Section 661.

• 2007 inflation adjustments. In Revenue Procedure 2006-53, the IRS issued the 2007 inflation adjustments:

  For an estate of a decedent dying in calendar year 2007, if the executor elects to use the special use valuation method under IRC Section 2032A for qualified real property, the aggregate decrease in the value of qualified real property resulting from electing to use IRC Section 2032A cannot exceed $940,000.

  As for the annual exclusion, there is no change to the “normal” annual exclusion, but the first $125,000 of gifts to a spouse who is not a citizen of the United States is not included in the total amount of taxable gifts under IRC Sections 2503 and 2523(i)(2) made during that year.

  For an estate of a decedent dying in calendar year 2007, the “2-percent portion” of the estate tax extended as provided in IRC Section 6166 is $1.25 million.

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