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The Tax Prophet Newsletter   Issue # 47 March, 2007

REDUCE TAXES!
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In This Issue:
Introduction
The Scheme
Taxation
IRS Response
Unwinding The Transaction
Conclusion


IRS Attacks the Private
Annuity Trust Tax Ploy


Introduction

IRS has aimed its gun sites on the heavily promoted "private annuity trust" tax shelter scheme, to the chagrin of the promoters who are raking in huge commissions and management fees selling these dubious products.

The private annuity trust is supposed to "defer" capital gains taxes on appreciated property, although the federal long-term capital gains rate is now only 15%, the lowest in decades.

Not content with actually paying a historically low capital gains rate, greedy taxpayers are flocking to the private annuity trust scheme that could cost them huge fees, in addition to an expensive tax audit, and repayment of the taxes, plus interest and penalties. What a deal!


The Scheme

Instead of selling an appreciated asset and paying the tax, the owner transfers the asset to a promoter-designed private annuity trust in exchange for an annuity (a promise of payments for the rest of the owner's life). The promoter then sells the asset, takes his cut and, presumably, invests the balance of the proceeds to pay the owner his annuity.

The downfall of most promoted private annuity trust schemes is that, in substance: (i) there was a sale; (ii) the promoter was merely acting as the agent of the taxpayer and not as an independent party; or (iii) the purported trustee of the private annuity trust was not acting independent of the taxpayer.


Taxation

Under a valid annuity transaction, the recipient of the annuity is taxed on a portion of the payments, as and when he receives them, much like the vanilla and non-controversial "installment sales" rules, when property is sold for a series of payments over time.

Of course, with installment sales, unlike the private annuity trust, promoters have nothing exotic to sell and, therefore, cannot enrich themselves at the expense of their customers.


IRS Response

To combat perceived abuses involving private annuity trusts, the Treasury Department has issued proposed regulations (REG-141901-05) that will require the recognition of capital gains at the time of sale, rather than over the lifetime of the person receiving the annuity.

The effective date is October 18, 2006 which means that any private annuity trusts funded after that date will be subject to this new regulation.

Note: The new regulation reaches all private annuities, not just the private annuity trust schemes touted by tax-shelter promoters.

However, private annuity trusts in existence may still be subject to challenge and disallowance under a variety of tax-shelter related arguments (e.g. lack of substance, sham transaction, alter ego).

Consequently, those who purchased a private annuity from a promoter should not sleep more soundly just because they completed the transaction before the effective date of the new regulation.


Unwinding The Transaction

Unwinding the private annuity trust transaction could be difficult and expensive, since tax-shelter promoters may be reluctant to release the trust assets, because it means the loss of lucrative management fees, in addition to the tacit admission that they sold taxpayers a bogus shelter.

Oftentimes, the promoter used the taxpayer's funds to purchase a commercial annuity (which usually contain onerous early termination penalties), thus straight-jacketing the taxpayer into an expensive and illiquid investment.


Conclusion

Taxpayers who sold an appreciated asset to a private annuity trust should have an independent tax advisor review the transaction to determine whether the transaction can withstand IRS scrutiny.

If not, then the taxpayer should immediately take remedial action by amending his return in the year of the transaction and reporting the capital gains in full.

The taxpayer will be liable for the taxes and interest, but should be able to avoid penalties by voluntarily coming forth and correctly reporting the private annuity trust transaction as a sale.




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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet tm is a trademark of Robert L. Sommers.