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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.

Private annuity trust promoters on the web include National Association for Private Annuity Trusts, The National Private Annuity Trust and the National Association for Financial and Estate Planning ("NAFEP"). If you have purchased a private annuity trust from any one of these companies, you should have an independent tax expert review your situation and advise you immediately.



Pandering to the Greedy   There's an old Wall Street saying that applies equally to tax planning: "Bulls and bears make money, hogs get slaughtered." Appealing to greed is a time-honored formula for profit.

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 gain 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 legal basis for the scheme is IRS Revenue Ruling 69-74 (issued in 1969) which concluded that because the value of the annuity cannot be determined, there is no gain at the inception of the transaction. Instead, the person receiving the annuity is taxed as he receives payments over his lifetime.

However, one cannot disguise what in substance is a sale, merely by calling it an annuity transaction. Substance over form prevails, as verified by the two Tax Court cases discussed below. The downfall of most promoted private annuity trust schemes is that, in substance, there was a sale, the promoter was merely acting as the agent of the taxpayer and not as an independent party, or 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 (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.



Promoter Response   Predictably, NAFEP, mentioned above, whines and cries "foul" over the elimination of the private annuity trust on its website:

"This action by Treasury, and with no forewarning or grace period, is quite devastating and completely unexpected. This decision will kill a viable and legal tax strategy overnight, thereby negatively impacting the livelihoods of many professionals, and the tax and investment planning of clients everywhere."

Evidently, this promoter was "unaware" of the Tax Court case, Stokes v. Commissioner, 77 T.C.M. 2206 (1999), involving guess who? -- the very same NAFEP! The Tax Court noted that David J. Orr, an employee of NAFEP, acted as trustee. According to the Court's opinion:
"On August 1, 1994, with assistance from an organization called the National Association of Financial and Estate Planners (Financial Planning Co.), petitioner entered into an annuity contract and formed a so-called annuity trust, and petitioner purportedly transferred all of the property and assets of the pizza business to the annuity trust in exchange for a joint and survivor annuity."

The Tax Court considered the transaction a sham and held the taxpayer responsible for taxes and an accuracy-related penalty.

NOTE: Several years later, David J. Orr pled guilty to promoting and selling a fraudulent tax scheme to more than 300 clients and was sentenced to 60 months in jail, although it is unclear from the Department of Justice's press release whether the tax crimes involved the promotion of the NAFEP private annuity trust.

In Melnik v. Commissioner, T.C. Memo. 2006-25 (filed February 15, 2006), almost one year before NAFEP complained that the Treasury regulation was "completely unexpected," the Tax Court, once again, found the sale of appreciated stock -- this time to an off-shore trust -- in exchange for annuities was a sham transaction.



Unwinding The Transaction   If IRS repeats its strategy in dealing with the Son of Boss tax shelters, it will declare the private annuity trust as sold by promoters an abusive tax shelter and will offer an amnesty program for taxpayers to come forth, amend their returns, and pay the tax and interest in full. Whether IRS will insist on an accuracy-related penalty in addition to the payment of taxes and interest remains an open question.

As with the Son of Boss amnesty program, many taxpayers who no longer have the funds available to comply with the amnesty requirements, will fail to come forward, thereby risking discovery and much harsher treatment by IRS. Expect IRS to demand customer lists from promoters.

In any event, 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.