& Tax Fraud
Education Associates, Inc.
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[Editor's note: Mr. McGrath is also well known and highly respected within the American Bar Association's Real Property, Probate and Trust section for his commentary on advanced estate planning technique, and is widely regarded within the section as one of the leading and most credible authorities on private annuity arrangements. We are very privileged and thankful to have somebody of Mr. McGrath's stature contribute the right to reprint his article on this website.]
Kevin J. McGrath is Of Counsel to The Saylor Law Firm in Atlanta, GA, where his practice includes income, gift, estate and generation-skipping transfer tax planning for high net worth individuals, charitable planning, insurance planning and planning related to tax shelters and shelter-related registration, disclosure and listing issues. Kevin graduated from the University of Florida (B.S. Accounting with Highest Honors) and the University of Florida College of Law (graduated Order of the Coif), and is a member of the Georgia Bar and the Atlanta Bar Association. Kevin's recent publications include "Private Annuity Trusts -- The Numbers Don't Support the Hype," Tax Notes, Vol. 109, No. 1, October 3, 2005; "Using Derivatives to Enhance After-Tax Hedge Fund Returns," Tax Notes, Vol. 110, No. 4, January 30, 2006; "Private Annuity Sales and The Exhaustion Test", presented to BNA Advisory Board (pre-publication), and "Melnik - Deferred Private Annuity Sale Disregarded" as a commentator for Leimberg Information Services. Kevin can be reached at (404) 892-4400 or by email at firstname.lastname@example.org
The private annuity trust ("private annuity trust") is a tax deferral transaction offered to taxpayers seeking to dispose of appreciated assets, often real estate. The private annuity trust is an old transaction but appears to be more popular than ever. Several websites actively and proudly promote the strategy. There is a National Association for Private Annuity Trusts ("NAPAT"), The National Private Annuity Trust ("NPAT") and the National Association for Financial and Estate Planning ("NAFEP"), which offers the private annuity trust as its "Premier VI" plan.
Despite its apparent popularity, the private annuity trust is a questionable tax strategy from a tax perspective. It is far from clear that the transaction works in the manner in which its promoters claim. Even more problematic, however, is that assuming the private annuity trust does in fact offer the tax benefits that it purports to offer, in the typical case (see Section IV below for possible beneficial uses of the private annuity trust), it is an economically bad transaction, at least from an income tax standpoint. In fact, economic analysis of the private annuity trust reveals that not only is it worse than perhaps most every other tax minimization strategy that would be available to a taxpayer, but the private annuity trust also leaves the taxpayer in a worse economic position than the taxpayer would be in by merely selling the asset and paying the tax.
After a brief description of the transaction, an overview of a few technical problems of the private annuity trust is provided. Then, a few of the claims of promoters are dispelled. Finally, a summary of an economic analysis of the private annuity trust is given.
I. Private Annuity Trust Overview
A private annuity is an annuity issued from a party not engaged in the business of writing annuity contracts. If a taxpayer sells an appreciated asset in exchange for a private annuity, Rev. Rul. 69-74 provides that gain is realized, but not recognized, on the sale. The annuity payments received are treated as (i) a recovery of basis (the portion treated as basis recovery is equal to the seller's adjusted basis in the property divided by the seller's life expectancy); (ii) a recovery of capital gain (the portion treated as capital gain is equal to the capital gain realized on the sale divided by the seller's life expectancy); and (iii) the remaining portion of the annuity is treated as ordinary income. Once the seller's life expectancy is attained, all basis will have been recovered and all capital gain recognized, so thereafter the payments received are treated in their entirety as ordinary income.
Rev. Rul. 55-119 outlines the tax consequences to the purchaser of property under a private annuity contract. Upon a disposition of the purchased property, the basis for determining gain is equal to the total of the annuity payments made under the contract up to the date of disposition plus the value of the prospective payments remaining to be paid at the date of such disposition.
General Counsel Memorandum 39503 (the "GCM") reaffirms that private annuities transactions are taxed the manner prescribed by Rev. Rul. 55-119 and Rev. Rul. 69-74, and not under the installment sale rules. The purpose of the GCM was not, as implied by some promoters, to notify the public that the private annuity trust is a legal transaction. Instead, the purpose was merely to delineate when an annuity would be subject to the private annuity rules and when it would be subject to the installment sale rules.
The private annuity trust simply implements these well established rules in the following manner:
1) Owner ("Seller") of appreciated asset ("Asset") establishes irrevocable trust ("Trust"). Trust is funded with a seed gift ("seed gift").
2) Seller sells Asset to Trust in exchange for a private annuity. Seller realizes, but does not recognize, gain on the sale. Gain is reported ratably over Seller's life expectancy under the private annuity rules as described above.
3) Trust sells Asset to third party buyer. Trust reports basis in Asset in accordance with Rev. Rul. 55-119. Because basis will be close, or equal, to the sales price, little or no gain is reported.
4) Trust reinvests proceeds, and pays annuity amount to Seller, either currently or on a deferred basis.
5) Upon death of Seller, Trust must recompute the basis of Asset. The recomputed basis will equal the sum of annuity payments actually made to Seller. The recomputed basis is then compared to the amount realized from Trust's sale of Asset to third party buyer, and the difference will be gain at such time. (Alternatively, if Trust's annuity payments at some point exceed its amount realized, then Trust will thereafter recognize losses as annuity payments continue to be made.)
II. Nature of Technical Problems
A. Potential Application of Judicial Doctrines
The revenue rulings and GCM merely state that the seller under a private annuity contract defers recognition of gain, and that the purchaser under a private annuity contract receives an immediate, if temporary, cost basis equal to the present value of the annuity. They represent authority for those simple propositions alone, and they do not represent authority that the series of steps that make up a private annuity trust offers the purported tax benefits, or that the IRS has blessed the transaction.
Perhaps because these rules are a little complex, they tend to obfuscate the general tax principals that would otherwise jump out at practitioners. In practice, the private annuity trust promoter is targeting taxpayer ("A"), who is selling property and has already found buyer ("B"). The promoter then tells A to insert C (Trust), the parties knowing full well that C will be buying the asset and then selling it to B. C's involvement has one real purpose, and that is tax avoidance. Depending on the facts, there are several judicial doctrines that could be applied: sham transaction, step transaction, substance over form, agency theory and assignment of income.
Of course C is not the equivalent of a foreign or tax indifferent party who stays in a transaction for 30 days. C is a trust, and presumably the trust will stay around for years, and there are real economics back and forth between A and C. So there should be arguments against application of at least most judicial doctrines, but the existence of such counter-arguments does not negate the existence of risk.
Indeed, there have been at least three cases to date in which the fact pattern was remarkably similar to the marketed private annuity trust, and in each, judicial doctrines were in fact applied by the Tax Court to strike down the claimed benefits of transaction. In Stokes, the taxpayer transferred his pizza business to a private annuity trust arranged by NAFEP. Sixteen days later, the trust sold the pizza business to a third party buyer. The Tax Court held the trust to be a sham, noting that the taxpayer continued to manage the pizza business after the purported transfer to the trust, and the trustees performed no meaningful functions. In Melnik v. Commissioner and in Usher v. Commissioner, the Tax Court ruled that the trust was a conduit for the taxpayer, and attributed the sale of the asset to the third party directly to the taxpayer.
Additionally, there are several other cases in which private annuity sales to trusts have been recharacterized as transfers in trust with a retained interest. Such a recharacterization would eliminate the tax deferral (as the original private annuity sale would not be recognized), and also cause estate tax inclusion under section 2036. While there are some Ninth Circuit cases that have overturned the Tax Court's recharacterization of a private annuity as a transfer in trust with a retained interest, the Tax Court has hinted that it will not follow the Ninth Circuit in cases not appealable to the Ninth Circuit.
Interestingly, there are no references to the Stokes, Usher or Melnik decisions on the websites of NAPAT, NPAT or NAFEP. Each of the cases can be properly labeled a "bad facts" case, and presumably promoters dismiss it as such. Likewise, however, the private annuity trust can be labeled a "bad facts" tax strategy. Promoters outline the planned steps of the strategy, and most acknowledge that the sale to the Trust will not occur until after a buyer for Asset is found. This means that, in hindsight, many, if not most, fact patterns will in fact look a lot like Stokes, Usher and Melnik.
Again, while Stokes, Usher and Melnik were decided under the sham transaction doctrine, the IRS may assert, and a court may hang its hat on, any of the other judicial doctrines, all of which tend to be indiscriminately applied by courts in transactions like this. Analysis of each of those doctrines is impossible with a hypothetical fact pattern, but a typical private annuity trust established by a promoter after targeting a seller of real estate is, at the least, problematic. And we know from these cases that, in sharp contrast to promoters' inferences that the IRS has approved the private annuity trust, the IRS does have a history of challenging these transactions.
The risk of application of judicial doctrines is one that can be mitigated by careful planning, and while this risk alone may be not be enough to recommend against the private annuity trust on a technical basis, the existence of this risk puts a lot of pressure on a transaction the economic benefits of which are speculative at best.
B. Section 7520 regulations
i. Exhaustion Test
Aside from judicial doctrines, there is one glaring technical hurdle in the private annuity trust: the exhaustion test of Treas. Reg. 25.7520-3(b)(2). The exhaustion test prevents use of the standard Section 7520 annuity factor for an annuity if the obligor is a trust or other limited fund, unless the governing instrument and the funding of the trust have the effect of ensuring that the annuity will be paid for the entire period. If the annuity is a life annuity, the period is assumed to last until the annuitant attains the age of 110. Because private annuity trust uses an annuity, and because a trust is the obligor of the annuity, the exhaustion test is applicable. Accordingly, the Trust in the private annuity trust must have sufficient funding to pay the annuity until Seller attains the age of 110.
The exhaustion test is not really a technical hurdle in the sense that application of judicial doctrines is - if the exhaustion test is met, then it is not an issue. It becomes a substantial technical hurdle, however, when it is ignored, as it is almost without exception. Some promoters erroneously claim that the Tax Court, in Estate of Shapiro v. Commissioner, T.C. Memo 1993-483, overturned the exhaustion test. This is not true. Shapiro actually predated the exhaustion test, and the exhaustion test was put in the regulations in response to Shapiro.
The exhaustion test does seem to make sense. When somebody buys a life annuity, he is, in effect, making a bet on his life with the transferee, usually an insurance company. If the annuitant lives his life expectancy, the bet should be a relative wash. If the annuitant dies prematurely, the annuity will be a loss for the annuitant, as the annuitant will not have received enough annuity payments to compensate for the purchase price of the annuity. The benefit of the bargain for the annuitant lies in the chance that the annuitant outlives his life expectancy, in which case the annuitant continues to receive payments well over and above the cost of the annuity.
Similarly, an annuitant in a private annuity trust will lose (economically) if he dies prematurely. The benefit of the bargain for the annuitant lies in the chance that he lives a long time. An economically rational person would not enter into such a bet if the outcomes are (i) you lose the bet by dying early, or (ii) you win the bet by living a long time, but you lose anyway because you do not get paid. The rule requiring the trust to have sufficient funding to make payments to age 110 is there to ensure that the annuitant receives the benefit of the bargain, should it occur.
In reality, the exhaustion test probably understates the amount that the trust should have. Because there are no restrictions on trust investments, the trust will likely invest its assets in marketable securities, or if not marketable securities, assets with at least some volatility. Volatility means that the trust value will occasionally drop, which combined with a fixed annuity obligation, means that trusts could run out of money, even though it was projected to not run out of money at the outset. The Section 7520 regulations, in contrast, assume a straight-line growth rate with zero volatility - the regulations will thus lead to a presumption that the private annuity trust either runs out of money before age 110 or does not run out of money before age 110. In reality, modeling illustrates that even if the exhaustion test is met, if the Trust invests in assets that experience normal volatility, the Trust has well over a 20% chance of running out of money prior to age 110. Accordingly, the exhaustion test is arguably favorable to the taxpayer in the private annuity context, in that it requires less funding than would be required by unrelated parties in arms'-length negotiation.
The exhaustion test will be satisfied if the sum of (i) the seed gift and (ii) the value of the property sold to the Trust is at least equal to the annuity divided by the Section 7520 rate. If such sum is less than the annuity divided by the Section 7520 rate, then it is still possible that the exhaustion test is satisfied, but the tables must be consulted.
For smaller transaction sizes (i.e., less than $1 million), the seed gift required by the exhaustion test will not be difficult to meet within the seller's gift tax exemption. For example, a 55 year old selling a $500,000 asset would need to fund the trust with a seed gift of approximately $200,000. In contrast, for larger transaction sizes, the seed gift requirement makes the private annuity trust an untenable strategy, particularly for older sellers. For example, a 65 year-old seller of a $5 million asset would need to fund the trust with a seed gift of nearly $3.5 million.
The consequences of failing to meet the exhaustion test are two-fold. First, you have a gift, equal to the value of the asset sold, less the recomputed value of the annuity. Second, the Trust will take the recomputed value of the annuity as its basis in the purchased asset, meaning basis will be less than FMV. Assuming the Trust subsequently sold the purchased asset, gain will likely result, and if the sale was made within one year of the Trust's purchase, then the gain will be short-term capital gain. With both gift tax and potential short-term gain to the extent of the failure to meet the exhaustion test, the price for being wrong is extremely high.
ii. Governing Instrument requirement
One other requirement of Treas. Reg. Section 1.7520-3(b)(2)(i) is that the "effect of the trust, will or other governing instrument is to ensure that the annuity will be paid for the entire defined period" (referred to herein as the "governing instrument requirement"). The regulation then goes on to state the exhaustion test. The regulation states that if the exhaustion test is not met, then the governing instrument requirement will not be met. It does not say the opposite, that meeting the exhaustion test conclusively means you meet the governing instrument requirement.
What requirements can be inferred from the governing instrument requirement? Perhaps no distributions are allowed to be made to any other beneficiaries so long as the trust doesn't have adequate assets to fund its future obligations under the annuity. A similar rule is contained in Treas. Reg. Section 1.7520-3(b)(2)(ii)(B), which governs the use of the tables to value ordinary income interests. While no identical rule is spelled out in Treas. Reg. Section 1.7520-3(b)(2)(i) (which governs annuity interests), if a trust did allow income and/or corpus distributions to other beneficiaries, how could the effect of the trust's governing instrument be to ensure that the annuity will be paid for the entire period?
While the governing instrument requirement probably represents a small risk, the consequences of failing the governing instrument requirement are huge: as in failing the exhaustion test, the Seller would face potential gift tax as well as short-term capital gain upon the Trust's sale of Asset to the third party purchaser.
C. Deferral of Recapture Income
A much-hyped benefit of the private annuity trust is that recapture income is deferred under a private annuity sale, whereas it is not in competing strategies. By mere repetition, this claim appears to have gained acceptance as truth. None of the promoters provide a cite for this claim. Moreover, none of the authority cited by promoters to prove the IRS has blessed the private annuity trust addresses the recapture issue, and none of the slew of cases dealing with private annuities addresses the issue either. Resolution of the issue thus presumably hinges on analysis of Rev. Rul. 69-74 and the recapture provisions of the Code.
Section 1245 provides that recapture income is triggered, and gain is recognized, upon the mere transfer of property. In private annuity trust, there is of course a transfer of property from Seller to Trust. Rev. Rul. 69-74, on the other hand, provides for deferral of gain recognition on the transfer of property in exchange for a private annuity. Pursuant to Rev. Rul. 69-74, the deferred gain is recognized as payments under the annuity are received. Thus, Section 1245, which compels gain recognition, conflicts with Rev. Rul. 69-74, which allows for deferral of gain recognition.
But this seeming conflict is resolved several times by the Code and regulations. Two different parts of Code Section 1245 provide that recapture income is recognized notwithstanding any other provision of the Code. Treas. Reg. Section 1.1245-1(a) provides that "Generally, the ordinary income treatment applies even though in the absence of Section 1245 no gain would be recognized under the Code." Treas. Reg. Section 1.1245-6 provides that "The provisions of section 1245 apply notwithstanding any other provision of subtitle A of the Code. Thus, unless an exception or limitation under section 1245(b) applies, gain under section 1245(a)(1) is recognized notwithstanding any contrary nonrecognition provision or income characterizing provision." Accordingly, it seems fairly clear that the conflict between the non-recognition afforded by Rev. Rul. 69-74 and the recognition provision of Section 1245 is addressed, and it is addressed in favor of recognition.
It is often assumed that because Section 453(i) mandates that recapture income be recognized in the year of an installment sale, and because private annuities are not subject to the installment sale rules, that recapture income does not have to be recognized in a private annuity. However, the reason that Section 453(i) is necessary is that Section 1.1245-6(d) carves out an exception for recapture recognition for installment sales, but such regulation then states that this exception is applicable only to the extent otherwise allowed by Section 453. Thus, the recapture regulations carve out a tentative exception for installment sales but ultimately punt the issue to Section 453. There is no similar exception, or punting, for private annuities, which means that presumably recapture in a private annuity transaction is subject to the general rule (automatic gain recognition) of Section 1245. This represents yet another significant pressure point in the private annuity trust that should be considered in the economic analysis by taxpayers who want to defer recapture income.
The good news is that the "recapture" income most taxpayers are attempting to defer is actually "unrecaptured section 1250 gain." When promoters talk about deferring the recapture income taxed at a 25% tax rate, they are referring to "unrecaptured 1250 gain." Unrecaptured 1250 gain is capital gain taxed at a special 25% tax rate; it is not recapture income. Any tax deferral strategy that is successful at deferring capital gains (e.g., a CRT, an installment sale, etc.) will also defer unrecaptured 1250 gain. Thus, any inference by promoters that the private annuity trust is somehow unique in this regard is incorrect.
D. Deferral of annuity
Promoters of the private annuity trust offer the opportunity for sellers to enter into deferred private annuities. A deferred annuity will have two consequences:
First, the exhaustion test will be even more difficult to meet. Deferring an annuity will cause payments to significantly increase. For example, if a 45-year old seller of a $1 million asset is willing to defer annuity payments for twenty years, then his annuity payment will jump from around $65,000 to almost $300,000. Because payments under the deferred annuity must begin by age 70 ½, the Trust must have enough funding to pay the higher annuity amount for at least 39 years. While the immediate annuity would require a seed gift of approximately $250,000, the deferred annuity requires a much larger seed gift of approximately $1 million.
Second, on a present value basis, the economics of private annuity trust are similar, but early death will result in a substantial benefit to donor, while a late death will be extremely detrimental. This kind of bet could easily be made by purchasing term life insurance, which has no tax risk whatsoever.
III. Miscellaneous Promoter Claims
There are a few other aspects of the private annuity trust that are marketed to taxpayers.
A. Income Stream for life?
One apparently attractive benefit of the private annuity trust is that it gives the annuitant "an income stream for life." This is misleading.
Commercial annuities, which can be structured to provide an income stream for life, are often confused with private annuities, which do not. Of course, private annuities are likewise structured to give the donor an income stream for life, but this is largely a tax fiction. The tax fiction is that we pretend that the assets will grow at exactly the Section 7520 rate each year, and that all the money will be there to continue making the annuity payments for the donor's life.
The fallacy of the "income stream for life" notion results from the fact that the donor is playing with his own money. You can't transfer money from your left pocket to your right, asking your right pocket to pay an annuity to your left. Your money is what it is, and when it runs out, it runs out. This is not a commercial annuity, where longevity risk is transferred to an insurance company. This is a private annuity, where there is no transfer of risk outside the family. If the funds are in fact sufficient to pay the annuity for life, they would have been sufficient to pay the donor outside the private annuity context. It is the same pile of money (although the pile of money is larger in the private annuity trust context because of the initial tax deferral, as described below, it quickly becomes smaller due to the tax inefficiencies of private annuity payments).
B. Estate Tax Benefits
Private annuity trust promoters are quick to point out the estate tax benefits of the strategy. The promised benefits, however, are misleading. While the estate tax benefits do exist, they help mask what a lousy income tax planning strategy private annuity trust is.
First, the benefits are misleading, to say the least. NAPAT's website claims that the private annuity trust "eliminates the estate taxes due upon taxpayer's death." In fairness, if one digs deeper in their site, the claim is somewhat narrowed: "A Private Annuity Trust removes the asset from the estate therefore eliminating estate taxes on the assets in the trust." This, unlike the first quote, is actually accurate, but tells you nothing. Bill Gates could sell all of his Microsoft stock, thereby eliminating estate taxes on the Microsoft stock! Of course, the proceeds of the sale are taxable.
The estate tax benefit of a private annuity is that only the payments received by the seller are included in his estate. Thus, if seller sells asset for $1 million, and receives an annuity of $100,000 and lives 2 years, then only $200,000 will be included in his estate. This is an estate tax benefit: $200,000 of estate inclusion beats $1 million. However, if seller lives 30 years, estate inclusion will be $3 million. There is a break-even point at which the annuity payments received exceeds what the seller would have had in his estate had he not done an annuity. This break-even point is usually close to the seller's life expectancy. Thus, if seller dies prior to his life expectancy, then the transaction is an estate tax benefit; if seller dies beyond his life expectancy, then the transaction increasingly becomes an estate tax detriment.
Finally, Section 2036 may operate to bring the entire trust value back into the seller's estate, negating any estate tax benefits. The IRS has been aggressively using Section 2036 of late in the family limited partnership context, and they have been successful at recharacterizing private annuity sales to trusts as transfers with retained interests. Thus, there is little reason to believe that they wouldn't pursue a section 2036 argument in the private annuity trust context. With proper planning, the section 2036 risk can be mitigated, but taxpayers going into a private annuity trust should be aware that the promised estate tax benefits are no slam dunk.
C. Taxpayer may Benefit from Future Decreases in Tax Rates
A factor in determining whether the private annuity trust makes sense that is perhaps as important as any is volatility of tax rates. Most taxpayers and practitioners intuitively understand the value of deferring income - you get to invest, and make money on, the government's money. Further, in the retirement planning context, most people assume they'll be in a lower tax rate during retirement years than they are today, and to the extent that progressive tax rates are with us, this assumption should hold true.
However, in the capital gain deferral context, this assumption is a little more difficult. Capital gains rates are at 15%, and recent past experience proves that rates are highly volatile (and volatility is actually incorporated into existing law, with scheduled rate increases). The value of deferring tax is at some point completely offset, or negated, by deferring the income to a higher tax rate. For example, if you assume that one can earn 8% per year (with no volatility) and that marginal tax rates are 15%, then the value of deferring tax for one year is approximately 1.2%. If tax rates rise by 1.2%, then the deferral will be offset by the increased tax rate.
Granted, over a long period, it would take a much higher tax rate to offset the value of tax deferral than may be realistic, but increasing tax rates do cut into the benefit of (or increase the detriment of) a deferral strategy. Most promoters do note that taxes will be paid on the annuity based on rates in effect at the time payments are received, but usually in the context of highlighting that lower future rates make the private annuity trust even more beneficial.
The effect of changing tax rates is difficult to model, as tax rates are somewhat random and do not follow any sort of normal distribution. Rates are, however, scheduled to rise. If rates do in fact rise as scheduled, the fact that rising rates were foreseeable could be an ugly fact highlighted by malpractice lawyers.
D. Discounted Assets
Some websites hype the potential for the seller to sell discounted assets to the Trust. For example, if appreciated real estate is first contributed to a family limited partnership, discounts may be taken on the partnership interest, so that the sale price to the Trust will be reduced. It is not entirely clear what the purpose of selling discounted assets in the private annuity trust transaction would be, but it is likely (i) to increase the likelihood of obtaining a transfer tax benefit, or (ii) to relax the seed gift requirement.
While selling discounted assets could achieve the desired transfer tax benefit, there is an income tax tradeoff. For example, assume Asset is worth $100, and Seller contributes it to a family limited partnership. Seller than sells the partnership interest to the Trust for $70, taking a 30% discount. While $30 would escape the transfer tax system, Trust would now have an outside basis in the partnership of only $70, which would leave at least $30 of gain when the partnership sells Asset. Discounting has the effect of trading an uncertain and future estate tax for a certain and current 15% or 35% income tax.
IV. When is the private annuity trust a good alternative?
As the numbers below illustrate, the private annuity trust does not always result in a detriment. There are a few scenarios where the private annuity trust can reasonably be expected to provide a benefit, provided the transaction works from a technical perspective. This article focuses on the marketed private annuity trust, which is directed to taxpayers with more typical fact situations - e.g., taxpayers with appreciated real estate or securities. Although the private annuity trust does not always result in a detriment, it usually will, and the exceptions are mostly limited to taxpayers with shortened life expectancies (but not too short!).
Two relatively uncommon scenarios where the private annuity trust might be beneficial are for (i) ordinary income property with low basis (uncommon because most ordinary income property with low basis is not the type that can be sold in a private annuity sale), and (ii) preserving a property's status as capital gain property (e.g., if the property will be converted to a use that would result in ordinary income upon a later sale). Additionally, private annuities may have creditor protection benefits that trump any income tax considerations. And any taxpayer may have unique circumstances such that the private annuity trust happens to be the perfect income tax strategy. The numbers below, as well as the numbers hyped by promoters, are based on generic assumptions, and are meaningless when applied to any specific taxpayer. The numbers below are only shown to illustrate that in normal circumstances, the private annuity trust is not an economically beneficial transaction.
V. Economic Analysis
Assuming these technical difficulties are overcome, there are several economic reasons why the private annuity trust results in a financial detriment rather than a benefit. Three are discussed here: (i) phantom income; (ii) the tax inefficiencies resulting from the Trust's recomputed basis at death; and (iii) fees. This is followed by an illustration of what private annuity trust modeling reveals.
A. Phantom income
The biggest problem with the private annuity trust is that, while deferring one tax, the strategy generates another more costly one. In accordance with Rev. Rul., 69-74, there is a capital gain component and an ordinary income component to each annuity payment. The capital gain portion of the annuity is not a problem - it truly does represent a deferral of the capital gains tax that otherwise would have been paid upfront by Seller, and provided capital gains tax rates do not rise, this is good.
On the other hand, the ordinary income portion of the annuity is a problem, as it represents phantom income, meaning income not represented by any increase in wealth. To illustrate why, assume Seller sells $1,000 asset to Trust for annuity paying $100 per year, $60 of which is the capital gain portion and $40 of which is the ordinary income portion. After Trust sells Asset for $1,000, it reinvests the proceeds. If it earns 8%, or $80, it will report the $80 as income. Trust will then pay Seller $100 pursuant to the annuity agreement. Seller will report $60 of capital gain. Again, this is no problem, as it represents capital gains it otherwise would have reported immediately.
Seller will also report $40 of ordinary income. Unlike the capital gain portion of the annuity, the ordinary income portion is "phantom" income because it is not represented by any increase in wealth (either at Seller or the Trust level). The family accrued $80 in new wealth (the 8% earnings on the trust assets), but the family will pay tax on $120 of income (this includes the $80 of trust income and $40 of ordinary income under the private annuity, but does not include the $60 capital gain portion). 
The reason that private annuities create "phantom," non-economic income is that, unlike commercial annuities, intra-family private annuities involve a transfer of money from one pocket to the other and involve no shifting of risk. As a result, from a family perspective, there is no economic income resulting from an intra-family private annuity - one family member's loss is another family member's gain. To pay tax on a portion of the annuity payment each year on this shifting of wealth (especially with no corresponding current deduction at the Trust level) drastically cuts into the benefits of the tax deferral, so much so that the transaction as a whole becomes an income tax detriment.
One uniquely negative characteristic of the private annuity trust is that the feature causing the negative economics (phantom income on the annuity) is distinct from the aspect of the transaction that is the aggressive tax position (the deferral of the capital gain at the Trust level).
If the IRS successfully challenges a private annuity trust transaction, it will likely be on the deferral of the capital gains tax (or recapture tax), or they may assess a gift tax as a result of an inadequately funded Trust. A successful challenge by the IRS on either of these issues will have no bearing, however, on the annuity and its concomitant negative tax drag. The annuity, and the phantom income that it generates, will still be there.
B. Recomputed Basis upon Annuitant's Death
The private annuity trust also involves a tax inefficient trade-off to the trust. Trust will recognize income if the annuitant dies and the trust has not made annuity payments equal to the price at which it sold the asset. This income will be short-term or long-term gain, depending on the Trust's holding period for the asset, but given the manner in which the private annuity trust is marketed (to taxpayers who have already made the decision to sell an appreciated asset), gain will likely be short-term.
Alternatively, once the Trust has made annuity payments that exceed in value the amount received by it upon selling the asset, then the Trust will get capital losses as it continues to make annuity payments (again short or long-term, depending on holding period). This would seemingly be a fair trade off, but it is not. Gains are always taxable, whereas capital losses are often difficult to use, especially when trapped inside an irrevocable trust. Moreover, modeling reveals that the size of the capital loss incurred by the Trust upon the Seller's death is inversely related to the expected value of the Trust upon Seller's death. This makes sense, because a larger loss directly correlates with a longer life for the Seller, which means the Trust is losing the "bet" on the annuity. A losing bet on the annuity means that an increased likelihood that the trust's assets fall in value. A large capital loss at the irrevocable trust level combined with relatively insubstantial trust assets means that the loss is unlikely to have much value to the Trust.
Implementing a private annuity trust costs money. The promoter of the strategy will likely want a fee. The drafter of the documents will want a fee. And the client's independent advisor will also charge for his or her time to figure out whether the strategy works. As illustrated above, the exhaustion test makes the private annuity trust infeasible for most larger cases. On the other hand, for smaller cases, the fees will likely be too large in relation to the tax being deferred.
Assuming the aforementioned fees total $20,000 for the first year (this includes drafting documents, the due diligence the client's attorney will likely do, and the fee paid to the promoter), the fees represent a staggering 4% on a $500,000 transfer. This is for a mere deferral of tax. If $75,000 of capital gains tax would otherwise be due, the taxpayer is paying $20,000 for the right to pay that $75,000 later (if capital gains rates don't move). Additionally, of course, the taxpayer is incurring a different, new income tax that he otherwise wouldn't incur.
In addition to fees for setting up a private annuity trust, the taxpayer will incur ongoing management fees. Presumably, an independent trustee will be hired. The trustee may charge a trustee fee. The trust will require a tax return each year. And this will go on every year as long as the seller lives (unless, as will often be the case, the Trust runs out of money before that time).
D. Economics of Private Annuity Trust - Modeling Results
The private annuity trust is both an income tax strategy and a transfer tax strategy. The benefits of strategies that involve both income and estate tax savings (particularly the income tax benefits) are often obscured by the potential monster benefits afforded by generation-skipping transfer tax ("GST") savings. What makes the benefits in these situations so misleading is that GST is relatively easy to avoid; basic strategies, such as an outright gift of the gift/GST tax exemption amount to a GST Trust, will likewise achieve huge GST savings. Accordingly, combining GST savings in the analysis masks other benefits and detriments. For this reason, GST is ignored in the models used herein.
The assumptions used in modeling a private annuity trust greatly impact the projected benefits or detriment. The three most important assumptions are the expected growth rate of the Trust portfolio, the volatility of that growth rate and Seller's marginal income tax rates. Higher expected growth rates result in more growth on the deferred income tax. Higher volatility results in an increased likelihood that the Trust runs out of money (thus negating any estate tax benefit of the strategy). The modeling assumes an expected growth rate of 10%, with a relatively modest volatility of 18%. Finally, the tax rate that would otherwise be applicable to the sale of Asset, as well as the amount of gain that would result on the sale, dictate the amount of tax being deferred. Obviously, the private annuity trust will look better if more tax is being deferred. The modeling assumes, for the sake of putting the private annuity trust in its best light, that Asset has zero basis. Modeling is done under two different tax rate assumptions, described below.
Because the private annuity trust is both an income and transfer tax strategy (and the income tax element of the strategy is severable from the estate tax element), it is helpful to isolate the income tax benefits of the private annuity trust from its transfer tax benefits. The income tax benefits of the private annuity trust can then be compared to other income tax strategies, and the transfer tax benefits can be compared to other estate planning strategies.
This is done by first setting the estate tax rate at zero percent, thus isolating the income tax benefits of the private annuity trust. Income tax rates are then set at zero percent in order to isolate the estate tax benefits. Running the numbers in this way shows that the private annuity trust is a bad income tax strategy (the strategy is likely to result in more of an economic detriment to the taxpayer than selling Asset and paying tax would), but, if the grantor has a life expectancy substantially less than the actuarial tables assume (yet long enough to allow the use of those same tables), it is an excellent estate tax planning strategy. Finally, any benefits of the strategy should be risk adjusted to take into account the probability of negative legal outcomes.
i. Transfer Tax Benefits
In isolating the transfer tax benefits, it is assumed that Seller makes a seed gift to the Trust in an amount that will enable trust to satisfy the exhaustion test. To allow for an apples-to-apples comparison, in the "do-nothing" scenario, it is assumed that Seller makes an identical seed gift to a trust. It is also assumed that no gift tax will be paid, and that any amounts remaining in Seller's estate upon his death will be taxed at a 45% estate tax rate.
The charts below illustrate the expected estate tax benefits of the private annuity trust for a 55-year old and a 65-year old. For the younger Seller, the private annuity trust beats an outright gift by 6% if the seller lives his life expectancy of 29 years. For the older Seller, the private annuity trust beats an outright gift by almost 3% if the seller lives his 20-year life expectancy. If Seller lives beyond his life expectancy, however, the private annuity trust gradually becomes a detriment. The estate tax benefits of a private annuity are highly driven by the assumption here that the investment performance of the trust will beat the Section 7520 rate of 5%.
While the expected transfer tax benefit are potentially substantial, these benefits can be achieved without the income tax cost by doing a private annuity sale to a grantor trust. Further with the increase in the estate tax exemption, many of the taxpayers to whom the private annuity trust is mass marketed are unlikely to face an estate tax, or alternatively, could avoid the estate tax through relatively simple and risk-less planning.
ii. Income Tax Benefits
While the private annuity trust offers a taxpayer a potential estate tax benefit, it results in a detriment from an income tax perspective. The charts below show that, for either a 55-year old or 65-year old Seller, if Seller lives his life expectancy or beyond, the private annuity trust is worse from an income tax perspective than the alternative, which is assumed to be selling the asset and paying the tax. Each chart shows that the private annuity trust is a slight, 1% benefit if Seller dies several years after implementation and several years before reaching his life expectancy, and an approximate 5% detriment if Seller lives his life expectancy.
For either the 55 or 65-year old Seller, the best-case scenario appears to be dying between years 10 and 15. In this range, (i) the median outcome for a private annuity trust is equivalent to the median outcome for a taxable sale and (ii) the tax inefficiencies of the trust's recapture tax are minimized (Trust should recognize very little short term gain, or alternatively, the amount of unusable capital loss is likely to be minimized). Of course, if the best-case scenario of a strategy is achieving equivalence with paying tax, it is not a good strategy.
iii. Income Tax Benefits - Recapture income present
If Section 1245 (or Section 1250, if applicable) recapture income is being deferred, then the income tax benefits of the private annuity trust increase. Assuming that the gain being deferred is a mix of ordinary, recapture income, unrecaptured Section 1250 gain taxed at 25%, and long-term capital gains taxed at 15%, for an average tax rate of 27% (including state tax), the chart below actually shows an income tax benefit of 4% if the Seller dies in year 10, which benefit gradually drops to 0% by year 20. However, the private annuity trust can still be considered a bad income tax strategy even if recapture income is deferred, because the likely outcome, Seller living his life expectancy, produces a detriment of about -3%. And this -3% benefit is not yet risk-adjusted.
iv. Risk-Adjusting the benefits
To risk-adjust benefits, the model assumes that taxpayer loses in the 3rd year after implementing the strategy and pays the tax that was otherwise deferred. The taxpayer is also generously assumed to incur only $20,000 in incremental costs at such time (be it interest, penalties and/or defense). Predictably, the model shows a huge financial detriment to losing.
As noted earlier, losing with a private annuity trust is much worse than losing in some other strategies. With many tax strategies, losing means that the taxpayer is out the tax and interest. In the private annuity trust, losing means that the taxpayer is out the tax and interest, but the taxpayer is nevertheless still stuck with the phantom income caused by the annuity.
The chart below illustrates the financial detriment resulting from losing in a private annuity trust transaction. How the benefit/detriment is risk-adjusted is up to the advisor. Suffice it to say that the range of expected benefit of a private annuity trust in which recapture income is being deferred, and assuming the seller lives his life expectancy, is somewhere between -13% and -3%.
Despite the degree to which the private annuity trust is presently being marketed, it is simply not a very good strategy. Paradoxically, it represents both an income tax risk if it fails and an income tax detriment if it succeeds. In fact, it is a very bad strategy, more likely to generate more revenue for the government than less.
From an estate tax perspective, the benefits of the transaction depend largely upon the Seller's life expectancy. For a seller with a shortened life expectancy, private annuities are certainly sometimes appropriate strategies for estate tax reduction. However, private annuities can be done without the income tax bite.
 See, e.g., Usher v. Commissioner, 45 T.C. 205 (1965).
 Rev. Rul. 55-119, 1955-1 C.B. 352.
 Rev. Rul. 69-74, 1969-1 C.B. 43.
 Rev. Rul. 69-74 gives a more complicated formula. The amount excluded as a recovery of basis under the revenue ruling is equal to the product of (i) the basis of the property sold divided by the product of the seller's life expectancy and the annuity amount, and (ii) the annuity amount. However, because the annuity amount is in both the numerator and denominator, it appears that the equation can be more simply stated as basis divided by life expectancy.
 Rev. Rul. 69-74.
 Rev. Rul. 55-119, 1955-1 C.B. 352.
 As discussed below, there are several tangential purposes that the trust purportedly serves. But if it were not for gain deferral, the transaction would not be entered into.
 See, e.g., Stokes v. Commissioner, T.C. Memo 1999-204; Usher v. Commissioner; Melnik v. Commissioner, T.C. Memo 2006-25.
 The step-transaction doctrine "treats a series of formally separate 'steps' as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result." Esmark, Inc. v. Comm'r, 90 T.C. 171, 195 (1988), aff'd without published opinion, 886 F.2d 1318 (7th Cir. 1989). In the private annuity trust, the risk is that the intermediate step of creating the Trust would be ignored, so that the sale to third party would be deemed a sale directly by Seller.
 Agency would be a risk where the trustee is seen as carrying out Seller's instructions rather than acting as a truly independent trustee. See Commissioner v. Bollinger, 485 U.S. 340 (1988). This is what happened in Stokes, but the Tax Court just used a different doctrine to strike down the private annuity trust therein.
 If the creation of the Trust and sale of Asset to it occurs after a binding agreement to sell Asset to third party buyer is entered into, then an assignment of income risk would be present.
 T.C. Memo 1999-204.
 In Melnik, a foreign corporation owned by the trust was actually the purchaser under the private annuity contract, and the foreign corporation was held to be a conduit.
 Weigl v. Commissioner, 84 T.C. 1192 (1985); Stern v. Commissioner, 77 T.C. 614 (1981), rev'd. 747 F.2d 555, 558 (9th Cir. 1984); LaFargue v. Commissioner, 73 T.C. 40 (1979), affd. in part and revd. in part 689 F.2d 845 (9th Cir. 1982); Lazarus v. Commissioner, 58 T.C. 854, 864 (1972), affd. 513 F.2d 824 (9th Cir. 1975); Bixby v. Commissioner, 58 T.C. 757, 789 (1972); Archbishop Samuel Trust v. Commissioner, 36 T.C. 641 (1961), affd. sub nom. Samuel v. Commissioner, 306 F.2d 682 (1st Cir. 1962); Waegemann v. Commissioner, T.C. Memo. 1993-632.
 Stern v. Commissioner, 747 F.2d 555; LaFargue v. Commissioner, 689 F.2d 845.
 Estate of Fabric v. Commissioner, 83 T.C. 932 (1984); Benson v. Commissioner, 80 T.C. 789 (1983), Melnik v. Commissioner, T.C. Memo 2006-25.
 Promoters' websites, while ignoring Stokes, contain references to many cases discussing private annuities. However, none of these cases involve the tax play at issue here, whether a seller of an asset can insert a trust as an intermediary to buy the asset for a private annuity and then sell it and claim a high basis.
 Treas. Reg. 25.7520-3(b)(2)(i).
 The promoters' websites do suggest that the taxpayer sell his asset for an annuity having a present value less than the value of the asset. Although this could help meet the exhaustion test, it appears that the promoters are attempting to avoid Section 2036 issues, not meet the exhaustion test. Also note that such a sale would result in short term gain to the trust equal to the difference between the sales price to the third party buyer and its basis, which will equal the value of the reduced annuity.
 This is analogous to retirement planning analysis. Assuming straight-line growth of, for example, an IRA produces a much more optimistic picture of one's retirement needs than assuming volatile growth.
 Private Annuity Trust modeling indicates that, for a 55 year old seller, where the exhaustion test is satisfied, and assuming relatively low volatility (18%) and reasonable expected growth rates (10%), the Trust has about a 22% chance of running out of money prior to the time at which the seller attains the age of 105. The probability of the Trust running out of money by age 110 is necessarily higher than the probability of the Trust running out of money by age 105.
 Rev. Rul. 69-74.
 Section 1245(a)(1); Section 1245(d).
 See also Treas. Reg. Section 1.1250-1(c)(1).
 The amount of Section 1245 or 1250 gain is predicated on the amount realized on the transfer. Because private annuities are taxed under an open transaction theory, it may be tempting to argue that there is no "amount realized." However, Rev. Rul. 69-74 states that the amount realized in a private annuity is the present value of the annuity. Even though realized gain under a private annuity is not recognized, there is nevertheless an amount realized.
 It has been suggested that Section 1245 governs character, not timing. But the statute and regulations seem to address both, requiring ordinary treatment and requiring recognition even if a non-recognition provision (i.e., timing provision) otherwise applied.
 A similar rule is contained in Treas. Reg. Section 1.1250-1(c)(6).
 This assumes a Section 7520 rate of 5%.
 This is to ensure the annuitant receives payments through age 110.
 Some promoters properly claim that there will be estate tax inclusion of the annuity to the extent that annuitant does not consume (i.e., spend) the annuity payments. While this is also technically true, the annuitant will presumably consume the same amount (thereby depleting the estate to the same extent) with or without the private annuity trust, although Monte Carlo simulation reveals that to the extent Seller's consumption rates increase (as a percentage of the annuity), the private annuity trust transfer tax benefits vis-à-vis a do nothing scenario increase. On the other hand, the likelihood of the Trust running out of money (which means the annuity that Seller is counting on will run out) also increases. From Seller's cash flow perspective, if Seller is relying on a portion of the annuity to fund his living expenses, careful modeling must be done to ensure preservation of Seller's cash flow expectations.
 Section 2036 provides that the value of the gross estate includes the value of any transfer in trust to the extent the decedent retained possession or enjoyment of, or the right to income from, the property transferred. Because all of the seed gift is presumably set aside to service the annuity, there is a risk that the arrangement could be considered a retained life estate.
 See the cases cited in endnote 14.
 One would earn 8% on the 15% that would have gone to government absent deferral (.08 * .15 = .012).
 The trust would presumably have the undiscounted value of the partnership's assets to count towards the equity requirement when applying the exhaustion test.
 This assumes Seller is in the highest marginal rates. It is unclear whether the gain in this hypothetical would be long-term or short-term.
 The trust eventually gets a tax benefit for the $40 represented by the ordinary portion of the annuity, but as discussed below, it is virtually unusable.
 The same problem exists if the Trust invests in a tax-deferred vehicle. If Trust earns 4% on a tax-deferred basis, then it might appear that the family has $40 of economic income, and is paying tax on $40 (not including the capital gain portion of the annuity). But the relevant comparison to the Trust's 4% earnings is to what Trust could have earned in a taxable environment, not the completely unrelated taxability of the private annuity payment.
 The heirs are on the other side of the annuity contract. If the annuity is a winning bet for the Trust, then the heirs, while winning the bet on the annuity, will receive a smaller inheritance. Conversely, if the annuity is a winning bet for the annuitant, then the heirs will lose the bet on the annuity (and receive less through the Trust), but receive a larger inheritance. The only economics going on is in the taxes and the tax rates applicable to the various transfers back and forth.
 Rev. Rul. 55-119.
 For example, for a 65-year old seller who lives 10 years beyond his approximate 20-year life expectancy, modeling shows an approximate 40% likelihood of the trust having a capital loss in excess of the value of the trust assets.
 One organization, NPAT, publishes a fee schedule on its website. Its fees are .5% of the assets in trust, or $5,000 per million. Additionally, there quote a fee of $2,000 per year for trust maintenance.
 Not only are GST savings easy to achieve, but they are routinely overstated by practitioners. With the likelihood of estate tax repeal or a substantial increase in the estate tax exemption amount, it is far from certain that the GST tax supposedly being saved would be incurred in the first place. Additionally, the GST savings, if they do exist, involve savings from taxes that would be incurred perhaps 30 years or more down the road, the present value of which are greatly reduced. Finally, projections of GST savings incorrectly assume a static, binary analysis, i.e., the taxpayer will either do the plan being offered by the advisor, or the taxpayer and his family will never do any planning. Of course, absent GST planning today, the next generation will get advice from the next generation of tax lawyers, and transfer taxes will be minimized at that time.
 Ten percent is only an "expected" growth rate. The model runs Monte Carlo simulations based on that expected growth rate, but each trial will produce different growth rates. In the 1,000 trials that are run, the mean growth rate should be approximately 10%.
 An 18% volatility would be comparable to the volatility of a diversified portfolio, or the S&P 500.
 One could, for example, do a private annuity trust to intentionally cause estate tax inclusion if the numbers proved it to be a good income tax strategy but bad estate tax strategy. Conversely, if the strategy is a good estate tax strategy but bad income tax strategy, one could sell the asset, pay the tax, and enter into a private annuity with a defective grantor trust.
 It is unlikely a taxpayer would elect to pay gift tax in order to defer income tax.
 The charts were generated from Monte Carlo simulation of investment returns. Each chart represents the median results in 1,000 trials. The column "median ratio" represents the median result of dividing the benefits of private annuity trust vs. the benefits of a do-nothing scenario in each of 1,000 trials. (It does not represent dividing the median private annuity trust result by the median Do Nothing result, although that would give you a similar result). The final column represents the number of times in each of the 1,000 trials that private annuity trust beat a do-nothing scenario.
 There are essentially two "hurdles" in determining whether a private annuity is a good estate planning transaction. First, the seller's life expectancy is a hurdle, the attainment of which usually means a private annuity is not a great plan. Second, the Section 7520 rate is a hurdle rate - if, and to the extent, the trust beats the Section 7520 rate (which is used to compute the value of the annuity), a private annuity is likely to pass wealth, even if the first hurdle (life expectancy) is not met.
 Unless otherwise indicated, modeling assumes a 5% Section 7520 rate, a 23% capital gains rate (consisting of a mix of Section 1250 unrecaptured gain taxed at 25% and 15% long-term capital gain rates, plus state tax), and a zero tax basis for the sold asset, thus putting private annuity trust in its best light; the results were "Monte Carlo" simulated: reinvested assets were assumed to grow at an expected rate of 10% annually, with a volatility of 18%; 1,000 trials were run; and only the median results are reported herein. All growth was subjected to a tax rate of 13% (the assumed average tax rate applicable to a diversified portfolio, including the zero tax rate applicable to unrecognized gain), and losses were given a tax benefit of 13% (because losses can be "harvested" and gain recognition controlled, giving losses a 13% benefit (even though all capital in nature) is not inappropriate). Ordinary income on the annuity is subject to a 39% tax rate (state and federal) and capital gain income is subject to the 23% rate described above. Fees for the private annuity trust (over and above fees for "do nothing") were assumed to be $20,000 during the first year and $2,000 thereafter. Any capital loss generated by Trust upon the annuitant's death is assumed to have a 5% economic benefit. For example, a $1 million capital loss is presumed to have a value to the Trust of $50,000. Some websites correctly note that the capital gains tax rate is actually higher than 15% for many taxpayers, reasoning that the incurrence of a large capital gain will cause some taxpayers to lose itemized deductions. While this may be a problem, the private annuity trust is not the answer to the problem. Over the seller's life, the private annuity trust will generate more than double the income than an outright sale would. Thus, any AGI threshold issues that exist with incurring capital gain income likewise exist, and to a greater extent, with the private annuity trust. Of course, individual modeling tailored to a taxpayer's actual circumstances will trump any of these general observations.
 The modeling illustrates a worst-case scenario, in which the taxpayer loses on the entire deferral. Of course, taxpayer could win on part of the deferral and lose on the recapture portion. In that scenario, the benefits would lie somewhere in between -13% and -3%. Risk-adjusting here does not factor in any gift tax (exhaustion test) and estate tax risk, but any advisor recommending a private annuity trust should do so.
 A private annuity between a grantor and his grantor trust will unlikely have any income tax consequences. See Rev. Rul. 85-13, 1985-1 C.B. 184.
© 2006 by Kevin J. McGrath, reprinted with permission, all rights reserved.
Private Annuity Court Opinion
Stokes v. Commissioner -- In a case involving the National Association of Financial and Estate Planners, the court held that the private annuity trust in that particular case "constituted a sham trust that lacked economic substance". Not only did Mr. Stokes not receive the promised tax benefits, but he also got slammed with an accuracy-related penalty!
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