Wealth  Trends: IRS’s Private-Annuity Rule Roils the High Net Worth Universe

A new proposal from the IRS regarding private-annuity sales has sent ripples through the estate-planning universe. In early December 2006, the proposal was still in the comment stage. However, if it passes, it will be implemented in phases: In some cases it will be retroactive to October 18, 2006—the day the change was proposed—and in other cases, it will take effect later.

The proposal restricts the use of private-annuity sales, a transaction that carries major tax advantages if used in just the right way, says Andrew Katzenstein, a partner in the trust and estates practice group at law firm Katten Muchin Rosenman.

Beliefs in the industry vary on the validity of these transactions, but the IRS's sentiment appears to be clear: "They hate it," Katzenstein says. WHe noted that when the IRS changes tax law, it typically makes just minor tweaks. But this would be a major shift. "It's unusual for the IRS to say, 'Ah, this is a dumb idea. Let's get rid of it,'" he says. But that is what is happening.

Furthermore, he says that many in the estate-planning industry believe the proposal is "draconian," going too far in eliminating tax strategies for the high-net-worth crowd. In private annuities, the owner of a valuable asset, usually a piece of real estate, sells it in a private transaction, and the buyer agrees to pay the seller in yearly installments. The real estate is usually sold by a parent to an adult child.

The tax implications are in how the payments are recorded, he says. The buyer (the grown child) records the asset at full value, even though he has just started making payments, which means he can technically sell it for full value and not record a capital gain. And if the parent happens to die before the full payment stream is received, which is often a 10- or 20-year schedule, he avoids much of the income tax.

The device is used mostly by people in their 50s or 60s who are terminally ill, and do not expect to live to the age predicted on the IRS actuarial table, Katzenstein says. "It's grim, maybe, but they're using their [impending] death to their advantage," he says. Under the proposal, the seller will now have to record the deal as if he received the full payment in cash up front.

But the fact that the IRS has not made any offsetting accommodations on the buyer's side is what has drawn the ire of many in the industry, he says.

These changes won't be in effect if the buyer of the property does not sell it within two years, but that takes away the main intent of these deals. Often, the buyer does flip the property immediately.

And that is precisely the problem, says Steven Oshins, CEO of law firm Oshins & Associates.

He says he is not surprised by the proposed changes because private annuities, at least the ones where the buyer sells the property immediately, simply "don't pass the smell test." He says if the buyer of the property in the originally deal (the grown child) truly had not yet identified another buyer, the whole issue would have a much cleaner appearance, but he declined to speculate on what would be a better time frame.

If the proposal eliminates the private annuity, Katzenstein says there are other tax mechanisms that can accomplish some of the same goals of the instrument.

A private annuity offers both income-tax benefits and estate-tax benefits. So to gain some of those same income-tax benefits, investors could use a charitable remainder trust or a self-canceling installment note, although both have drawbacks. And both have a maximum limit of $5 million for the value of the property, Katzenstein said.

Plus, the self-canceling installment note either allows a smaller annuity payment or comes with gift taxes attached, depending on how it's structured. A charitable remainder trust requires the property be sold to a charity instead of adult children. And even though that charity is usually a family foundation run by the adult children, it still does not offer as much latitude as to what they can do with the property.

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