Tax Facts
605 / How are payments taxed that are received under a private annuity issued before October 19, 2006?
The basic rules for taxing the payments received by the annuitant under a private life annuity issued before October 19, 2006, are set forth in Revenue Ruling 69-74.1 According to this ruling, the payments must be divided into three elements: (1) a “recovery of basis” element; (2) a “gain element” eligible for capital gain treatment for the period of the annuitant’s life expectancy, but taxable as ordinary income thereafter; and (3) an “annuity element” that is taxable as ordinary income. Each of these is discussed below.
If the annuity starting date is before January 1, 1987, the amount calculated to be excludable from income as a recovery of basis (as explained above) is excluded from all payments received, even if the annuitant outlives his or her life expectancy. If the annuity starting date is after December 31, 1986, then the exclusion percentage is applied only to payments received until the investment in the contract is recovered. Thereafter, the portion excludable under the percentage is included as ordinary income.3
If the fair market value of the property transferred exceeds the present value of the annuity (as determined from the applicable Estate and Gift Tax Valuation Tables), the difference is treated as a gift to the obligor ( Q 586).5
Assume that the valuation table interest rate for January is 5.0 percent. Therefore, the present value of the annuity equals $126,078: $12,000 × 10.2733 (annuity factor) × 1.0227 (annuity adjustment factor). The fair market value of the property exceeds the present value of the annuity by $8,922: $135,000 – $126,078. This is a gift by Mrs. White to her children and subject to gift tax. Mrs. White’s life expectancy is 19.2 years.
In Katz v. Commissioner, the Tax Court held that a taxpayer who had exchanged shares of common stock and put options for a private annuity (on February 3, 2000) was entitled to defer recognition of capital gain relating to the transfer until the taxpayer received annuity payments.6
According to the Tax Court, Revenue Ruling 69-74 is not applicable if the promise to pay the annuity is secured; securing the promise will cause the entire capital gain on the transfer of the property to be taxable to the annuitant in the year of transfer. The investment in the contract would be the present value of the annuity, but not more than the fair market value of the property transferred.7
In a private letter ruling, a private annuity arrangement was still taxed as such despite the presence of a cost-of-living adjustment applicable to the monthly annuity payments and a minimum payment provision that stated that if the annuitant had not received a specified dollar amount prior to her death, the remaining amount would be paid to her estate. The annuitant also had the option to accelerate the payments and receive a lump sum amount equal to the minimum payment amount less annuity payments previously received.8
When a private annuity became worthless, the determination that the loss was a capital loss and not an ordinary loss was upheld in McIngvale v. Commissioner.9
Whether a transfer to a trust will be treated as a sale in exchange for a private annuity or a transfer in trust with a right to income retained depends on the circumstances in the case. Properly done, a transfer to a trust will be treated as a private annuity transaction.10 However, purported transfers in trust were found to be sham transactions in Horstmier v. Commissioner.11
Amounts received under a private annuity contract are not subject to withholding because such amounts are not paid under a “commercial annuity,” that is, one issued by a licensed insurance company.
For estate tax implications of a private annuity, see Q 630.
1. 1969-1 CB 43.
2. LaFargue v. Commissioner, 800 F.2d 936, 86-2 USTC ¶ 9715 (9th Cir. 1986), aff’g, TC Memo 1985-90; Benson v. Commissioner, 80 TC 789 (1983).
3. IRC § 72(b)(2).
4. Garvey, Inc. v. U.S., 1 Cl. Ct. 108, 83-1 USTC ¶ 9163 (U.S. Cl. Ct. 1983), aff’d, 726 F.2d 1569, 84-1 USTC ¶ 9214 (Fed. Cir. 1984), cert. denied.
5. Benson v. Commissioner, supra; LaFargue v. Commissioner, supra.
6. Katz v. Commissioner, TC Memo 2008-269, citing Rev. Rul. 69-74, 1969-1 CB 43.
7. Estate of Bell v. Commissioner, 60 TC 469 (1973); 212 Corp. v. Commissioner, 70 TC 788 (1978).
8. Let. Rul. 9009064.
9. 936 F.2d 833 (5th Cir. 1991), aff’g, TC Memo 1990-340.
10. Estate of Fabric v. Commissioner, 83 TC 932 (1984); Stern v. Commissioner, 747 F.2d 555, 84-2 USTC ¶ 9949 (9th Cir. 1984); LaFargue v. Commissioner, 689 F.2d 845, 50 AFTR 2d 5944 (9th Cir. 1982) (followed by the Tax Court in Benson v. Commissioner, supra, because an appeal would go to the Ninth Circuit).
11. TC Memo 1983-409.
(1) The portion of each payment that is to be excluded from gross income as a recovery of basis is determined by applying the basic annuity rule ( Q 527). Thus, an exclusion percentage is obtained by dividing the investment in the contract by the expected return under the contract. The investment in the contract in a private annuity situation is the adjusted basis of the property transferred. If the adjusted basis of the property transferred is greater than the present value of the annuity, the annuitant’s investment in the contract for purposes of IRC Section 72(b) is the present value of the annuity on the date of the exchange.2 Expected return and annuity starting date are the same as explained in Q 534 and Q 536.Thus, expected return is obtained by multiplying one year’s annuity payments by the appropriate multiple from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made.
If the annuity starting date is before January 1, 1987, the amount calculated to be excludable from income as a recovery of basis (as explained above) is excluded from all payments received, even if the annuitant outlives his or her life expectancy. If the annuity starting date is after December 31, 1986, then the exclusion percentage is applied only to payments received until the investment in the contract is recovered. Thereafter, the portion excludable under the percentage is included as ordinary income.3
(2) The capital gain portion, if any, is determined by dividing the gain by the life expectancy of the annuitant. Gain is the excess of the present value of the annuity (it may not be the same as the fair market value of the property) over the adjusted basis of the property. The present value of the annuity is obtained from the Estate and Gift Tax Valuation Tables (see Q 921). The life expectancy of the annuitant is obtained from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made. This portion is reportable as capital gain for the period of the annuitant’s life expectancy, and thereafter as ordinary income. Recovery of capital gain may not be deferred until the entire investment in the contract has been recovered.4
(3) The remaining portion of each payment is ordinary income.
If the fair market value of the property transferred exceeds the present value of the annuity (as determined from the applicable Estate and Gift Tax Valuation Tables), the difference is treated as a gift to the obligor ( Q 586).5
Example. Mrs. White is a widow, age 66, with two adult children. She owns a rental property with an adjusted basis of $30,000 and a fair market value of $135,000. On January 1, she transfers this building to her children in exchange for their unsecured promise to pay her $1,000 a month ($12,000 a year) for life beginning January 31.
Assume that the valuation table interest rate for January is 5.0 percent. Therefore, the present value of the annuity equals $126,078: $12,000 × 10.2733 (annuity factor) × 1.0227 (annuity adjustment factor). The fair market value of the property exceeds the present value of the annuity by $8,922: $135,000 – $126,078. This is a gift by Mrs. White to her children and subject to gift tax. Mrs. White’s life expectancy is 19.2 years.
(1) Mrs. White will exclude from gross income as a recovery of basis $130, or 13 percent of each payment (until she recovers $30,000, because her annuity starting date is after December 31, 1986). The 13 percent exclusion percentage is obtained by dividing $30,000 (investment in the contract) by $230,400 (expected return: 19.2 × $12,000) ( Q 537).
(2) She will report $417 of each payment as capital gain for 19.2 years. This portion is obtained by dividing her gain of $96,078 (excess of present value of annuity [$126,078] over adjusted basis of the property [$30,000]) by 19.2, her life expectancy ($96,078 ÷ 19.2 = $5,004 a year or $417 a month). After 19.2 years, she will report this $417 as ordinary income.
(3) She will report the balance of each payment, or $453 ($1,000 – ($130 + $417)) as ordinary income. (Because her annuity starting date is after December 31, 1986, she also will report as ordinary income the portion of each payment no longer excludable as recovery of capital after her investment in the contract has been recovered.)
In Katz v. Commissioner, the Tax Court held that a taxpayer who had exchanged shares of common stock and put options for a private annuity (on February 3, 2000) was entitled to defer recognition of capital gain relating to the transfer until the taxpayer received annuity payments.6
According to the Tax Court, Revenue Ruling 69-74 is not applicable if the promise to pay the annuity is secured; securing the promise will cause the entire capital gain on the transfer of the property to be taxable to the annuitant in the year of transfer. The investment in the contract would be the present value of the annuity, but not more than the fair market value of the property transferred.7
In a private letter ruling, a private annuity arrangement was still taxed as such despite the presence of a cost-of-living adjustment applicable to the monthly annuity payments and a minimum payment provision that stated that if the annuitant had not received a specified dollar amount prior to her death, the remaining amount would be paid to her estate. The annuitant also had the option to accelerate the payments and receive a lump sum amount equal to the minimum payment amount less annuity payments previously received.8
When a private annuity became worthless, the determination that the loss was a capital loss and not an ordinary loss was upheld in McIngvale v. Commissioner.9
Whether a transfer to a trust will be treated as a sale in exchange for a private annuity or a transfer in trust with a right to income retained depends on the circumstances in the case. Properly done, a transfer to a trust will be treated as a private annuity transaction.10 However, purported transfers in trust were found to be sham transactions in Horstmier v. Commissioner.11
Amounts received under a private annuity contract are not subject to withholding because such amounts are not paid under a “commercial annuity,” that is, one issued by a licensed insurance company.
For estate tax implications of a private annuity, see Q 630.
1. 1969-1 CB 43.
2. LaFargue v. Commissioner, 800 F.2d 936, 86-2 USTC ¶ 9715 (9th Cir. 1986), aff’g, TC Memo 1985-90; Benson v. Commissioner, 80 TC 789 (1983).
3. IRC § 72(b)(2).
4. Garvey, Inc. v. U.S., 1 Cl. Ct. 108, 83-1 USTC ¶ 9163 (U.S. Cl. Ct. 1983), aff’d, 726 F.2d 1569, 84-1 USTC ¶ 9214 (Fed. Cir. 1984), cert. denied.
5. Benson v. Commissioner, supra; LaFargue v. Commissioner, supra.
6. Katz v. Commissioner, TC Memo 2008-269, citing Rev. Rul. 69-74, 1969-1 CB 43.
7. Estate of Bell v. Commissioner, 60 TC 469 (1973); 212 Corp. v. Commissioner, 70 TC 788 (1978).
8. Let. Rul. 9009064.
9. 936 F.2d 833 (5th Cir. 1991), aff’g, TC Memo 1990-340.
10. Estate of Fabric v. Commissioner, 83 TC 932 (1984); Stern v. Commissioner, 747 F.2d 555, 84-2 USTC ¶ 9949 (9th Cir. 1984); LaFargue v. Commissioner, 689 F.2d 845, 50 AFTR 2d 5944 (9th Cir. 1982) (followed by the Tax Court in Benson v. Commissioner, supra, because an appeal would go to the Ninth Circuit).
11. TC Memo 1983-409.
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