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IRS Stakes Out A Position
on Private Annuities
F. Bentley Mooney, Jr.
As you recall, I developed an esoteric, tax-oriented
transaction in 2000, and updated it when new regulations were
later published for key sections of the Internal Revenue Code.
(“Code”) The transaction serves to take the sting out
of capital gain taxation, reduce income taxes, remove assets from
the estate without payment of gift taxes, retain an income, and
keep the property value in the family on a tax-favored basis.
It is supported by an extensive tax opinion. Generically, it is
a foreign private annuity designed to avoid the obstacles thrown
up by IRS (variously “IRS” or “the Service”)
in its recent regulations construing Sections 679, 684 and 958
of the Code, doing so in a manner that does not put the client
at serious tax risk.
My experience in such matters is that the Service
will not endorse this sort of transaction with a private letter
ruling because it has no desire to see such strategies widely
employed. In the workaday world of tax planning, this also means
that the Service will not seek out and challenge the transaction
when it is at serious risk of losing in court. If, however, a
particular transaction is regarded as abusive and becomes so widely
publicized that it invites Congressional attention, the Service
must act no matter what the litigation risk. Those promoting the
“other” foreign private annuity method are now in the
IRS’ cross hairs.
The other method employs an irrevocable life insurance
trust, domestic or foreign. The trustee purchases a universal
life insurance policy on the client (or perhaps a family member
if uninsurable or too old). The purchase is made from an insurance
company located in an offshore financial center, typically the
Cayman Islands or Bermuda. The risk is usually laid off to U.S.
reinsurance companies. After issuing the policy, the offshore
carrier creates a foreign corporation and transfers some of the
premium dollars to it. The stock constitutes part of the policy
cash values. The insured/client then transfers appreciated property
to that corporation in exchange for a private annuity based on
tables set forth in the Code. The insured/client receives lifetime
payments under the private annuity agreement, and anything left
of the exchange property at his or her death is passed up to the
carrier and paid to the life insurance trust as part of the policy
death benefit. With all the middle persons taking a percentage
as the funds pass through, this is an expensive undertaking, usually
requiring cash and exchange property value of $2 million or more
before it makes economic sense.
The Service recently threw down the gauntlet with
respect to the life insurance-based plans. At the 2002 Florida
State Bar Annual Tax Conference, its representative reported the
following:
- Life insurance-based foreign private annuities
will be regularly challenged.
- The use of the structure to purportedly “de-control”
the private annuity payor (“Payor”) as a controlled
foreign corporation will not be respected.
- The Service is receiving numerous complaints
from tax practitioners due to heavy marketing of this structure
throughout the country.
- The structure constitutes a “step transaction”
collapsible into a direct sale of the exchange property to the
Payor.
- Code Section 367(f) (dealing with recognition
of appreciated property contributed to a corporation as capital
or surplus) applies to require recognition of gain.
These positions are based on the following IRS
analyses:
- The economic substance of the life insurance-based
foreign private annuity transaction is a sham: the transaction
is actually a direct sale by the U.S. person under a private
annuity agreement to a controlled foreign corporation or other
foreign entity.
- The life insurance policy is not really “insurance”
because the insurer offsets its risk by acquiring a valuable
property through the private annuity contract and using it to
offset its obligation to pay the death benefit. For that position,
it points to Helvering vs Le Gierse, 312 U.S. 531 (1941).The
court in Le Gierse stated that where the insurer simultaneously
issues a single-premium life insurance contract and a single-premium
annuity contract, the risks offset each other. Thus, if the
insured dies prematurely, the insurer is compensated by a profitable
annuity premium, and if the insured lives beyond life expectancy,
the insurer is compensated by profitable life insurance premiums.
Thus, there is no shifting of risk to the insurer, and no insurance.
- The arrangement is seen as a step-transaction,
negotiated entirely by the U.S. taxpayer. The standards for
determining whether to telescope a series of transactions remain
unclear, even after 60 years of litigation. Its essence, however,
is that the separate steps of an overall transaction will be
treated as part of a single transaction if the steps can fairly
be integrated. By this means, the Service feels that it can
sweep away the rationale for the individual steps if it dislikes
the end result.
- Code Section 367(f) applies to require recognition
of the gain realized on the exchange. This is based on the notion
that the U.S. taxpayer is treated as transferring property to
a foreign corporation as paid-in surplus or as a contribution
to capital. Under that view, the transfer is treated as a sale
or exchange for an amount equal to the fair market value of
the exchange property. There are no Treasury Regulations construing
Section 367(f), but the Service has made this a high-priority
project.
- Based on its conclusions that the transaction
utilizes a foreign grantor trust and a controlled foreign corporation,
the reporting requirements are extensive; they may include those
set forth in Code Sections 6038, 6038A, 6038B, 6046, 6046A,
or 6048. As a result (under §6501(c)(8)), the time for
assessment of tax expires three years after the required filing
date. In addition, filings under Schedule B, Part III, of Form
1040 or Form 1120 may be suspended by petition to quash summons,
held open due to fraud, extended by filing an amended return,
or extended by failure to correctly file certain information
returns.
- Gain realized on the transfer of appreciated
property to the Payor is treated as a transfer to the trust,
and is recognized (taxed to the U.S. transferor) under Treasury
Regulation 1.684-1(a).
Those are the positions of the Service on the
life insurance-based private annuity transaction. Suffice it to
say that the one I designed avoids the IRS roadblocks with positions
soundly supported in the law.
As a cautionary note, you may become the target
of a marketer who clings to the notion that the life insurance-based
plan works. And it may. But the more enlightened among them will
warn you in clear language that you bear serious audit risk, and
that the plan remains untested in the Federal District Court or
the U.S. Tax Court. Ask whether you will receive a supporting
tax opinion by a qualified tax professional on your specific transaction.
The resultant apoplexy or major squirming should be entertaining.
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