NAFEP CRITICAL NEWS! 10-18-2006

THE PRIVATE ANNUITY TRUST IS DEAD!

Today, October 18, 2006, the U.S. Treasury Department released proposed regulations (REG-141901-05) for private annuities which reverse both the Treasury and the IRS position on private annuities. The proposed regulations disallow deferral of capital gains taxes via a private annuity from this point forward. The effective date of these proposed regulations is today, Oct 18, 2006. This means that private annuity trusts which have not been funded with the exchange property prior to Oct. 18, 2006 will not be allowed capital gains deferral by the IRS, even though the regulations are still in the proposal stage.

Unfortunately, Treasury neither gave any advance notice that this was coming, nor have they given any grace period for transactions in process (1). Normally Treasury and the IRS do give notice and/or grace periods in order to provide taxpayers and professionals with a smoother transition. But in this case we just found out about the new rules yesterday afternoon, and the official announcement of it only occurred today.

NOTE: It is important to understand that the Treasury and IRS did not rule that existing private annuity transactions are illegal. Treasury's explanation of the logic behind the new rules is that they no longer believe their old rules to be correct (nor, apparently, the affirmative court cases). So they retracted Revenue Ruling 69-74 (from 1969), presumably as their only change to existing rules which was necessary to permit this draconian rule. But, it seems clear that completed, pre-10/18/06 transactions which have been properly structured under the old rules will stand. The IRS just won't recognize future transactions for capital gains tax deferral purposes. As an interesting side note, at least for now other capital gains strategies have been left untouched. These include: Charitable remainder trusts (CRT), charitable gift annuities (virtually identical to PATs in structure), installment sales, and 1031 exchanges.

As a result of these proposed but already effective regulations, NAFEP will immediately stop accepting all orders for the Premier VI Private Annuity Trust product. Given this, NAFEP advises all CEAs to stop all private annuity related sales activities, regardless of where you are in the sales cycle. This includes, but is not limited to: Filling orders, taking client monies, soliciting new business or relationships as they may relate to the private annuity. Additionally, all CEAs should follow-up with existing clients to verify that all delivered trusts have been funded. Any un-funded trusts as of Oct. 18 will not qualify the client for deferral of capital gains.

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. The IRS is accepting comments on the proposed rules and will hold a formal meeting regarding this early next year. Some changes to the new regulations could come out of that process. NAFEP will definitely participate in the comment process and keep you posted. There may be other actions we can take as well, but for now the private annuity trust (1), regardless of how it is structured, will not yield capital gains tax deferral on the exchange of appreciated assets.

NAFEP will continue to offer the rest of its products and services, will be introducing an important new product in approximately 30 days and will continue to create new services for estate and tax planning purposes. We have complete confidence that elimination of the PAT from our lineup does not threaten our survival or prosperity.

Regarding any order in-house, in process, with payment:

NAFEP will review each case and order as to the merits of any refunds. On many of these, even if the trust has not been delivered a lot of work has already been done, and therefore only a partial refund may be paid. And, it is NAFEP's position that if the trust was delivered, that we will not provide refunds as a result of Treasury's actions. There is no way that this sudden reversal of decades old law, which continues to be recognized for existing PATs, could have been foreseen, nor should NAFEP be held responsible for Treasury's abrupt change of the status quo (2). In any case, we will not ship any PATs now and will not accept new orders.

Regarding unfunded trusts:

Clients who have trusts in hand, but not funded, may want to go ahead with funding and finishing up their private annuity trust transaction. There is some chance, maybe slim, that when the IRS gets bombarded with complaints about the no-notice of the new regulations that they will grant a grace period of 90 or 180 days past 10/18/06. If no grace period is provided, the client will end up paying the capital gains, possibly with interest if they haven't paid the taxes by the end of the taxable quarter. But they may feel they have everything to gain and nothing to lose by completing their transaction and waiting out the comment process to see if their transaction becomes the beneficiary of a grace period. However, we will notify all clients who received a trust from NAFEP in the last few months that if their PAT is not funded and completed, and they proceed with completion now, we will not honor the audit support warranty (we will honor the warranty for transactions completed prior to 10/18/06). As to sales which haven't been closed, or orders in-house at NAFEP which have not been filled, we are reluctant to proceed with filling those orders, at least for now. This paragraph is not to be construed that we will proceed on this "nothing to lose" basis with new orders or with in-house unfilled orders. We will not ship any PATs now.

Regarding funded trusts with no private annuity contract in place:

If a client has funded the trust, whether or not a sale of the property from the trust has taken place, we can evaluate these on a case-by-case basis and determine whether the transaction can be safely completed by issuing a private annuity contract now. Many of these should be fine, depending on the facts of their situation.

NOTE: There are a number of trusts in this position, no formal private annuity contract has been issued. We don't know in any given case why this hasn't been done, but we are aware that some clients and trustees have relied on nothing more than a preliminary private annuity illustration, and private annuity payments to the client have begun based on that. These are at serious risk of failing an IRS audit if we don't get a formal and correctly calculated contract in place. We recently notified every client for whom no formal contract was ever ordered from us, and asked for information regarding why this hasn't been done. If you are aware of any situation like this, you have an E & O risk if you fail to help correct the problem, especially in view of the new regulations.

If you care to review the proposed regs. click here: Proposed Regs for Private Annuity

Footnotes:

(1) The ruling will allow private annuity transactions to go forward until April 18, 2007, under the following circumstances: "A special effective date applies if (1) the issuer of the annuity contract is an individual, (2) the annuity contract is not secured, directly or indirectly, and (3) the transferred property is not subsequently sold or otherwise disposed of by the transferee within the 2-year period beginning on the date of the exchange. Under the special effective date, the Proposed Regulations apply to property-annuity exchanges occurring after April 18, 2007." For private annuity trust transactions which are in process, but the trust is not-funded, it may be possible for the client/annuitant to still obtain capital gains deferral (up to 4/18/07), by transferring the exchange assets directly to the heirs, no trust, and issuing the normal private annuity contract directly from the heirs to the client/annuitant. In this case the heirs would have to hold the property for two years before they could sell it. This is a risky strategy for the client/annuitant, though, because the heirs would have direct ownership of the property, and later the cash. These assets in the hands of the heirs would be subject to all their divorce settlements, IRS liens, lawsuits, dishonesty or poor handling. As a result, it is unlikely that NAFEP will be willing to participate in these transactions.

(2) As recently as last Friday, 10/13/06, Mike Janko, NAFEP President, had a conference pre-planning meeting with a Treasury official. The conference was to be a pro-PAT presentation for an American Bar Association tax meeting, which both Mike and the Treasury official were planning to participate in. The Treasury official was also involved in developing the above proposed new regulations, but gave Mike no indication at all of what was coming. This was due to Treasury privacy considerations, no doubt, but nonetheless is an indication of how unexpected and confidential the new rules were before today.

CLICK HERE For an Alternative to the Private Annuity Trust.

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