IRS approves tax treatment for annuity termination and partnership-interest sale

Plain-English summary

The IRS approved the requested tax treatment for two trusts that planned to transfer partnership interests to a buyer in exchange for terminating life annuity contracts and receiving cash. The transfer that terminates the annuity contracts will be treated as an annuity payment, and each trust will recognize gain or loss in the year of the transfer under the cited revenue ruling. Each trust will also recognize gain or loss on the partnership-interest sale based on its adjusted basis compared with the annuity value, cash payment, and its allocable share of partnership liabilities. The ruling applies only to the described transaction and facts.

Ruling snapshot

• Question: How are the proposed annuity-contract termination and sales of partnership interests treated for federal income tax purposes?
• Outcome: approved
• Key authorities: IRC §§ 61(a)(3), 72, 1001, 1011, 752, and 6110(k)(3); Treas. Reg. §§ 1.72-1(b), 1.72-2, and 1.1001-2(a)(1); Rev. Ruls. 55-119, 68-392, 69-74, and 2007-40.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201149005 Third Party Communication: None
Release Date: 12/9/2011 Date of Communication: Not Applicable
Index Number: 72.00-00, 1001.00-00,
752.04-00 Person To Contact:
-------------------, ID No. -----------------
------------------------------------------------ Telephone Number:
------------------------------------------------------- ---------------------
------------------------------------------------------------ Refer Reply To:
---------------- CC:FIP:B04
----------------------- PLR-109506-11, PLR-109507-11
---------------------------------------- Date:
------------------------------- September 06, 2011

Trust 1 -------------------------

Trust 2 --------------------------------

Buyer ----------------------------------------

Date 1 -------------------

Date 2 -------------------

Date 3 -------------------

Date 4 -------------------

Date 5 -----------------------

Date 6 ----------------

Date 7 --------------------------

Date 8 -------------------

Grantor: ---------------------

Co-Trustees: -------------------------------

Beneficiary 1 --------------------

Beneficiary 2 -------------------

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Amount 1 ---------

Amount 2 -----------

Amount 3 ---------

Amount 4 ---------

Amount 5 -----------

Amount 6 -----------

Amount 7 ------

Corporation 1 -----------------------------------

Corporation 2 ----------------------

Corporation 3 ---------

Partnership1 ----------------------------------------------

Partnership 2 -----------------------------------------------------------

Partnership 3 --------------------------------------------------

Real Property ----------------------

City ---------------------------

Dear -------------------------------------------

This is in response to your request for a letter ruling regarding the application of the
Internal Revenue Code to a transaction you contemplate undertaking.

FACTS

The following is represented:

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On Date 1, Grantor and Co-Trustees, established Trust 1 for the sole benefit of
Beneficiary 1. On Date 1, Grantor and Co-Trustees established Trust 2 for the sole
benefit of Beneficiary 2.

Date 2 Annuity Contracts:

On Date 2, Trust 1 and Trust 2 (“Trusts”) each purchased Amount 1 shares of common
stock of Corporation 1 from Grantor. The consideration paid by each Trust was Date 2
Annuity Contracts that provide that each Trust must pay a fixed annual annuity payment
to Grantor for the full term of Grantor’s life. The present value of the fixed annual
annuity payments to be made by the Trusts pursuant to the Date 2 Annuity Contracts,
as determined pursuant to the regulations under section 2512 of the Internal Revenue
Code, was equal to the fair market value of the Corporation 1 Stock as of Date 2.

Trusts have paid the fixed annual annuity payments to Grantor as required by the
Date 2 Annuity Contracts.

On Date 3, each Trust exchanged the Corporation 1 Stock for Amount 2 shares of
Corporation 2 stock pursuant to a tax-free merger of Corporation 1 and Corporation 2.

Each Trust subsequently sold some shares of Corporation 2 Stock to unrelated third
parties.

On Date 4, each Trust exchanged Amount 3 shares of Corporation 2 Stock for Amount 4
shares of Corporation 3 pursuant to a tax-free merger of Corporation 2 and Corporation 3.

Each Trust subsequently sold all of its shares of Corporation 3 stock to unrelated third
parties.

On Date 5, each Trust purchased Amount 5 shares of common stock of Corporation 2
from Grantor pursuant to a Sale Agreement. The consideration paid by each Trust in
exchange for the Amount 5 of stock was an annuity (Date 5 Annuity Contracts). The
Date 5 Annuity Contracts provide that the Trusts must pay a fixed annual annuity
payment to Grantor for the full term of Grantor’s life. The present value of the fixed
annual annuity payments to be made by the Trusts pursuant to the Date 5 Annuity
Contracts, as determined pursuant to section 2512, was equal to the fair market value of
the Date 5 Corporation 2 Stock as of Date 5.

On Date 4, each Trust exchanged the Date 5 Corporation 2 Stock for Amount 6 shares
of Corporation 3 stock pursuant to a tax-free merger of Corporation 2 and
Corporation 3.

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Each Trust subsequently sold all of its shares of Corporation 3 stock to unrelated third
parties.

Taxpayer represents that the annuity contracts are unsecured.

Contemplated Transaction:

On or around Date 6, each Trust acquired Amount 7 partnership interest in Partnership

1. On or around Date 7, each Trust acquired Amount 7 partnership interest in
   Partnership 2. On or around Date 8, Partnership 1 merged with Partnership 2. The
   surviving entity changed its name to Partnership 3. As a result of the merger, each
   Trust owns an amount 7 partnership interest in Partnership 3. Partnership 3 owns Real
   Property in City.

Grantor intends to assign his rights and obligations under the Annuity Contracts to
Buyer. Thereafter, Trust 1 and 2 intend to sell their Partnership Interests to the Buyer in
exchange for 1) the termination of the Annuity Contracts and 2) cash.

Buyer is a grantor Trust within the meaning of section 671 of the Internal Revenue
Code.

The fair market value of the Partnership Interest of each of Trust 1 and Trust 2 at the
time of the sale will equal the sum of 1) the present value of the future annuity payments
due under the Annuity Contracts, plus 2) the Cash Payment. The Annuity Value will be
computed as of the closing date of the contemplated transaction using the appropriate
table identified in Treas. Reg. section 20.2031-7T and the applicable section 7520
interest rate as of the closing date of the contemplated transaction and the age of the
Grantor.

REQUESTED RULINGS

Taxpayer requests rulings that:

1. The transfer by each Trust of a portion of each Trust’s Partnership Interest to the
   Buyer in exchange for the termination of the Annuity Contracts is treated as an annuity
   payment made under each of the Annuity Contracts in an amount equal to the Annuity
   Value for purposes of Revenue Ruling 55-119, 1955-1 C.B. 352, and each Trust shall
   recognize gain or loss as a result of such transfer in the tax year that includes such
   transfer as provided therein.

2. Each Trust will recognize gain or loss as a result of the sale of its Partnership
   Interest to the Buyer in the tax year that includes such sale in an amount equal to the

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difference between each Trust’s adjusted basis in its Partnership Interest and the sum
of (i) the Annuity Value, (ii) the Cash Payment, and (iii) the Trust’s allocable share of the
Partnership’s liabilities immediately prior to the sale pursuant to section 752(d).

LAW and ANALYSIS

Requested Ruling #1

Section 72(a) of the Internal Revenue Code provides that gross income includes any
amount received as an annuity. Section 72(b) provides that to the extent an amount
received as an annuity represents a reduction or return of premiums or other
consideration paid, such amount is not included in gross income.

An annuity is a periodic amount paid at a regular interval under an annuity contract
which provides a determinable amount of payments in consideration for a fixed sum or a
transfer of property. See section 1.72-2 of the Income Tax Regulations.

Treas. Reg. section 1.72-1(b), in defining "amounts received as an annuity," provides
that in general they are "amounts which are payable at regular intervals over a period of
more than one full year from the date on which they are deemed to begin, provided the
total of the amounts so payable or the period for which they are to be paid can be
determined as of that date." Thus, an annuity may be for a fixed period of time (so the
payments will total a predetermined amount), or for a period determined by the life of the
annuitant, or a combination of the two.

A private annuity is generally an arrangement whereby an individual transfers property,
usually real estate, to a transferee who promises to make periodic payments to the
transferor for the remaining life of the transferor. A private annuity may also include a
transaction whereby the transferee agrees to make periodic payments until a specific
monetary amount is reached or until the transferor's death, whichever occurs first.
Private annuity arrangements are often used for intra-family transfers whereby an older
family member transfers appreciated property to a younger family member in order to
gain tax advantages, e.g., removal of the property from the transferor's gross estate.

Various revenue rulings have prescribed methods for recognizing gain, recovering
basis, and computing the transferee's basis in this type of annuity transaction. See Rev.
Rul. 69-74, 1969-1 C.B. 43, and Rev. Rul. 55-119, 1955-1 C.B. 352.

In Rev. Rul. 69-74, a father transferred a capital asset having an adjusted basis of
$20,000 and a fair market value of $60,000 to his son in exchange for the son's legally
enforceable promise to pay him a life annuity of $7,200 per year, in equal monthly
installments of $600. The present value of the life annuity was $47,713.08. The ruling

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concluded that: (1) the father realized capital gain based on the difference between the
father's basis in the property and the present value of the annuity; (2) the gain was
reported ratably over the father's life expectancy; (3) the investment in the contract for
purposes of computing the exclusion ratio was the father's basis in the property
transferred; (4) the excess of the fair market value of the property transferred over the
present value of the annuity was a gift from the father to the son; and (5) the prorated
capital gain reported annually was derived from the portion of each annuity payment
that was not excludible.

Rev. Rul. 55-119, 1955-1 C.B. 352, holds that, if property is exchanged for an annuity,
and such annuitized property is disposed of prior to the death of the annuitant, the basis
(unadjusted) for determining gain shall be 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. The basis (unadjusted) for
determining loss shall be the total of the annuity payments actually made at the time of
disposition. If the selling price is less than the adjusted basis for gain and greater than
the adjusted basis for loss, neither gain nor loss would be recognized at the time of the
sale. See sections 72(e)(5)(A) and 72(e)(5)(E)(ii) (distribution on complete surrender or
redemption of a contract included in gross income only to the extent that the distribution
exceeds the investment in the contract, determined under section 72(e)(6). This
treatment applies even if the distribution arises from a complete surrender or
redemption of the contract on or after the annuity starting date. Section 72(e)(5)(E)
(flush language)).

When a taxpayer conveys appreciated or depreciated property in satisfaction of an
obligation or in exchange for the performance of services, that taxpayer must recognize
gain or loss equal to the difference between the basis in the transferred property and
the property’s fair market value at the time of the transfer. See, e.g., United States v.
Davis, 370 U.S. 65 (1962), International Freighting Corp., v. Commissioner, 135 F.2d
310 (2nd Cir. 1943), United States v. General Shoe Corp., 282 F.2d 9 (6th Cir. 1960);
Wood v. Commissioner, 39 T.C. 1 (1962).

The transfer by each Trust of a portion of each Trust’s Partnership Interest to the Buyer
in exchange for the termination of the Annuity Contracts is treated as an annuity
payment in an amount equal to the Annuity Value made under each of the Annuity
Contracts under section 72. The termination of the Annuity Contracts ceases the
deferral treatment set forth in Rev. Rul. 69-74 and causes recognition of any remaining
gain. Furthermore, the disposition of the property that was exchanged for the Annuity
Contracts may be relevant in determining the gain or loss realized. Each Trust shall
recognize gain or loss as a result of such transfer in the tax year that includes such
transfer in accordance with Rev. Rul. 55-119.

Requested Ruling #2

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Section 61 (a)(3) provides that gross income includes gains derived from dealings in
property.

Section 1001(a) provides that gain from the sale or other disposition of property is the
excess of the amount realized over the adjusted basis provided in section 1011 for
determining gain, and the loss shall be the excess of the adjusted basis over the
amount realized.

Section 1001(b) provides, in part, that the amount realized from the sale or other
disposition of property shall be the sum of any money received plus the fair market
value of the property (other than money) received.

Treas. Reg. section 1.1001-2(a)(1) provides that the amount realized from a sale or
other disposition of property generally includes the amount of liabilities from which the
transferor is discharged as a result of the sale or disposition.

Section 752(d) provides that, in the case of a sale or exchange of an interest in a
partnership, liabilities shall be treated in the same manner as liabilities in connection
with the sale or exchange of property not associated with partnerships.

When a taxpayer conveys appreciated or depreciated property in satisfaction of an
obligation or in exchange for the performance of services, that taxpayer must recognize
gain or loss equal to the difference between the basis in the transferred property and
the property’s fair market value at the time of the transfer. See, e.g., United States v.
Davis, 370 U.S. 65 (1962), International Freighting Corp., v. Commissioner, 135 F.2d
310 (2nd Cir. 1943), United States v. General Shoe Corp., 282 F.2d 9 (6th Cir. 1960);
Wood v. Commissioner, 39 T.C. 1 (1962).

In Rev. Rul. 68-392, 1968-2 C.B. 284, a testator established a trust for the benefit of his
daughter. Under the terms of the trust document, the trustee was directed to distribute
24x dollars to daughter annually for her life, first out of income of the trust and, if
necessary, out of corpus. In its first taxable year, the trust had income of 10x dollars all
of which was distributed to daughter. In satisfaction of her right to receive an additional
14x dollars, daughter accepted securities that were part of trust corpus. The securities
had a fair market value of 14x dollars at the time of distribution and a basis of 12x
dollars in the hands of trust. Rev. Rul. 68-392 concludes that transfer of the securities
to daughter in partial satisfaction of the annuity obligation is treated as though the
trustee had sold the securities to daughter for cash and immediately thereafter
distributed the entire proceeds to her. Since the securities distributed had a fair market
value in excess of their basis at the time of distribution, the gain (2x dollars) must be
included in the gross income of the trust as capital gain.

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In addition, Rev. Rul. 2007-40, 2007-1 C.B. 1426, concludes that a partnership realizes
gain upon the transfer of appreciated property to one of its partners as a section 707(c)
guaranteed payment in an amount equal to the difference between the partnership’s
adjusted basis in the property and the property’s fair market value at the time of the
payment.

In the instant case, each Trust is obligated to make fixed annuity payments to Grantor
under the Annuity Contracts. Pursuant to the proposed transaction, following the
assignment by Grantor of his rights and obligations under the Annuity Contracts to the
Buyer, each Trust will transfer its Partnership Interest to the Buyer in exchange for the
termination of the Annuity Contracts and the Cash Payment.

In determining the gain to be recognized by the Trusts in connection with the proposed
sale, the Trusts’ allocable share of liabilities with respect to their Partnership Interests
must be taken into account both for purposes of determining the tax bases that the
Trusts have in their Partnership Interests under sections 722 and 752(a) and also the
amount realized by the Trusts in connection with the proposed sale under section
752(d).

Accordingly, we conclude that each Trust will recognize gain or loss as a result of the
sale of its Partnership Interest to Buyer in the tax year that includes such sale in an
amount equal to the difference between each Trust’s adjusted basis in its Partnership
Interest and the sum of (i) the Annuity Value; (ii) the Cash Payment, and (iii) the Trust’s
allocable share of the Partnership’s liabilities immediately prior to the sale pursuant to
section 752 (d).

Conclusion

Based solely on the facts submitted and the representations made, we conclude as
follows:

1. The transfer by each Trust of a portion of each Trust’s Partnership Interest to the
   Buyer in exchange for the termination of the Annuity Contracts is treated as an annuity
   payment in an amount equal to the Annuity Value made under each of the Annuity
   Contracts under section 72. The termination of the Annuity Contracts ceases the
   deferral treatment set forth in Rev. Rul. 69-74 and causes recognition of any remaining
   gain. Furthermore, the disposition of the property that was exchanged for the Annuity
   Contracts may be relevant in determining the gain or loss realized. Each Trust shall
   recognize gain or loss as a result of such transfer in the tax year that includes such
   transfer in accordance with Rev. Rul. 55-119.

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2. Each Trust will recognize gain or loss as a result of the sale of its Partnership
   Interest to the Buyer in the tax year that includes such sale in an amount equal to the
   difference between each Trust’s adjusted basis in its Partnership Interest and the sum
   of (i) the Annuity Value, (ii) the Cash Payment, and (iii) the Trust’s allocable share of the
   Partnership’s liabilities immediately prior to the sale pursuant to section 752(d).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent. In accordance with the Power of
Attorney on file with this office, a copy of this letter is being sent to your authorized
representative.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,

                                        /S/

                                   Sheryl B. Flum
                                   Chief, Branch 4
                                   (Financial Institutions & Products)