Offshore Private Annuity By Vernon K. Jacobs, CPA  & J. Richard Duke, J.D., LLM

One of the more widely promoted methods of getting funds transferred into a foreign corporation or foreign trust on a tax favored basis is to utilize a private annuity contract. This could be an effective arrangement in some cases if the foreign entity were not a foreign grantor trust under the rules of IRC section 679 or a controlled foreign corporation under the rules of IRC 951-954. But if the foreign entity is not effectively controlled by the U.S. person who is parting with his or her assets in exchange for a private annuity, the risk to the U.S. annuitant is substantial and often much greater than justified by the tax advantages.  But if it is controlled by the U.S. annuitant, the IRS will argue that the arrangement is invalid. And we expect the U.S. courts will agree.

The primary appeal of the private annuity was that until October 18, 2006 it was a legal way to defer capital gains tax on the transfer of highly appreciated property in exchange for a deferred annuity. But on October 18, 2006, the IRS issued a notice of proposed rule making with regard to Regulation 141901-05. The proposed rule making essentially rescinded a long standing IRS position with respect to private annuities to the effect that because the value of the annuity was not determinable, gain on the transfer of apprecated assets in exchange for the annuity would be deferred until the payments were received. Due to perceived abuses of the private annuity with respect to offshore transactions and to the use private annuity trusts, the IRS has concluded that a private annuity can be valued and that deferral of a capital gains tax is no longer required or necessary. However, they are not proposing to alter the tax treatment of the deferred income earned from the investment of the cash value in the contract. A private annuity will be taxed the same as a commercial annuity. In addition, a private annuity can still be used to remove property from the estate of the taxpayer by selling his or her assets to relatives in exchange for a life income private annuity. And, while the IRS did not comment on the matter, a self cancelling installment note can still be used to accomplish substantially the same results as a private annuity.

The following is a description of the use of a private annuity in connection with an offshore corportion. Unless the IRS changes their mind as a result of hearings on the matter, these transactions will no longer have the appeal they had before the IRS change in their regulation on private annuities.

First, a very brief description of a private annuity is that it's an annuity arrangement that is an unsecured contract entered into by the taxpayer (annuitant) and by someone who is NOT in the business of issuing annuity contracts. Thus, you can't enter into a private annuity with an insurance company. In the U.S., when private annuities are used, they are almost always used as devices to transfer assets to ones heirs without being first subject to the federal estate tax.

By way of example, you might have some land that is worth $1 million and has a very low cost - perhaps as little as $200,000. If you sell the land, you will pay a federal capital gains tax of about $120,000 on the gain, plus some state income taxes. If you transfer the land to your only child in exchange for a lifetime annuity based on your life expectancy, you can defer the gain until the annuity payments are received. Unless you need the annuity income now, you can usually defer the beginning of the annuity paymentys.

In many respects, a private annuity is a lot like an installment note, except that when you die, the payments stop. However, with an installment note, a portion of the payments is treated as interest by the buyer of the property, and is usually deductible. By contrast, the entire payment for a private annuity is treated as part of the purchase price of the property and is not deductible by the buyer of the property, even though part of the proceeds are taxable to the seller. Hence, most people only use this device with their natural heirs. If they die early, their children get the property free of estate taxes. If they live a long time, they will usually provide annual gifts to their children to help with the annuity payments. And whatever the child pays to the parent as annuity payments will eventually be returned as an inheritance if it hasn't been consumed.

If you enter into a private annuity with a foreign person (or company) located in a tax haven or low tax country, there is a tax advantage on the part of the buyer who doesn't have to worry about paying taxes on the income generated by the assets. An ideal situation would be one where a child is a permanent resident of a low tax country and is not a U.S. citizen. Without the family relationship, there is an assortment of risks that are usually unacceptable to those who are given a full explanation of this arrangement.

Bear in mind that a private annuity is a transfer of property in exchange for an unsecured contract. If the buyer of the property defaults, the property can't be taken back as collateral and the U.S. annuitant would have to pursue payment in a foreign jurisdiction.

Where a person forms a foreign corporation with the idea that he will then transfer property to that corporation with a private annuity, there is usually an implicit assumption that the corporation or IBC is not a controlled foreign corporation, a foreign personal holding company or a passive foreign investment company.

But in many cases, the corporation is a CFC, FPHC or PFIC and the annuitant is then in the position of being on both ends of the annuity transaction and "doing business with himself". Because of the CFC/FPHC and PFIC rules, there is no advantage in doing that. In fact, the costs of establishing and maintaining such an arrangement would be prohibitive in relation to the tax benefits - even if the U.S. annuitant is not doing business with himself.

We've been asked if it would make a difference if an heir were to form the foreign corporation. Would that alter the results? Basically, no. The heir is going to be subject to the same adverse tax treatment but at a much greater expense. In addition, there is an attribution of ownership among relatives with respect to the ownership of stock in a controlled foreign corporation so that the parent would be deemed to own any stock owned by a child.

What if the foreign corporation is owned 50% by a foreign person? Would that alter the results? Yes. It would. But, on the death of the annuitant, the foreign corporation would become the owner of the property and the foreign person who owns half (or more) of the company.

Where this structure would work is when a foreign person is an heir of the U.S. person, in which case there is not really any need for the foreign corporation. The foreign heir could simply enter into a direct annuity contract with the U.S. person.
 

About the authors: Vernon Jacobs is a CPA who provides tax accounting and consulting services for clients with international interests.   J. Richard Duke, JD, LLM is an attorney who specializes in international tax law and is an Adjunct Professor of international tax law. Sponsored by Offshore Press, Inc.., Copyright,  2006, all rights reserved. Offshore Press, Inc., Box 8194, Prairie Village, KS 66208. Phone (913) 362-9667. Email to Offshore Press  Vernon K. Jacobs, Webauthor.