Estate of Bell v. Commissioner

SimpsoN, J.,

dissenting: I must dissent from tbe majority opinion with respect to its holding that tbe gain resulting from tbe exchange of tbe stock for the private annuity was taxable in tbe year of the exchange. Such conclusion was not sought by the respondent. Although tbe majority opinion results in no part of tbe gain on tbe exchange being taxable in 1968 and 1969, it may ultimately result in the petitioners having a larger tax burden than that contended for by tbe respondent. If section 1311, I.R.C. 1954, is applicable, as may be the case, tbe entire gain of $105,142.81 will be taxable to tbe petitioners in 1967; whereas, under tbe respondent’s approach, none of tbe gain would be taxable in that year, but a portion of each annuity payment would be treated as capital gain until tbe entire gain is reported. See Rev. Rul. 69-74,1969-1 C.B. 43.

Tbe opinion states in part:

It would be manifestly inconsistent to find that tbe annuity contract bad a fair market value for purposes of determining a taxpayer’s cost or investment in tbe contract under section 72(c), and yet to bold it bad no determinable value for purposes of section 1001.

Such statement implies that the actuarial value of an annuity constitutes its fair market value in all cases, whether or not there is security for the performance of tbe obligation. Such statement ignores the long-established position of this Court. Frank C. Deering, 40 B.T.A. 984 (1939); J. Darsie Lloyd, 33 B.T.A. 903 (1936); see Commissioner v. Kann's Estate, 174 F. 2d 357 (C.A. 3, 1949), affirming a Memorandum Opinion of this Court; Bella Hommel, 7 T.C. 992 (1946). In J. Darsie Lloyd, 33 B.T.A. at 905, this Court held that the transfer of property to an individual, in consideration for an unsecured promise to pay an annuity, did not require the reporting of gain in the year of the transfer because of “the uncertainty as to whether or not the one agreeing to make payments will be able to make tbem as agreed when the time for payment actually arrives.” The Court found that the annuity had no fair market value even though the application of the tables would have rendered an actuarial value. We have found no cases which deviate from such holding where a private, unsecured annuity was involved.

The security present in this case may provide a basis for distinguishing Lloyd, but it should not result in gain being reported on the transfer of the stock for the private annuity. This Court has held many times that a cash method taxpayer does not include in the computation of the “amount realized” under section 1001 (b) the right to receive future income unless that right is readily transferable in commerce. Western Oaks Building Corp., 49 T.C. 365 (1968); Estate of Coid Hurlburt, 25 T.C. 1286 (1956); Curtis B. Andrews, 23 T.C. 1026 (1955); Estate of Clarence W. Ennis, 23 T.C. 799 (1955); Nina J. Ennis, 17 T.C. 465 (1951); Harold W. Johnston, 14 T.C. 560 (1950); see John B. Atkins et al., 9 B.T.A. 140 (1927). In determining whether a right is readily transferable in commerce, this Court has examined such factors as whether the right had a “readily realizable market value” {John B. Atkins et al., supra at 151), whether it was “freely and easily negotiable” (Nina J. Ermis, supra at 470), and whether it was of the type that “commonly change[s] hands in commerce” {Harold W. Johnston, supra at 565). If a right to receive future income is found to be readily transferable in commerce, it is often referred to as the “equivalent of cash.” Western Oaks Building Corp., supra at 376; Nina J. Ennis, supra at 470; John B. Atkins et al., supra at 151. The issue in these cases is significantly different from that involved in such cases as Stephen H. Dorsey, 49 T.C. 606, 634 (1968) (Simpson, J., dissenting), and Charles Wilson, 39 T.C. 362 (1962).

The peculiar characteristics of a private annuity require a finding that the right to receive income during a person’s life is not ordinarily a right which is readily transferable in commerce. The span of each person’s life is so speculative that it is impossible to determine with any degree of certainty the number of annuity payments that will be made prior to the annuitant’s death. Actuarial estimates may be accurate in the macrocosm where the margin of error in forecasting one life will be offset by the margin in forecasting other lives. However, if a taxpayer is considering the purchase of an annuity on another’s life, there is no margin of error to offset the extremely speculative nature of the lifespan. See Mancina, “The Private Annuity,” 43 Taxes 255, 258-259 (1965); Note, “Private Annuities: Revenue Ruling 69-74 — Its Significance, Effect, and Validity,” 23 Vand. L. Rev. 675, 688 fn. 77 (1970). For example, in this case, although the expected return on the private annuity was $224,400, there was no obligation to pay that amount. In fact, it was almost certain that the annuitants would receive, not that amount, but more or less than that amount. A right as speculative as a life annuity, or, in this case, a joint annuity for two lives, cannot be said to have a readily realizable market value or to be freely and easily negotiable or to be of the type that commonly changes hands in commerce. Indeed, in 1954, Congress rejected a proposal to tax the gain on the exchange of property for a private annuity in the year of the exchange. S. Kept. No. 1622. 83d Cong., 2d Sess., p. 116 (1954).

The question remains of how the gain on the transfer of property for a secured private annuity should be treated within the framework of the present law. Under pre-1954 law, Congress adopted a 3-percent formula in taxing annuities. As explained by the Senate Finance Committee, the rule taxed an annuitant on the annuity payments he received to the extent of 3 percent of the amount paid for the annuity. Any payments he received above this amount were considered to be the return of his capital and were excluded from tax until the total amount excluded equaled the amount he paid for the annuity. Thereafter, the annuity payments were taxable in whole. S. Kept. No. 1622, swpra at p. 11. Section 72 was enacted because the 3-percent rule was erratic. After the annuitant recovered his investment, the rule could lead to a situation in which:

the annuitant finds that after being retired for a few years and becoming accustomed to living on a certain amount of income after tax, he suddenly has to make a sizable downward adjustment in his living standard because, when his exclusion is used up, the annuity income becomes fully taxable. [S. Kept. No. 1622, supra at p. 11.]

Congress intended to eliminate this difficulty by enacting section 72, under which there is a proration of the cost of the annuity — a portion of each annuity payment is treated as annuity income, and the balance is treated as a return of cost. The treatment of the gain from the transfer of the property for an annuity should, insofar as possible, be in accord with this legislative treatment of annuities.

I agree with the majority that the investment in the contract for the purposes of section 72 is, in this case, equal to the actuarial value of the annuity, and, in this respect, I would reject Kev. Kul. 69-74,1969-1 C.B. 43. The investment in the contract is the fair market value of the stock exchanged for the annuity, and in view of the family relationship in this case and the fact that a gift was obviously made as to a portion of the stock, it is reasonable to conclude that the amount of stock exchanged for the annuity is equal to the value of the annuity. Thus, stock worth $126,200.38 was paid for the annuity.

Section 72(b) provides that gross income does not include that part of any amount received as an annuity which bears the same ratio to such amounts as the investment in the contract bears to the expected return under the contract. Hence, the exclusion ratio in this case is $126,200/$224,400 or approximately 56 percent. Of each, annuity payment of $1,000, approximately $437.62 is includable under section 72 as annuity income, and the remaining $562.38 is not taxable under section 72. However, in this case, a gain of $105,142.81 has been realized on the exchange of the stock for the annuity, and there is no indication that by the enactment of section 72(b), Congress intended for any such gain to be excluded from taxation. Such provision was designed to exempt that portion of the annuity payment from taxation under section 72 which was a return of cost, but since the annuity payments also constitute payment for the stock exchanged for the annuity, a part of each payment must be treated as taxable gain. Cf. Hill's Estate v. Maloney, 58 F. Supp. 164 (D. N.J. 1944).

If the rule of Burnet v. Logan, 283 U.S. 404 (1931), were adopted, approximately $562.38 of each annuity payment would be- excluded until the recovery of the petitioners’ entire basis in the stock of $21,-057.57. After the recovery of basis, then such portion would be wholly taxable as capital gain, until the $105,142.81 of gain was all reported. Such an approach is manifestly inconsistent with the objective of section 72; whereas, an approach which prorates the capital gains would be consistent with the approach taken by that section. Under the latter approach, the gain resulting from the exchange of the stock for the annuity would be divided by the life expectancy of the annuitant at the time of the exchange; that is, tire gain of $105,142.81 would be divided by Mr. and Mrs. Bell’s joint life expectancy of 18.7 years. Each year the portion of the gain allocable to the annuity payments received in that year would be subjected to taxation. If the annuitant lived less than his life expectancy and received less than expected, only a part of the estimated gain would be taxable. When the entire gain is reported, no additional amounts would be taxable as gain. The American Law Institute proposed in 1953 that the portion of each annuity payment allocable to the gain on the exchange should be treated as capital gain, however long the annuitant lived, but that approach would require legislation. See 1 ALI Fed. Income Tax Stat. sec. X126 (Feb. 1954) ; Andró, “Non-Commercial Annuities — Income Tax Consequences to the Transferor Who Exchanges Property in Return for an Annuity,” 9 Tax L. Rev. 85,89 (1953); Ross, “The Private Annuity as a Tax Minimizing Instrument,” 41 Taxes 199,204-206 (1963).

Under my suggested approach, Mr. and Mrs. Bell would treat each $1,000 monthly payment as follows: Approximately $437.62 as ordinary income, approximately $468.54 as capital gain income, and approximately $93.84 as excludable from income. If Mrs. Bell lives beyond the joint life expectancy of herself and Mr. Bell, the capital gain will not be reportable thereafter, and she can exclude approximately $562.38 of each payment. The $437.62 will continue to be taxable as ordinary income.

The suggested approach, does not necessarily require that a similar approach 'be used in the case of a commercial annuity, where such other factors as cash surrender value and guaranteed benefits might be involved. Moreover, a commercial annuity is usually purchased for cash, and the question of how to tax gain resulting from a transfer of property for a commercial annuity would not arise in such a situation.

Drennen, Dawson, Tannenwald, Hall, and Wiles, //., agree with this dissent.