A recently decided Tax Court case called into question some of the uses of private annuities. The court analyzed a private annuity under the economic substance doctrine and raised the issue that certain private annuities may not be respected by the Tax Court in the future.
Two brothers, Zalman and Moshe Melnik, owned and ran a scrap metal business in Houston. During the 1980s and early 1990s, attempts were made to sell the business, but it was not sold until 1996, when Moshe Melnik and his wife divorced. As part of the divorce, also in 1996, the business was valued at nearly $2 million. However, shortly after the divorce, the Melnik brothers were offered over $8 million for the business. Because he feared a suit by his ex-wife, Moshe Melnik sought legal advice to ensure that the appraisal of the business as part of the divorce would stand.
Eventually, the Melnik brothers agreed to enter into a private annuity transaction with a foreign trust to facilitate the sale of their business. The sale was finalized in 1997, and the private annuities (one for each brother) were structured as deferred annuities to begin payments in 2006 and 2008, when each of the brothers reached age 57.
On their 1997 tax returns, the brothers did not report income from the sale because of the deferred annuity arrangements that were in place. The Internal Revenue Service contended that the private annuities were economic shams and that the Melniks should have recognized capital gain income at the time of the sale.
The Tax Court first noted that the appropriate rule is that a transaction will not be respected for tax purposes if it lacks a business purpose and a reasonable possibility of generating a profit independent of tax considerations. Much of the opinion seems to indicate that the Melniks and their attorneys did not do a good job in presenting evidence and arguments that the transactions were done for a valid business purpose. Also, the court made numerous comments about document backdating and other issues with documentation of the transaction.
However, it did dismiss some of the contentions for entering into the transaction as it was structured. One purported reason was for retirement planning. The court said there was no evidence that the Melniks had engaged in retirement planning before the sale of the business; more specifically, the business had not set up any type of retirement plan. Also, the Melniks would not admit that tax considerations played any role in how the transaction was carried out. Because of these reasons the court ruled that the private annuity was an economic sham.
The opinion is in the case of Melnik v. Commissioner, TC Memo 2006-25.