Private Annuities/Private Annuity Trusts
Sum mary
Recently, a number of companies have begun to actively market the use of private annuity trusts. Caution should be used when dealing with these companies to ensure that marketing is not placed above sound estate planning practices. While the private annuity has been recognized as a valid strategy by the IRS, some companies may attempt to use private annuity trusts in ways that have not yet been addressed by the IRS and that may carry the risk of failing to deliver the intended tax benefits.
An attorney and accountant, both with experience and expertise in tax planning and estate planning, should be consulted when considering the use of the private annuity or the private annuity trust techniques.
UPDATE: The Treasury Department has issued proposed regulations (Reg-1 41901-05) that will require the recognition of capital gains at the time of the sale/transfer of assets. The effective date of the proposed regulations is October 18, 2006.
Questions
• What is a private annuity?
• What are the estate and gift tax consequences of a private annuity?
• What are the income tax consequences of a private annuity?
• What is a private annuity trust?
Important: State Laws Vary
It is critical to note that state law varies on how trusts are executed and interpreted. It is important that clients consult with their legal professional prior to executing any estate planning document.
What is a private annuity?
A private annuity is an arrangement between two parties in which the transferor/annuitant transfers property to the transferee/payor in return for a lifetime stream of fixed periodic payments. It is a tax and estate planning technique and should be distinguished from commercial annuity products sold by insurance companies. It can be used to remove assets from the transferor/annuitant’s estate for estate tax purposes, while retaining an income stream for the transferor/annuitant and deferring recognition of capital gains over their life expectancy.
While the details of these arrangements may vary, they are typically designed as described below to obtain the full tax and estate planning benefits. The parties involved in a private annuity can be individuals, corporations, trusts, or others. However, neither party may be regularly involved in the business of issuing or selling annuities. Often the parties are related family members. The assets transferred can be cash, marketable securities, closely held securities, real property, etc.
The exchanged property has often appreciated in value and/or has the potential to appreciate in value. The annuity stream is typically over the lifetime of the transferor, but it can also continue forward for the lives of others such as the transferor’s widow. The promise to make annuity payments
is typically unsecured.
What are the estate and gift tax consequences of a private annuity?
When the private annuity is properly structured, the property transferred by the transferor/annuitant will not be included in their gross estate for estate tax purposes if the annuity payments terminate at their death. However, if the arrangement is structured as a joint and survivor annuity, the present value of the payments to be paid to the survivor will be included in the decedent’s gross estate. Though this may be of limited concern if the survivor is the transferor/annuitant’s widow, as the inclusion of that interest will be offset by the marital deduction.
Because of these benefits, the IRS will look closely at those situations where death of the transferor/annuitant followed shortly after the transaction. The tax benefits will not be available in those situations where it is found that death was “imminent” at the time of the transaction. Care should be taken when structuring a private annuity to ensure that it is not included in the annuitant’s gross estate by the retention of any interest in the property. Therefore, the transferor should not retain any interest or control over the property.
Additionally, the annuity stream should be a fixed stream of payments independent of any income that is generated by the property. If the fair market value of the transferred property is equal to the present value of the annuity payments due to the transferor/annuitant, there will be no gift tax consequences to the transferor/annuitant. If the value of the transferred property is greater, a taxable gift may occur. Care should be taken to determine the market value of the transferred property so that the existence and/or the value of the gift are properly documented.
What are the income tax consequences of a private annuity?
Provided that a transferor/annuitant did not retain a security interest in the transferred property, any capital gain from the transaction will be recognized over the course of the transferor/annuitant’s life expectancy. If the payments were secured in any way, the entire capital gain would be recognized in the year of the transfer. During the transferor/annuitant’s life expectancy, each payment will consist of three fixed components: ordinary income, capital gain, and return of capital. If the transferor/an nuitant outlives their life expectancy, the entire remaining payments will be taxed as ordinary income.
Generally, the transferee/payor’s basis in the property is the present value of the annuity payments. However, if the transferor/annuitant dies before their life expectancy, the basis is limited to payments actually made, while if the transferor/annuitant outlives their life expectancy, the basis is increased by the ongoing payments. The transferee/payor will not be entitled to a deduction for interest paid to the annuitant.
UPDATE: The Treasury Department has issued proposed regulations (Reg-141901-05) that will require the recognition of capital gains at the time of the sale/transfer of assets. The effective date of the proposed regulations is October 18, 2006.
What is a private annuity trust?
The term “private annuity trust” refers to the combination of the estate planning concepts of the private annuity and a trust. It is not a specific product, but rather a reference to an estate planning technique or strategy. When this technique is used, a trust is created and serves as the transferee/payor.
The trustee of the trust would be responsible for the management of the asset(s), payment of the periodic payments to the transferOr/annUitaI~t, and eventual distribution of assets to the trust beneficiaries. Use of a trust could provide advantages traditionally associated with trusts, such as asset protection. While trusts can be a party to a private annuity transaction, caution should be used and the plan should be scrutinized to ensure that the plan qualifies for the intended tax benefits.
Example:
A father owning a closely held family business would like to retire and pass the business to his
daughter. However, the bulk of his wealth is tied up in the business and he does not have adequate
other resources to provide for his accustomed standard of living. The business is currently valued at
$5 million ($1 million basis) and it is anticipated that the business will continue to appreciate in value.
The father could exchange his interest in the business for a lifetime monthly annuity stream from his daughter. The daughter would then own the business and the father would have a lifetime annuity stream for his support (because the annuity interest is unsecured, there must be a high level of trust and responsibility between the parties). The business, and any further appreciation, would be removed from his taxable estate for estate tax purposes (if that annuity was structured to provide for both the father and mother, the present value of the remaining annuity interest would be included in his estate at his death, but he would obtain an offsetting marital deduction).
If the present value of the annuity stream is equal to the fair market value of the property, there will be no gift for gift tax purposes. There will be no immediate taxable gain resulting from the exchange, but rather the gain would be recognized proportionately over the life expectancy of the father. Each annuity payment over his life expectancy will be composed of a return of basis component ($1 million), a capital gain component ($4 million), and an ordinary gain component (the interest).
If the father does not survive his life expectancy, more leverage is obtained in the transfer. For example, if he survives just a couple of years, he will have obtained only a portion of the annuity payments under the agreement, but the entire value of the business interest would be outside of his taxable estate. Note, however, the daughter’s basis would also be adjusted to reflect just those payments made by her.