Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company1 An arrangement between two parties, neither of whom is an insurance company –Transferor-Annuitant conveys complete ownership of property to transferee-obligor –Transferee-Obligor promises to make periodic payments to annuitant for a period of time, usually life Two types: –Single life which ceases at the death of the annuitant –Joint and last survivor in which payments continue until the death of the last survivor What Is A Private Annuity?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company2 To spread gains over a number of years from the sale of an asset –Low cost basis –High income tax bracket Want to retire and shift control of a business to a family member or key employee To remove a sizeable asset, such as a business, from an estate for estate tax purposes When Is Use Of A Private Annuity Appropriate?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company3 Converting a large parcel of non-income producing property into income producing To avoid GST tax when the sole heir of a large estate is a grandchild Purchaser wants to bar others from purchasing the property but he cannot afford to pay for the asset in a lump sum payment When Is Use Of A Private Annuity Appropriate?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company4 Any type of property can be used but preferably: –Income producing, rapidly appreciating –Not subject to indebtedness, depreciation recapture, or investment credit recapture Important to ascertain the ability of the obligor to make annuity payments Extremely important that the obligor’s promise be unsecured –If the promise is secured, a taxable event will occur immediately upon the transfer What Are The Requirements?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company5 Obligor should be someone not regularly engaged in issuing private annuities –Family member –Trusted key employee Annuity amount must be determined by measuring the FMV of the property –Appraisal by an independent court-recognized appraisal expert is suggested Payments must be completely contingent on the life (lives) of the transferor(s) What Are The Requirements?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company6 Client should be –In a high estate tax bracket –Desirous of reducing estate –Interested in a lifetime income stream An agreement with a trust or corporation that has very few other assets may be attacked by the IRS as a sham What Are The Requirements?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company7 Example: –George, age 65, owns farmland with a basis of $100,000 and FMV of $1,000,000 –He wants his son Bill to own the land but does not want to pay gift taxes on the transfer –A private annuity agreement would be drawn stating the farmland is to be sold to Bill in return for Bill’s promise to pay his father an income for life Father’s life expectancy at age 65 is 19.5 years How Is It Done?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company8 Assume the IRC Section 7520 rate is 5% The annual annuity generated by the property with FMV $1,000,000 is $92,657 –Out of the $92,657 annual payment, $5,128 can be excluded from income until the father recovers his basis –Exclusion ratio = $100,000 Basis / $1,806,812 Expected return ($92,657 x 19.5) –Excludable amount $5,128 = Exclusion ratio / annual payment of $92,657 $1,000,000 - $100,000 Basis = $900,000 gain –$900,000 / 19.5 = $46,154 capital gain each annuity payment –{$92,657 – ($5,128 + $46,154)} = $41,375 taxed as ordinary income How Is It Done?

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company9 Tax Implications

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company10 Steps in computing the income tax treatment of a private annuity: –Determine the value of the promised annuity using the appropriate IRS annuity valuation tables –Compute the excludable amount –Determine the portion of each payment that is taxed at capital gains rates –Determine the ordinary income portion Remember the annuity cannot be secured or gain will be immediately recognized Tax Implications

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company11 Each annuity payment is treated as partially: –Tax-free return of capital –Capital gain, and –Ordinary income The obligor is not allowed a deduction for any payments made to the annuitant Obligor receives a “temporary basis” equal to the value of the calculation of the annuity, which is adjusted at the annuitant’s death to the amount actually paid in annuity payments Tax Implications

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company12 No gift tax if annual payments are actuarially determined to be equal to the FMV of the property sold –If the value is less, then the difference will constitute a gift by the annuitant –In a joint and survivor annuity, the value of the survivor annuity constitutes a gift of a future interest and does not qualify for the gift tax annual exclusion If survivor annuitant is a spouse, the gift tax marital deduction may be applied to the gift Tax Implications

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company13 Where the annuity is based on a single life and ceases at the death of the annuitant, it is excludable from his estate In a joint and last survivor annuity, the PV of future payments to the survivor will be included in the annuitant’s estate for federal estate tax purposes –If annuitant survivor is a spouse, use of the unlimited marital deduction will mean no estate tax will be due on the annuity at the first annuitant’s death Tax Implications

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company14 Obligation of the transferee must be unsecured and at transferee’s death the obligation passes to their estate Obligor’s spouse or a trustee of an irrevocable trust for spouse’s benefit may purchase a life insurance policy on the obligor-transferee to provide funds to continue annuity payments –Make sure there is no formal connection between the life insurance and the private annuity Use of Life Insurance

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company15 Life insurance can help to equalize the estate –Where a private annuity was used to sell the family business to one child, life insurance can be purchased on the annuitant by the other children to supplement what they would have received had the family business passed to them through the annuitant’s estate Use of Life Insurance

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company16 Since property is owned ½ by each spouse a private annuity can be set up as either –Joint and survivor, or –A separate annuity contract for each community half of the husband and wife Under a joint and survivor annuity, payments may be lower, but will continue after the first death Under separate annuities, payments may be higher, but when the first person dies, their annuity payment ceases Issues In Community Property States

Private Annuity Chapter 36 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company17 Note: If obligor makes payments out of earnings in a community property state, the obligor’s spouse could be obtaining an interest in the property purchased –Consider having the spouse make a gift to the obligor of their part of the earnings used to make the payments, so they do not acquire an interest in the property –This is a concern where the property purchased is a family business Issues In Community Property States