by Bob Rywick
A private annuity is usually used to transfer property to a transferee ("obligor") in exchange for a promise to make periodic payments to the transferor (or "annuitant") for the remaining life of the annuitant. Private annuity arrangements are often used for intra-family transfers. The following are key differences between a private annuity and a commercial annuity:
1. In a private annuity, an individual (often an older family member) transfers property (usually appreciated property), and not cash, to one or more younger family members in return for the annuity.
2. To avoid recognizing gain at the time of the exchange, the private annuity must be unsecured. The obligor, who may be a family member, a corporation or other business entity controlled by the family, or an unrelated purchaser, promises to make the annuity payments. In such a case, there is a greater risk that the promisor will not be able to make the annuity payments throughout the annuitant’s life than if the annuity was issued by an insurance company subject to governmental supervision and regulation.
3. In some instances, the value of the property transferred in a private annuity transaction may not be the same as the value of the annuity received. This will result in tax consequences.
In addition to providing the annuitant with an income for life, a private annuity frees the annuitant from the burden of managing the transferred property. This can be especially important for an older family member or for a surviving spouse who is not familiar with the business or investment property that he inherited. Using a private annuity may also have the following tax benefits:
1. The entire value of the transferred property is excluded from the annuitant’s gross estate. How beneficial this is will depend on how long the annuitant lives, and whether the annuity payments received are spent during the annuitant’s life, or end up being saved and included in his estate.
2. Any post-transfer appreciation in the value of the transferred property will not be included in the annuitant’s estate.
3. If the annuitant dies before his tabular life expectancy, the property will have been transferred to the obligor for less than its true value. This is especially advantageous if the obligor is a loved one who the annuitant would want to transfer property to at the lowest possible tax cost.
4. The transfer will not be subject to gift tax as long as the value of the annuity equals or exceeds the value of the property transferred. The value of the annuity is determined under IRC § 7520 tables. The tables may be used even if the annuitant is not in good health and has a shorter than average life expectancy, provided that death is not imminent at the time of the transfer. However, if the annuitant is known to be terminally ill, a special actuarial factor which takes into account the annuitant’s actual life expectancy must be used to value the annuity instead of the factor from IRC § 7520 tables.
Observation: The lower the interest rate, the lower the amount of the annuity payment that has to be made for the value of the annuity to equal the value of the transferred property.
Example: A 70-year-old client wants to transfer property worth $1 million to her son in exchange for his promise to pay her an annuity for the rest of her life. If the IRC § 7520 rate is 6 percent, the annuity factor would be 8.4988, and her son would have to pay her $117,664 annually ($1 million divided by 8.4988) for the value of the annuity to equal the value of the transferred property.
If the IRC § 7520 rate is only 4 percent, however, the annuity factor would be 9.8560, and her son would have to pay her only $101,461 annually.
Observation: If the annuity is to be paid at intervals of less than a year, e.g., monthly, the payments will have to be adjusted to reflect this fact. Thus, if in the above example payments were to be made monthly instead of annually, and the IRC § 7520 rate is 4 percent, the monthly amount would be one twelth of 101.82 percent of the annual amount of $101,461. Thus, each monthly annuity payment would be $8,609 (one twelfth of $103,108 ($101,461 multiplied by 1.0182)).
5. Only a part of each annuity payment is subject to income tax. The other part of the payment is treated as a return of capital. The part that is subject to tax often will be less than the taxable income thrown off by the property. If the fair market value of the property is more than the annuitant’s basis in the property, the transfer will not cause the annuitant’s gain to be immediately recognized. Instead, recognition of the gain will be extended over the annuitant’s life expectancy.
Spreading the gain in this fashion may produce other benefits, such as preventing Social Security benefits from being taxed, as might be the case if the gain were recognized in a single year. Deferral also could prevent loss of other tax benefits that are reduced or eliminated when adjusted gross income exceeds certain levels.
Observation: Unlike an installment sale where recapture income is recognized in full in the year of sale, with a private annuity, recapture income is taxed as payments are made. Also, a resale of the property by the obligor has no impact on the annuitant’s tax situation.
6. If the annuitant dies before the full amount of the basis is recovered through offsets against the annuity payments, any unrecovered basis is deductible on the annuitant’s final income tax return.
The main disadvantage of a private annuity arrangement is that the annuitant usually gives up title to valuable property in exchange for the obligor’s unsecured promise to make periodic payments. Thus, the annuitant’s income depends on the obligor’s trustworthiness and financial security.
Here are other key disadvantages of using a private annuity:
1. If the annuitant dies before his tabular life expectancy, the property will have been transferred to the obligor for less than its true value. However this would be a disadvantage only if the transaction is conducted with an unrelated party, or if it is conducted with a related party and the annuitant intends to use the annuity payments to make gifts to other family members who are not benefited by the annuity transaction.
2. If the property transferred is difficult to value, e.g., a closely held business interest, the Internal Revenue Service could contend that the transaction should be treated in part as a gift because the assigned value is too low. In some situations an undervaluation penalty could also be imposed, but you should be able to minimize this risk by getting the property appraised by one or more professional appraisers.
3. The real value of the fixed payments received by the annuitant could be reduced by inflation while the value of the transferred property increases. As a result, the payments may not be sufficient to allow the annuitant to live in his accustomed style.
Observation: Presumably, if the sale was made to a close family member, such as a child, that family member would be willing to provide help to the annuitant in addition to the annuity payments if inflation becomes a serious factor.
4. The amount of an older annuitant’s gross estate can grow if he cannot either consume or make gifts of part of the payments he receives. It’s unlikely, however, that the estate will end up being larger than it would have been if the annuity arrangement had not been made.
5. If the obligor dies first, the annuitant will have to rely on the obligor’s estate to continue the payments. If the estate is illiquid, or if the obligor invested poorly, the estate may not be able to continue to make all or part of the annuity payments.
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