The Private Annuity

No doubt you have heard about the kind of annuities that stop paying when the annuitant dies. They are called “Life Income Annuities” and they provide the annuitant with a maximum annual income that won’t run out no matter how long the annuitant lives.

Most large company pension plans use this kind of annuity to make pension payments to the retirees. The typical life income annuity is issued by an insurance company - but it doesn’t have to be. An annuity can be issued by anyone - even an individual. The “catch” is that the tax benefits require that the annuity be an unsecured contract. For that reason, hardly anyone ever enters into an annuity contract with anyone other than an insurance company or a large charity.

But some people enter into annuity contracts with their heirs in order to transfer assets to their heirs at a minimal estate tax cost. The transfer of assets to your heirs with a private annuity removes those assets from your estate because the payments to you cease at the time of your death. The assets you sold belong to your heirs - and they have been transferred to your heirs free of any federal estate tax. 

But the private annuity also provides income and capital gains tax deferral for the seller (annuitant). Suppose Mom and Dad sell the farm to the kids in exchange for an annuity for the rest of their lifetimes. The payments that Mom and Dad receive are a combination of a tax free return of their investment in the farm (tax basis), a tax favored capital gain and a portion of the payment that is ordinary income. 

A private annuity is a much discussed but little used device to eliminate estate taxes and to transfer appreciated property to your heirs with deferred capital gains taxes. It works best when it’s combined with a gifting program and/or with a charitable remainder trust . It works even better if you have family members who are not U.S. residents or citizens. And it’s most effective when the buyer of your property is in a very low or zero tax bracket.

You can sell appreciated assets to a private individual or entity (as contrasted to an insurance company) in exchange for what is called a "private annuity". This is like a life income annuity from an insurance company. When you die, the payments cease. But don't panic. If you make the annuity agreement with an heir (like a son or daughter), you will have avoided part of the capital gains tax and the federal estate tax as well. 

This tactic is most appropriate (financially) when there is a great likelihood of a pre-mature death at an early age ... and where there is a near certainty of a large estate tax.  For example, father has a terminal illness and isn't likely to live more than a few years, but is expected to live more than one year. He has substantial assets that are likely to be subject to the top estate tax rate of 45%. An alternative is to sell some of  the property to his children (assuming they are of legal age) in exchange for a private annuity. If he is 55 years old, the annual annuity payment would be about 12% of the value of the property each year. If father dies within two years, he will have transferred 76% of his estate to his children free of any estate taxes. The private annuity can zero out an estate in as little time as it takes to draw up the contract. (And there are ways to deal with the assets coming back into the estate.)

The heirs who are buying the property have a temporary cost basis equal to the present value of the future annuity payments. When father (the annuitant) dies, the cost basis is recomputed based on the total payments actually made to the annuitant. At that point, the heirs can pursue a variety of ways to minimize the capital gains tax - like a charitable trust.

Also be sure that the person or company that is issuing the annuity contract is not in the business of issuing annuity or insurance contracts. The reason is because the private annuity tax benefits are not available when the annuity payor is in the business of issuing annuity or insurance contracts.

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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