A Private Annuity Primer

Reprinted with the permission of Joseph Petrucelli, JD, LLM (Tax). Be sure to also check out Mr. Petrucelli's article on
Stupid Private Annuity Tricks at http://www.assetprotectionbook.com/private_annuity_mistakes.htm

In its most basic form, a private annuity is an arrangement in which a person (the “Annuitant”) transfers property to another person (the “Obligor”) in exchange for the Obligor’s unsecured promise to make periodic payments to the Annuitant for the remainder of the Annuitant’s life. Private annuity arrangements have been recognized as valid by the courts in one form or another for better than 70 years. Probably the earliest case dealing with the tax consequences of a private annuity type of arrangement was the Supreme Court case of Burnet v. Logan in 1931. There, the Supreme Court analyzed the income tax consequences of the sale of stock by Mrs. Logan to a corporation in exchange for the corporation’s promise to make annual payments to her based upon the production of an iron ore mine. While the doctrine enunciated by the Court in that case is of limited application today, the Court’s recognition of the transaction as a valid sale that would not result in immediate recognition of income was an important building block for the taxation of private annuity transactions.

When properly structured, a private annuity transaction can provide significant benefits. The benefits run the range of estate, gift, and income tax. Specifically, if properly structured, a private annuity can avoid gift tax, minimize estate taxes, and defer and possibly eliminate income taxes.

Gift Tax Avoidance

Properly structured, a transfer of property using a private annuity will avoid the imposition of gift tax. Section 2501 of the Internal Revenue Code (the “Code”) generally imposes a tax on all gratuitous transfers of property whether outright or in trust. The simple reason that gift tax is avoided by using a private annuity as the transfer mechanism is that the private annuity transaction will be treated as a sale of property for gift tax purposes and therefore §2501 will generally not apply.

The fact the transaction can be treated as a sale of property gives taxpayers an alternative to gifting strategies in which annual gifts are made from an older generation to a younger generation to effect an estate reduction. While the annual gift tax exclusion will allow fairly generous gifting without imposition of gift tax, it would be very difficult to reduce a large estate using annual gifting as the sole means of effecting the reduction.

Transferring property via a private annuity transaction avoids these potential limitations. Because the transfer of property via a private annuity is treated as a sale of property, the annual gift exclusions do not apply and virtually any amount of property could be immediately transferred to a successor generation without the imposition of gift tax. Also, unless the person is terminally ill at the time of transfer, the use of a private annuity transaction would eliminate any concern over the three year look back and inclusion of transferred property in the estate of a decedent.

Because of the potential of gift tax avoidance, the IRS may challenge private annuity transfers. The IRS may raise several issues in challenging a private annuity transaction. It may challenge the valuation of the property transferred for the private annuity or it may challenge the valuation of the annuity itself. In either case, if the IRS determines that the value of the property transferred was greater than the present value of the annuity promise, the difference would be subject to gift tax.

Another potential challenge the IRS could make is that the transfer of the property to the Obligor was really a transfer with a retained life estate. If the IRS were successful in making that challenge, a gift tax would potentially be imposed for the full fair market value of the property transferred to the Obligor. This would be the case in situations where the Annuitant retained too much control over the transferred property. For example, if the Annuitant was able to determine the specific use of the property transferred or was entitled to all the profits and income from the property, or was able to direct the investment of certain assets transferred via the private annuity.

Estate Tax Minimization

A private annuity can reduce estate tax by removing property from the estate of the Annuitant and therefore reducing the taxable estate and subsequently any estate tax owed. The reason for this is that private annuities are designed to cease making payments at the death of the Annuitant. Because of this, there is no value remaining in a private annuity that could be included in the taxable estate of the Annuitant.

This represents a significant benefit over an annuity purchased from a life insurance company (a “commercial annuity”). Typically, a commercial annuity would provide a death benefit or the ability to name a beneficiary to receive any remaining payments. In such an event, the value of the remaining interest of the annuity or the death benefit may be includible in the Annuitant’s taxable estate. As mentioned above, there is no similar problem with the private annuity because no value remains after the death of the Annuitant.

However, private annuity transactions have their own pitfalls in the area of estate tax minimization. With a private annuity, estate taxes are only minimized if the Annuitant passes away before his actuarially determined life expectancy or if the Annuitant spends what is received from the Obligor on items that do not re-build the estate. This is because the payments made under the terms of a private annuity are partially determined by the anticipated life expectancy of the Annuitant. If the person lives to reach that age, the Annuitant will have received back the entire fair market value of the property originally transferred.

The annuity payments received by the Annuitant would be considered part of the taxable estate of the Annuitant. If the Annuitant receives back all the value that was originally transferred there would be no estate tax savings.

The potential to lose any estate tax minimization requires that proper planning be done prior to the consummation of a private annuity transaction. That planning should entail looking at the various options that are available to ensure minimization of the estate tax if that is a goal of the planning.

Income Tax Benefits

The main income tax benefit of the private annuity sale is that no gain is immediately recognized by the Annuitant if the transferred property has capital gains associated with it. For example, if the Annuitant transfers property that is worth $1 million at the time of transfer but only cost $200,000, there would be no tax immediately due on the $800,000 gain associated with the property.

As mentioned above, this principle was first recognized by the Supreme Court in the context of a private annuity transaction in the case of Burnet v. Logan in 1931. The principle was also recognized by the IRS in Revenue Ruling 239 under the 1939 Code. Then in 1969, the IRS released Revenue Ruling 69-74 that essentially states that private annuities should be taxed under §72 of the Code like commercial annuities.

Essentially, the IRS has determined that the Annuitant will not be subject to immediate taxation on the gain associated with the transfer of appreciated property to the Obligor. Instead, the gain can be reported ratably over the life of the Annuitant. Basically, according to Revenue Ruling 69-74, each payment received by an Annuitant is made up of three potential “bands.” The first is a recovery of the principal or basis and is therefore not subject to tax. The second is capital gain and the third is an interest component.

The results of taxation under Revenue Ruling 69-74 is very similar to an installment sale under §453 of the Code in that tax is due only as payments are received rather than at the time of the sale of the property. However, because §72 is the governing Code section, there are some differences between installment sales and private annuities that are worth noting.

First, installment sales treatment is not available with respect to publicly traded stock making it impossible to defer the gain on the sale of appreciated stock under the installment method. However, a private annuity can be used to sell appreciated stock and defer the tax on the sale.

Second, if the property transferred is worth $5 million or more, the Code imposes an interest charge on the deferred tax. There is no similar requirement for sales via private annuity.

Finally, §453(g) of the Code provides that a transfer of appreciated property to a related party for an installment note will result in certain adverse tax consequences if that related party sells the property within two years of receiving it. Specifically, in such an instance, the person who initially transferred the property will be subject to tax on the gain under §453(g). A transfer by private annuity avoids the application of §453(g) and provides some safety so that the intended deferral of tax is assured in the event a related party decides to sell the property.

Common to both installment sales and private annuity transactions is that the buyer of the property receives a fair market value basis in the property transferred. This provides the opportunity for the Obligor to sell property at a reduced gain. For example, if property were transferred that was worth $5 million but cost only $500,000, and the Annuitant sold the property, there would be tax due on $4,500,000. However, if the Obligor sold the property following a transfer via a private annuity, there would be no tax due as long as the property sold for $5 million or less.

However, obtaining such a benefit may be subject to certain IRS challenge. Specifically, the IRS may argue that the transaction constitutes a “step transaction” in which the Annuitant received the benefit of tax deferral only because the Obligor was interposed between the Annuitant and the ultimate buyer of the property. It is therefore important that proper planning be done prior to entering into any private annuity transaction that could result in the transferred property being sold by the Obligor.

Also, the taxation of private annuity transactions is subject to all the other rules contained in the Code. These rules become complex and are sometimes specific to certain types of property. For example, depreciable property transferred via a private annuity might be subject to rules relating to the recapture of depreciation as ordinary income. It is therefore important that a professional knowledgeable in all areas of taxation be consulted prior to engaging in any private annuity transaction.

A Final Word

Private annuities can provide significant benefits in the three areas discussed above (gift tax, estate tax, and income tax). Not discussed here are the asset protection benefits that also should be considered. The most important thing to remember is that while private annuities have broad application and can be used for everything from buying out shareholders from a privately held business to transferring ownership of assets from one generation to the next they are fairly rigid structures that are not easily adaptable after implementation. Because of the broad applicability of private annuities and their rigid nature, it is important to consult counsel that is familiar with their uses, their benefits and their pitfalls. Private annuities are not a fix all or magic bullet and significant operational issues can arise that if not understood in advance could result in significant problems down road. Significant planning may therefore be necessary to determine the overall feasibility of the use of a private annuity prior to implementing a private annuity structure.

See Also:

Stupid Private Annuity Tricks
A list of common mistakes made in private annuity planning, by Joseph Petrucelli, JD, LLM

Private Annuity Trust
The Numbers Don't Support the Hype. by Kevin J. McGrath

Melnik v. Commissioner of the IRS
Stock sale to foreign corporation lacked economic substance; no penalty.

Stokes v. Commissioner
In a case involving the National Association of Financial and Estate Planners, the court held that the private annuity trust in that particular case "constituted a sham trust that lacked economic substance". Not only did Mr. Stokes not receive the promised tax benefits, but he also got slammed with an accuracy-related penalty!