Does a private annuity have a place in your estate plan?

by Adler Pollock & Sheehan P.C.
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When James met with his advisor to review his estate plan, he realized that his overall estate might be worth more than the current $5.43 million gift and estate tax exemption amount. In fact, his estate includes a family business, real estate holdings and a sizable investment portfolio.

James’ advisor suggested using a private annuity as a way to reduce his gift and estate tax exposure. Let’s take a close look at the pluses and minuses of using a private annuity.

A private annuity in action

In a typical private annuity transaction, you transfer property to your children or others in exchange for their unsecured promise to make annual payments to you for the rest of your life. It’s “private” because the annuity is provided by a private party rather than an insurance company or other commercial entity. The amount of the annuity payments is based on the property’s value and an IRS-prescribed interest rate.

A properly structured annuity is treated as a sale rather than a gift. So long as the present value of the annuity payments (based on your life expectancy) is roughly equal to the property’s fair market value, there’s no gift tax on the transaction. And the property’s value, as well as any future appreciation in that value, is removed from your taxable estate. In addition, a private annuity provides you with a fixed income stream for life and enables you to convert unmarketable, non-income-producing property into a source of income.

Until relatively recently, private annuities also provided a vehicle for disposing of appreciated assets and deferring the capital gain over the life of the annuity. Proposed regulations issued in 2006 (although not yet finalized) effectively eliminated this benefit, requiring you to recognize the gain immediately. It’s still possible, however, to defer capital gain by structuring the transaction as a sale to a defective grantor trust in exchange for the annuity.

Another potential benefit: Because the transferee’s obligation to make the annuity payments ends when you die, your family will receive a significant windfall should you fail to reach your actuarial life expectancy. In other words, your family will have acquired the property, free of estate and gift taxes, for a fraction of its fair market value. On the other hand, if you outlive your life expectancy your family will end up overpaying.

Keep in mind that private annuities can’t be “deathbed” transactions. If your chances of surviving at least one year are less than 50%, the IRS actuarial tables won’t apply and the transfer will be treated as a taxable gift.

Understanding the risks

A disadvantage of many popular estate planning techniques is “mortality risk.” For example, the benefits of a grantor retained annuity trust are lost if you fail to survive the trust term. Private annuities, on the other hand, involve “reverse mortality risk.” If you outlive your life expectancy, the total annuity payments will exceed the property’s fair market value, causing your family to overpay for the transferred property and potentially increasing the size of your taxable estate.

To avoid this result, consider a deferred private annuity, which delays the commencement of annuity payments, reducing reverse mortality risk. The U.S. Tax Court has given its stamp of approval to a deferred private annuity. In Estate of Kite v. Commissioner, the court approved a deferred private annuity transaction, even though the annuitant died before the annuity payments began. As a result, her children received a significant amount of wealth, free of estate and gift taxes, without having to make any payments.

There’s also a risk that your child or other transferee will be unable or unwilling to make the annuity payments. Private annuities are unsecured obligations, and if the recipient defaults, the IRS may challenge the arrangement as a disguised gift.

Consult your advisor

Like any estate planning strategy, a private annuity isn’t right for everyone. However, if your estate is potentially large enough to be subject to estate taxes, a private annuity may be one way to transfer substantial wealth to your children or other loved ones at a minimal tax cost. Discuss your options with your estate planning advisor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Adler Pollock & Sheehan P.C. | Attorney Advertising

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