Private Annuities

What Is a Private Annuity?

A private annuity is an agreement under which one party sells an asset (such as a business interest) to a second party in exchange for the buyer’s unsecured promise to pay an annuity. The buyer (someone who doesn’t regularly issue annuities) agrees to pay a fixed yearly sum to the seller for life in return for the asset.

What Are the Advantages?

A traditional advantage of the private annuity is the ability of the seller to spread the capital gains from the sale over the seller’s life expectancy if the annuity is unsecured. However, proposed regulations issued on October 17, 2006 would require the seller to recognize all gain in the year of the transfer. The private annuity can supplement a small business owner’s retirement income at the same time it removes a sizable asset from the owner’s gross estate and replaces it with a “wasting” asset whose value declines over time. The seller can use the private annuity to create an income from a previously non-income producing asset, such as unimproved real estate. The private annuity helps the seller transfer an asset without incurring a gift tax. For the buyer, the private annuity can make it possible to acquire an asset without paying the entire purchase price up front.

How Does it Work?

A private annuity is a legal contract. The buyer, the annuity payor, acquires legal title to the asset, and the seller, the annuity recipient, trades the asset for an income stream that is taxed as a commercial annuity.

Example: Frank owns an 80% share of a family business with a net worth of $1 million. He transfers his entire interest clear title with no residual interest—to his daughter, Zoe, in return for her agreement to pay him a private annuity that has a present value equal to the $800,000 asset. The annuity payment depends on actuarial tables and the applicable federal rate (AFR) at the time the agreement is made, and must be paid according to a regular schedule.

What Are the Tax Consequences for the Seller?

If an appreciated asset is sold, the seller will recognize gain to the extent the annuity’s present value exceeds the transferred property’s adjusted basis. The gain may be ordinary income or capital gain, depending on the kind of property transferred, the seller’s holding period, and any recapture of depreciation that may be involved. The gain may be spread over the seller’s life expectancy provided the buyer’s promise to pay the annuity is unsecured (note that proposed regulations require any gain to be recognized in the year of the transfer). Tax on the annuity payments will cover three parts:

• (a) tax-free payments for the recovery of the seller’s original investment in the asset under the annuity exclusion ratio,
• (b) capital gains tax on the difference between the original basis and the annuity’s present value as projected over the seller’s life expectancy, and
• (c) ordinary income tax on all income beyond the recovery of basis and capital gain. The seller may be subject to gift tax if the asset’s fair market value is greater than the present value of the annuity.

What Are the Tax Consequences for the Buyer?

The buyer’s basis in the asset is the present value of the annuity. The buyer may be subject to gift tax if the present value of the annuity is greater than the asset’s fair market value.

What Are the Risks?

Each party to a private annuity takes on a mortality risk. The seller risks that death may occur before reaching life expectancy, with the result that the seller may not have received all projected annuity payments. Conversely, the buyer risks that the seller may outlive life expectancy, meaning annuity payments would continue beyond the projected period. The seller/annuitant takes a financial risk that the buyer may be unable to pay the annuity, since the annuitant’s claim against the buyer is unsecured by any continuing interest in the asset transferred.

In a family context, a private annuity can create tension between members due to their economic self-interests. If the seller has a terminal illness, the average life expectancy under the IRS tables should not be used. Using the person’s actual life expectancy can avoid adverse gift tax consequences.

What’s the Conclusion?

The private annuity offers tax and financial advantages and a relatively simple way to transfer an asset. However, the exchange should be equal in order to preserve those advantages. These measures should be formal, with both parties retaining legal counsel, obtaining independent appraisals, and using the proper actuarial tables and interest rates. The private annuity can be especially useful when the asset transferred produces a cash flow, or can be converted to provide a cash flow, sufficient to make the annuity payments.