Private Annuities
Linscott R. Hanson

Private annuities are a little used and little understood tool in estate planning. Like any tool, they have their place, and should be considered with other alternatives when facing the estate planning task.

Most people understand commercial annuities in a general way. An insurance company issues a policy undertaking to pay the annuitant a monthly sum for life in return for either a single premium or a series of annual premiums. Once the annuitant reaches the age fixed in the policy (often 65), he or she receive the annuity payment thereafter for life. Based upon the original investment in the premiums, for tax purposes, a portion of each annuity payment is considered a tax free return of capital, and a portion is considered taxable income. This ratio, once established, continues during the annuitant's entire lifetime, even after the time when the annuitant has already recovered his/her entire investment in the contract.

So what's a private annuity? How does it differ from a commercial annuity?

A private annuity is not issued by an insurance company. Rather it is issued by one or more private individuals or a company not engaged in the insurance business. Normally it is issued in exchange for property rather than cash. It can be used as a means of transmitting wealth to a younger generation without incurring either gift of estate (unified transfer) taxes. It works like this:

Dad (or Mom) owns a business, piece of real estate, etc. The object is to transfer this asset to the next generation without gift tax. Instead of giving the asset to the children, Dad sells it to them. In this respect, the transaction resembles an "installment sale". Instead of receiving a note or contract, calling for a fixed number of payments at a fixed rate of interest, however, Dad receives an annuity contract from the children. They undertake to pay Dad a monthly annuity for the rest of his life. Sometimes they agree to pay this sum to Dad for life, and 2/3 of the amount to Mom thereafter as long as she lives.

What are the tax consequences?

1. Assuming the property was properly valued, and that the amount of the annuity payments was correctly calculated using the tables supplied by the Internal Revenue Service, no gift has occurred. An arms length sale has occurred. The children make the annuity payments during Dad's (and Mom's) life, and upon death, the obligation ceases or lapses. There is, then, no asset in Dad's estate to be taxed, since the annuity terminated. The children own the property.

A note of caution: If Mom or Dad have a condition of ill-health, it may be necessary to secure a private actuary to set the annuity amounts correctly, and this process can be very expensive.

2. There is an interest element in each payment. Dad pays income tax on the interest just as he would in any other interest transaction. Since the children are not in the insurance business, however, they do not deduct the interest element Dad is paying tax on.

3. Dad has sold his property. If he sold it for more than his cost "basis", he has a capital gain. A portion of each annuity payment represents this "gain" and is taxed. Once Dad's entire basis is recovered, the entire annuity payment, except the interest portion, is taxed.

4. Based on Dad's life expectancy, the children estimate their entire payments to Dad. This is their "basis" in the property. They use this for depreciation, even to calculate their gain if they sell the property. WHEN DAD DIES, their actual basis is calculated, and they amend their returns to give effect to what really happened.

The private annuity can be an attractive method of putting company or land ownership in the hands of the active generation while providing an income stream to the founders. Its disadvantage is that the income can stop and the property be gone if the new generation are not prudent managers. Additionally, if the parents live beyond their "expectancy" the payments for the property can exceed its market value. On the other hand, if the parents' lives are unusually short, the basis in the property will be unusually low.