A Private Annuity May Be A Worthwhile Technique to Consider

By: Randall A. Denha, J.D., LL.M.

As we all know, the current interest environment is historically low. In fact, the current 7520 rate is an astonishingly low 1.4% which gives us some rare planning opportunities. The 7520 rate (named after the section of the tax code) is used to calculate the transfer tax effects of certain wealth shifting techniques. In effect, it’s a sort of hurdle rate that the government assumes an asset is earning. As long as your asset earns more than the 7520 rate, you’re in the so-called money. For certain estate planning vehicles, a low Section 7520 rate provides a rare opportunity for transferring wealth to the next generation in a tax-efficient manner. A Private Annuity offers a number of income, gift and estate tax advantages. One of these rare planning opportunities is a technique called a private annuity.

A Private Annuity is a sale of assets between two parties. A Private Annuity involves the transfer of assets from a seller in exchange for a buyer’s unsecured promise to make a periodic stream of fixed payments. The party transferring assets may be an individual or a revocable living trust; the party to whom the assets are transferred may be an individual or an entity such as a trust, a partnership, or a corporation. Private Annuities are usually created between family members. For instance, a parent might create an annuity agreement with a child. The parent would then transfer assets to the child in return for the child making regular payments to the parent for life. To avoid any gift taxes, the promised annuity payments are based upon Internal Revenue Service published interest rates and life expectancy tables. As interest rates decline the value of each annuity payment also decreases, making the Private Annuity sale a more attractive estate planning vehicle in such periods of low interest rates. Further, the Private Annuity is a sale and not a gift, it will not be subject to the generation-skipping transfer tax. The private annuity works best when the parent is not terminally ill, but has health issues for which he or she has a probability of not living out his or her normal life expectancy. Early death of the parent means a windfall to the child because he or she ends up paying less than what was anticipated at the outset.

When properly structured, Private Annuities eliminate federal estate tax on the value of the transferred assets. A party transferring assets also saves probate fees to the extent that Private Annuities remove the transferred assets from the transferring party’s probate estate.

In 2006, the IRS issued proposed regulations that require all gain on the sale to be taxed in the year of sale. For some, this is perceived as the death knell to this planning technique. However, even with a current income tax bite, there are still advantages to the technique and justify its use in appropriate circumstances:

a. The benefit of shifting future appreciation out of the seller’s gross estate for estate tax purpose still fully applies (although this can backfire if a seller substantially outlives his or her life expectancy, since the total annuity payments may then exceed the value of the property plus appreciation).

b. Income taxes may not be a major issue. For example, there may not be much current appreciation (i.e., little or no gain) in the property. Or perhaps the seller has other losses they can use to offset the gain.

c. For 2012, recognizing long-term capital gain may be a good thing since maximum rates are only 15%, and are scheduled to increase next year.

d. In the past, a seller of property for an annuity could not secure the annuity obligation with a pledge or mortgage on property, because that would prevent income tax deferral. Thus, sellers had to take on increased risk of loss as to a default by the buyer. Now that deferral of tax is off the table, sellers can secure the payment obligation without giving up anything.

TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED NOR WRITREN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.