Private Annuity

A private annuity is a contract between one or two persons (the "annuitant" or "annuitants") and a person (individual, corporation, partnership, or trust) that is not in the business of selling annuities (the "payor"). Under the contract, the annuitants transfer money or property to the payor in exchange for the payor's unsecured promise to pay a fixed amount of money for the life or lives of the annuitants. If the annuity amount is calculated properly, the present value of the annuity payments will equal the value of the cash or other property transferred in exchange for the annuity, so that the transfers are not gifts.

Upon the death of the annuitant (or the last to die of two annuitants), the payments end and there is nothing included in the taxable estate of the annutant other than the accumulated payments already received.

Why Use It?

A private annuity can be a way of transferring property between family members without making a gift when the persons transferring the property do not need or want it any more but need or want a steady income, and are willing to rely on the ability of the payor to make the annuity payments. So, a family member owning real property, or closely held business interests, can transfer those kinds of properties to another family member (or another family controlled business or trust) in a private annuity transaction. The transaction can result in a net estate and gift tax benefit if the annuitants do not live out close to their normal life expectancies, or if the property transferred (or reinvested) is able to generate a net income that exceeds the interest assumption used to calculate the annuity payments.

If a property is about to be sold and capital gain realized, a private annuity transaction is a way of getting the benefit of installment sale treatment for the gain while keeping the financing costs (and risks) within the family. In a private annuity transaction, any capital gain is realized (under current law) over the life expectancy of the annuitant. But the person receiving the property and paying the annuity has an initial basis equal to the present value of the future annuity payments, which will be near to the market value of the property if the private annuity is properly calculated, and so a sale by the transferor should result in little or no taxable gain. The original owner (the annuitant) will therefore realize any gain ratably over his or her life expectancy while the payor of the annuity will be able to sell the property will little or no taxable gain.

Any capital gain for the annuitant can be eliminated if the private annuity transaction is with a trust of which the annuitant is considered the grantor for federal income tax purposes, because Internal Revenue Service rulings have established that transactions between a grantor and a "grantor trust" do not result in gain or loss. (But a later sale of the property by the trust to a third party would most likely result in taxable gain.)

How Does It Work?

The present value of an annuity can be calculated using actuarial factors in tables published by the Internal Revenue Service. The the annuity amount is multipled by a factor (and a second factor if the payments are more frequent than annual) and the result is the present value of the annuity payments. In order to create a annuity with a value equal to the value of a specific property, all that is needed is to run the calculation in reverse, dividing the desired present value by the appropriate factors to get the amount of the annuity to be paid.

Although a private annuity can be a convenient way of transferring property and serving the non-tax goals of the parties, a private annuity can also result in a net transfer of value between the annuitants receiving the annuity payments and the payor making the payments in the following ways:

• If the annuitant dies prematurely, then the payor gains because the payor acquired valuable property while making fewer payments than expected, but if the annuitant outlives his or her life expectancy then the payor loses because the payor has to make more payments than expected.
• The present value of the annuity is based on an assumption about interest rates and investment incomes. If interest rates rise, then the future annuity payments are worth less and the payor benefits. If interest rates fall, then the future annuity payments are worth more and the payor loses because the future payments will effectively cost more.
Regardless of whether interest rates rise or fall, if the property transferred by the annuitant(s) to the payor actually produces an income in excess of the interest rate assumed to apply at the beginning of the annuity contract, then the payor will be able to gain by making more of each payment out of the property's income than was originally expected, but if the payor's actual investment income is less than the initial assumed interest rate, then the payor will lose money by having to make more of the payment from other financial resources.

Although the annuity must be a "fixed amount," the amount can change from year to year, as long as the amount to be paid in any future year can be calculated in advance. So, for example, an annuity can increase by a fixed percentage each year, so as to keep pace with anticipated inflation or increases in costs of living, but it cannot be increased based on the Consumer Price Index because future increases in that index are not known at the beginning of the contract.

It is also possible to defer the beginning of the annuity payments for a fixed number of years. So, for example, if a person age 60 wants to tranfer property, but doesn't need or want the annuity payments until age 65, when he or she expects to retire, the start of the annuity payments can be deferred for five years. However, the payments cannot be deferred until actual retirement because that would allow the annuitant to decide in the future when the annuity payments will begin, and so the payments will not be fixed amounts payable at known times.

Because the payor of the annuity would benefit if the death occurred early, tax regulations do not allow the annuity to be valued using the usual mortality table if the annuitant is terminally ill and is likely (at least 50% probability) to die within one year. (However, if the annuitant survives for at least 18 months, there is a presumption that the annuitant was not terminally ill.)

Benefits

The possible benefits of a private annuity are:

• There may be non-tax benefits because the transaction may allow younger family members to use property they need or want while older family members can receive cash they may need for their support.
• The property may produce an income (or be invested to produce an income) that exceeds the income represented by the annuity payments, so that there is a net transfer from the annuitant(s) to the payor and a possible saving in death taxes.
• The annuity payments end at the death of the annuitant, and if the annuitant were to die before his or her normal life expectancy, there may be a net reduction in his or her estate (and a nontaxable benefit for the payor) that results in a death tax savings.

Costs

There are several possible costs to a private annuity:

• If the property being transferred has an income tax basis that is less than fair market value, capital gain will be realized that might not be realized if the property were held until death (when it would receive a new basis equal to fair market value).
• Part of each annuity payment will be ordinary income to the annuitant, but the payor will not be entitled to any income tax deduction, and so the combined net taxable income of the family may increase, resulting in a total net increase in income taxes.
• If the annuitant outlives his or her life expectancy, his or her estate may be increased, which may result in an increase in death taxes.
• If the annuitant were to die prematurely, there may be death tax savings (see benefits described above), but the payor's basis in the property that is acquired for the private annuity will have a basis equal to the total of the payments made, so a later sale of the property may result in capital gains.
• There may be transactional costs:
• The legal fees or other costs of preparing the private annuity contract.
• If real property, closely held business interests, or other properties with no readily ascertainable market values are being transferred, appraisals might be needed to be sure that the property is being transferred for fair market value.
• For transfers of real property, there may be costs of preparing and recording deeds, as well as possible realty transfer taxes.

Whether these possible costs are less than or more than the possible benefits should be considered under the circumstances of each case.

Who Should Use It?

A private annuity is often appropriate for an unmarried person who has real property, closely held business interests, or other assets that he or she wants to transfer to other family members, but he or she wants or needs a continuing income from the property transferred.

A private annuity is particularly suited to someone whose estate may be subject to federal estate tax or state death taxes, such as an estate that is more than the federal applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse), and is in poor health (but not terminally ill) and not expected to survive to normal life expectancy.

A private annuity should also be considered if a property needs to be sold, because a private annuity transaction with a family member (or trust for a family member), followed by a sale to a third party, can allow deferral of the realization of capital gain similar to an installment sale.