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Wealth Management, Tax Planning and Private Annuities

Under the right circumstances, a private annuity can provide excellent wealth management opportunities. Here’s what to consider.

July 19, 2007
Sponsored by BNA Software

by Nancy Faussett, CPA

No one will argue the fact that tax planning is an essential component of competent wealth management. But, for too many people, taxes are an afterthought and that can lead to disastrous results.

For both income tax and estate tax planning, the purchase of a private annuity certainly appears to be a sound idea for wealth management and it can be, but along with its advantages there are also certain potential disadvantages. To ensure successful tax planning, you must be aware of both.

Private Annuities

To purchase a private annuity, the annuitant (or “transferor”) transfers the ownership of property to a transferee in return for the transferee’s unsecured promise to make periodic fixed payments to the transferor for the remainder of the transferor’s life. The transferee may be an individual, corporation, trust, foundation, or other entity.

A private annuity differs from a commercial annuity in that the entity issuing the annuity is not in the business of issuing annuities (unlike a life insurance company) and, in fact, is often a family member. Also a private annuity means that the transferor can ensure that the property will eventually go to whomever the transferor wants, rather than it being left to an insurance company.

Advantages

When properly set up, a private annuity offers the following advantages:

  • Estate tax savings
    A private annuity eliminates estate taxes on the value of the transferred property and shifts the future appreciation of the property to the transferee, generally without any gift tax being assessed. (To avoid the gift tax, the FMV of the transferred property must equal the actuarial value of the annuity promise.) Transferring property on which one expects rapid appreciation will maximize the estate tax savings.
  • Income tax savings
    While highly appreciated assets could be transferred in return for an annuity, tax-free, before October 19, 2006 (or before April 19, 2007, in certain cases), according to recent proposed regulations, the transferor may have to recognize gain on appreciated property based on the annuity contract's current FMV at the time of its purchase. However, any future increase in the property’s fair market value is still effectively transferred to the transferee.

    Another tax advantage is that while the transferor does have taxable income due to the annuity payments received, part of each payment is considered to be a return of capital and, therefore, is tax-free. Furthermore, if the annuity payments are less than the income generated by the transferred property, additional tax savings result for the transferor. In fact, the reduction in income could mean certain other tax benefits such as avoiding losing the ability to itemize deductions by keeping income below a certain threshold.
  • Lifetime income stream
    A private annuity gives the transferor an amount of income for life and is an excellent source of retirement income.
  • Retention of transferred property within the family
    A private annuity ensures that the family maintains control of the transferred property.
  • Liquidity for the transferor’s estate
    This can be a distinct advantage when the transferred property is the stock of a closely held business. If the stock had remained in the estate, it could have increased the estate tax without providing any readily available means to sell the stock in order to pay the resulting tax (assuming the estate did not qualify for tax deferral under Sec. 6166).
  • Conservation of property in case of a catastrophic illness
    The transfer of property, in anticipation of either a catastrophic illness or rising medical care costs, can avoid having its worth depleted and may reduce the transferor’s net worth in order to qualify for federal or state assistance.

Disadvantages

There are some potential disadvantages of a private annuity to both the transferor and the transferee:

  • Investment risk to both the transferor and the transferee
    The risk to the transferor is if the transferred property declines in value, the size of the estate may be larger than if the transfer had not occurred. The risks for the transferee are that the transferred property may not generate sufficient income to make the payments and there is a mortality risk that the transferor will live much longer than expected.
  • Possible lower income tax basis
    If the transferee is still holding the property at the time of the transferor’s death, the transferee’s basis in the property is the sum of the payments made to date.

    * Therefore, if the transferor dies prematurely, the transferee’s basis may be lower than had the transferee inherited the property.

    * Be aware that the rules change for property acquired from decedents after December 31, 2009. IRS Section 1022(a), with some exceptions, generally provides that for such property, its basis will be the lesser of the property's FMV on the date of death, or the property's adjusted basis in the hands of the decedent.
  • No interest deduction for the transferee
    While part of each annuity payment constitutes interest income to the transferor, the transferee cannot claim an interest deduction for the any portion of the payments.
  • Risk of default
    While with an unsecured private annuity, the transferor avoids the immediate gain recognition, the transferor also incurs substantial risk. For example, the transferee may predecease the transferor or the transferee may have difficulty in making the payments.

To mitigate the risk, the transferor may:

    • Purchase insurance on the transferee, life insurance and/or disability insurance,
    • Gift other income-producing assets to the transferee, or
    • Make the private annuity transaction with a trust and have the trust beneficiaries personally guarantee the annuity payments.
  • Income tax burden
    It is important to consider the overall tax consequences for both the transferor (who has some taxable income) and the transferee (who has to make the payments without any deduction) when assessing the income tax ramifications. One method of mitigating the tax affect is to transfer property that either will be depreciable by the transferee or produces income that is tax-exempt.

Private annuities can reduce estate tax, create retirement income, and protect family assets. They can also constitute an investment risk and give the transferee both a reduced basis and an economic burden. How do you know if purchasing a private annuity makes sense for your client? One way is to purchase tax planning software that allows you to create multiple scenarios for your client. This allows you to determine the tax consequences both with and without the purchase of a private annuity. Good software has the ability to take the client’s expected income tax rate, the annuity’s interest rate, and the client’s assumed date of death, and calculate the after-tax annuity amount that will ultimately be included in the client’s estate. Under the right circumstances, a private annuity can provide excellent wealth management opportunities.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later
worked as a depreciation and tax specialist for Best Software.