An annuity is an insurance product, sold by insurance companies to individuals who want a guaranteed income for life or for a term of years. The buyer of the annuity, known as the annuitant, pays for the insurance through a series of premiums or a single premium for a fixed or variable income, beginning at a specified age or time and continuing for a term of years, or, in most cases, for the rest of the annuitant's life. A private annuity works the same way, but it is between 2 individuals who are usually related. A private annuity can be an effective means of reducing gifts, estate, or generation-skipping transfer taxes. A private annuity is between 2 private parties, neither an insurance company, usually between parent and child or grandchild. The transferor (annuitant, usually the parent) transfers ownership of a property to the transferee, the obligor, who is usually the child or grandchild, who promises to pay the annuitant an income for a term of years or for the rest the annuitant's life. The annuity can be a single life annuity, where payments stop when the annuitant dies, or it could be a joint and survivor annuity, where payments only stop when the survivor dies. Because there is a high probability that the annuity payments will continue for a longer time with a joint annuity, annual payments will be smaller.
The annuitant must recognize all the gain on the property in the year that the transaction is completed, equal to the fair market value (FMR) of the property minus the annuitant’s basis in that property. Nonetheless, a private annuity can be useful where the gain is small or were the seller has significant losses that can offset the gain.
The amount of the annuity payment would be based on the FMR of the asset transferred, the annuitant's age, and the IRC §7520 interest rate.
Private annuities are often arranged between parents and children or between employers and key employees, especially if the employer does not have any children. Any type of property can serve as the basis of the private annuity: home, stocks, businesses, or real estate. Ideally, the property should produce income and offer significant appreciation, but will not be subject to depreciation or investment credit recapture. Neither should there be any debt on the property.
When selling property to the transferee, the seller must consider whether the transferee will be able to make the income payments, since they will be legally required. If the transferee does not have significant other income, then the property transferred should produce enough income to cover all expenses and the required annuity payments.
If structured correctly per IRS rules, the private annuity is treated as a sale and not as a gift, so it is not subject to gift or generation-skipping transfer taxes. The private annuity reduces the estate of the annuitant for estate tax purposes. Even if the annuitant dies shortly after the transaction, the annuity payments will cease and neither the asset nor the promised payments will be includable in the estate of the annuitant. Setting up a private annuity can also allow the transference of certain property to specific the family members, which will eliminate the possibility of any will contests over the property.
The transferee's basis in the property will be the greater of the amount paid to the annuitant or the amount paid plus the present value of all the future payments if the annuitant lives to her life expectancy.
Private annuities do have disadvantages. The payment obligation ceases when the transferor dies, even if only one payment was made, which will be advantageous to the transferee, but will be disadvantageous to the other heirs of the annuitant. On the other hand, private annuities are annuities, and just like their insurance counterpart, the transferee must continue making payments for as long as the annuitant lives. The transferee may pay more than expected if the annuitant outlives his life expectancy. Even if the transferee dies before the annuitant, annuity payments will still have to be paid by the estate of the transferee. Additionally, higher payments will be required by the transferee if the annuitant is older.
A major difference between a private annuity and an installment sale is that the property on which the private annuity is based is removed entirely from the estate of the annuitant, even if the annuitant dies shortly after the transaction. On the other hand, the present value of the remaining payments on the installment sale will be includable in the estate of the seller. Another disadvantage of the installment sale is that a good portion of the early payments of an installment sale is considered interest, which may be taxed at a higher percentage if it was based on long-term capital gain property. Another advantage of the private annuity over the installment sale is that the transferee can sell the property immediately afterwards without being subjected to the IRC §453 related-party rule, which would cause the resale of installment property to be includable as income to the original seller if the sale took place within 2 years of the original sale.
The IRS treats the annuity as a sale by the transferor, who then use the proceeds to buy the annuity. Therefore, the seller’s entire gain is recognized in the year of the transaction. The annuity agreement can provide for a maximum payment, but the payments cannot continue for more than twice the remaining life expectancy of the annuitant.
The annuity payment amount is determined by the fair market value of the property, which should be appraised by an independent appraiser. Payments must depend on the life expectancy of the transferor, but there can be a maximum payout provision in the private annuity agreement. The maximum payment provision will be for the shorter of the life of the annuitant or for a fixed term of years, which can be no longer than twice the life expectancy of the annuitant. The minimum interest rate will be determined by IRC §7520 interest rate for the month that the private annuity agreement was signed.
There are 3 taxable components of income to the seller of the private annuity property: recovery of basis, which is always tax-free, a gain subject to the capital gains tax rate, and an income element subject to ordinary income taxes.
The annual annuity payment is calculated thus:
- Annual Annuity Payment = FMV of Property Transferred ÷ Present Value of Annuity Factor
- Expected Return of Annuity = Annual Payment × Life Expectancy
- Exclusion Ratio = Sellers Cost Basis ÷ Expected Return
- Excludable Amount until Total Basis Recovered = Exclusion Ratio × Annual Annuity
- Annual Gain Portion of Annuity Payment until Total Gain is Recognized = (FMV of Property – Property's Basis) ÷ Life Expectancy of Annuitant
- Ordinary Income Portion of Annuity Payment = Annual Payment – (Excludable Amount + Gain Amount)
The annuity factor is determined by IRS valuation tables, which should not be used if the annuitant is terminally ill, which the IRS has defined as one who is expected to die within 2 years. Otherwise, the private annuity would truly be an effective means of reducing estate tax!
|Transferred Property Fair Market Value||$1,000,000|
|Taxpayer's Basis in Property||$200,000|
|Life expectancy||16||Found in IRS annuity tables in Publication 939|
|IRC §7520 discount rate||5%||Found in IRS annuity tables in Publication 939|
|Factor for present value of annuity based on age||9.3180||Found in IRS annuity tables in Publication 939|
|Annual annuity||$107,319||= Land fair market value/factor for present value of annuity|
|Expected return of annual payments||$1,717,107||= Annual annuity payment × life expectancy|
|Exclusion ratio||0.116475||= Basis/Total annuity payments for life expectancy|
|Excludable amount = return of capital =||$12,500||= exclusion ratio × annuity annual payment|
|Total capital gain||$800,000||= Land fair market value – basis|
|Annual capital gain||$50,000||= total capital gain/life expectancy|
|Annual ordinary taxable income||$44,819||= Annual annuity payment – return of capital – annual capital gain|
For a single life annuity, the annuity terminates when the annuitant dies, so there are no future payments to be included in the estate. However, if it is a joint and survivor annuity, then payments will continue until the death of the survivor, which is usually the spouse, in which case the tax would not be due because of the unlimited marital deduction. However, if the spouse is not a United States citizen, then the future payments will be includable in the annuitant's estate, if he was the only owner of the property that was transferred for the annuity payment.
If the actuarial present value of the annuity is less than what would be justified by the value of the property transferred, then the difference will be treated as a gift in the year when the agreement was signed. So, if the annuity payment was $90,000 in the above example rather than $107,319, then the difference of the fair market value of the property, which in this case is $1 million, and the expected return of $838,620 equals $161,380, which will be subject to gift tax in the year that the private annuity agreement was signed.
|Expected return of annual payments||$838,620|
To summarize, the income tax treatment of an unsecured private annuity is based on the following:
- capital gain is equal to the difference between the FMV of the property and the transferor's basis
- gain is reported ratably over the life expectancy of the annuitant
- the transferor's investment in the contract is the transferor's basis in the property;
- each annuity payment consists of a return of basis, capital gain, and ordinary income.
After the basis has been recaptured and all capital gain reported, all subsequent annuity payments will be treated as ordinary income. Thus, annuity payments to an annuitant who was outliving his life expectancy is taxed as ordinary income. Additionally, the annuity payment must be based on IRS actuarial tables and cannot be related in any way to the amount of income earned by the asset; otherwise, the asset will be included in the annuitant's estate.
The transferee's initial basis in the property equals the FMV of the property when transferred. This allows the transferee to sell the property with little or no gain or to use a higher basis for depreciation, if the property is depreciable. When the annuitant dies, then the transferee's basis in the property will equal the annuity payments that were paid.
If the transferee dies before the annuitant, then the transferee's estate will have to continue making payments for as long as the annuitant lives. Therefore, it would be prudent for the transferee to have life insurance on his own life so that his surviving spouse and heirs will have the money to pay the annuity.