Cummings & Lockwood Estate Planning FAQs

A private annuity is an arrangement where in exchange for property sold, the seller/annuitant receives annual annuity payments for the remainder of their lifetime.  An annuity is private if the purchaser is not in the business of making annuities.  A private annuity might be advantageous if the seller’s actual life expectancy is likely to be less than his or her actuarial life expectancy.

The client sells an asset or pays money to a buyer in exchange for such an agreement to pay an annuity to the seller for the seller’s lifetime (or the joint lifetimes of the seller and his or her spouse).  The seller removes appreciating property from the seller’s estate and retains the value of the annuity payments.  This is a particularly useful strategy to provide income to the seller (and perhaps the seller’s spouse) for life while transferring the property to the next generation.

This technique is a bit of a gamble as the tax benefits of the technique are maximized if the transferee dies before life expectancy.  If the transferor survives beyond his or her life expectancy, the transferee may repay an amount in excess of the value of the asset transferred, and potentially increase the value of the transferor’s estate more than if the transfer had never occurred.  This risk is minimized where the asset grows substantially in value while in the hands of the transferee.  Private annuities work best for those who are ailing, but not someone who is terminally ill.

A properly structured private annuity agreement must meet the following criteria:

• The value of the annuity payments should equal the value of the property transferred, because the annuity transaction is not treated as a gift as long as the actuarial value of the annuity equals the value of the stock that is transferred.  Unless the seller/annuitant has a terminal illness, the annuity payments are determined by using the section 7520 rate and the IRS-approved actuarial tables for the month in which the sale occurs.  An essential element to this planning requires that you get a medical opinion that you have at least a 50% likelihood of surviving for one (1) year as of the date of the sale.  Actuarial tables cannot be used to value the seller’s life expectancy if there is a 50% or more chance that the seller will die within one (1) year after the transaction due to current health problems.  If there is a 50% or more chancethat the seller will die within a year, the seller’s actual life expectancy must be used.  However, if the seller actually lives for eighteen (18) months after the transfer, then the seller is presumed to not have been terminally ill.
• The annuity payments cannot be tied to the income generated by the transferred interest, either directly or circumstantially.  Doing so would give the IRS grounds to assert that the seller retained the right to enjoy the income for his or her lifetime, which would cause the entire value of the transferred interest to be includible in the seller’s estate for estate tax purposes.

The private annuity offers the following benefits:

Estate tax savings upon premature death.

The remaining principal balance would not be included in the seller’s estate at their death because, by the terms of the private annuity contract, it cancels at the seller’s death.  The estate tax savings can be substantial if the seller dies materially prior to his or her life expectancy.  If the purchaser is a nongrantor trust, the seller’s estate would be further reduced by the capital gains taxes paid on the sale.

Backloading of payments.

The private annuity can be designed so that each annuity payment increases up to 120% more than the prior annuity payment.  Such backloading offers the advantage of necessitating small payments in the beginning to leverage the return on the interest that was sold.  Compare this with a traditional installment sale, where backloading is available in the form of interest-only payments with a balloon payment of principal at the end of the term.

Lesser Risk of Survivorship.

Survivorship beyond the seller’s actuarial life expectancy is likely to result in a higher estate tax liability than if the seller were to implement a traditional installment sale.  However, this risk is less severe with a private annuity than a Self-Cancelling Installment Note (“SCIN”) (see separate white paper topic), which includes a risk premium and provides for a balloon payment of principal at the end of a term that is shorter than the seller’s life expectancy.

Fewer calculation uncertainties.

Since the factors on which a private annuity are based are given by the IRS, the calculation of payments under a private annuity are relatively straightforward.  A SCIN does not come with such assurances.