Why a Private Annuity is a Powerful Estate Planning Tool

Affluent families looking for ways to reduce their gift and estate tax exposure should consider private annuities. Under the right circumstances, a private annuity can generate significant tax savings. A 2013 U.S. Tax Court decision that approved the use of a  deferred  private annuity for estate planning purposes has potentially made this tool even more powerful.

Many Benefits

To take advantage of a private annuity, you simply transfer property — such as securities, family business interests, real estate or other assets — to your children or other beneficiaries in exchange for their promise to make periodic payments, usually for the rest of your life.

This technique offers several benefits. It gives you a source of fixed income for life, often taxable (at least in part) at favorable capital gains rates. Once you complete the transfer, the property’s value — plus all future appreciation — is removed from your taxable estate. And there’s no gift tax on the transaction, so long as the present value of the annuity is roughly equal to the property’s current fair market value.

Another benefit of a private annuity is that, if you fail to reach your life expectancy, your beneficiaries will receive a windfall. Typically, the transaction is structured so that the present value of annuity payments over your actuarial life expectancy (according to IRS tables) equals the property’s value. After you die, your beneficiaries are no longer obligated to make annuity payments. So if you don’t reach your life expectancy, they’ll acquire the property at a substantial discount.

Advantages of Deferral

A  deferred  annuity provides for payments to commence at some date in the future. Structured properly, it increases the chances that the transferor will die before the annuity payments are complete — or, in some cases, before they begin. Understandably, the IRS isn’t a big fan of this technique. But in a 2013 case,  Estate of Kite v. Commissioner , the U.S. Tax Court approved its use — at least in one set of circumstances.

In 2001, at age 74, the taxpayer sold her interests in a family limited partnership to her three children in exchange for three private annuity agreements. The agreements called for annuity payments to begin 10 years later, in 2011. The taxpayer died in 2004, so her children never had to make any payments. The tax benefits of the private annuity transaction were substantial: In challenging it, the IRS sought to collect more than $11 million in federal gift and estate taxes.

The IRS claimed that the transaction was a disguised gift. It argued that there was no real expectation of payment and, therefore, the annuities didn’t constitute adequate consideration for the transfer.

The Tax Court disagreed, finding that the family was justified in relying on IRS life expectancy tables because the taxpayer wasn’t terminally ill (and presented a physician’s letter to that effect). In light of the taxpayer’s 12.5-year life expectancy, her children’s financial independence, and other evidence, the court concluded that her children expected to make annuity payments and were prepared to do so.

A Calculated Risk

Private annuities aren’t risk-free: If you surpass your life expectancy, the beneficiaries will end up overpaying (and the payments will be part of your taxable estate). Also, if your beneficiaries default on the payments, the strategy may unravel. But, given the potential benefits, these may be risks worth taking.