Private annuities

An annuity (a contractual promise to make periodic payments for life or a term of years) issued by a private individual (versus a company which issues commercial annuities and spreads actuarial risk), in exchange for an asset. A private annuity can be issued between family members.

A private annuity may be issued to transfer ownership of a family business such as a farm or closely held corporate stock without incurring gift tax and ensuring the annuitant a steady stream of income for life.

Gift tax consequences

If the annuity is for full and adequate consideration, there should be no gift. However, there are certain circumstances, such as when the income from the property is the only source of annuity payments, when the transfer may be considered a gift. Careful structuring of the transaction is necessary.

Estate tax consequences

If the annuity is for the life of the annuitant alone, there should be no inclusion in the annuitant’s estate since his/her interest ends at the moment of death. The annuity payments received between the time the annuity is issued and death to the extent not consumed will be in the annuitant’s estate.

Income tax consequences

The annuitant receives two components in each payment. One component is a proportionate share of principal (the original purchase price of the annuity). This component is broken down into the original basis of the property, which is treated as return of capital to the annuitant, and into gain, which is the difference between the purchase price of the annuity and the original basis. The second component is income. Therefore, the annuitant reports the gain from the “sale” of the property over his/her life expectancy. If the annuity extends beyond the original life expectancy, the payments become wholly taxable as income.

Advantages

The appreciation of the property is taken out of the annuitant’s estate.

The annuitant receives an income for life.

Disadvantages

If the annuitant lives much longer than his/her life expectancy, the annuity payer may end up paying substantially more than he/she would have in an installment or outright sale of the property.

Certain structuring of the transaction could result in gift/estate tax inclusion in the estate of the annuitant such as if the annuity is secured by the transferred property. Thus, the annuitant risks default on an unsecured annuity or inclusion for gift/estate tax purposes.

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