A private annuity can be a powerful strategy for passing assets to heirs in a tax-efficient manner. It involves transferring property to children or others in exchange for their unsecured promise to make annual payments to the transferor for the rest of his or her life. This article examines both the benefits and risks of private annuities, while a sidebar looks at a case in which the U.S. Tax Court approved a deferred private annuity, which, under the right circumstances, can minimize the risk.

Private annuities can offer big tax savings

Now that the federal exemption is permanently set at an inflation-adjusted $5 million ($5,340,000 in 2014), fewer families are subject to gift and estate taxes. But affluent families remain exposed to potentially significant tax liabilities, particularly if they plan to transfer family businesses, real estate holdings, investment portfolios or other large assets to the younger generation.

A private annuity can be a powerful strategy for passing assets to your heirs in a tax-efficient manner. Although this strategy isn’t risk-free, the U.S. Tax Court recently gave its stamp of approval to a deferred private annuity, which, under the right circumstances, can minimize the risk.

What are the benefits?

In a typical private annuity transaction, you transfer property to your children or others in exchange for their unsecured promise to make annual payments to you for the rest of your life. It’s “private” because the annuity is provided by a private party rather than an insurance company or other commercial entity. The amount of the annuity payments is based on the property’s value and an IRS-prescribed interest rate.

A properly structured annuity is treated as a sale rather than a gift. So long as the present value of the annuity payments (based on your life expectancy) is roughly equal to the property’s fair market value, there’s no gift tax on the transaction. And the property’s value, as well as any future appreciation in that value, is removed from your taxable estate. In addition, a private annuity provides you with a fixed income stream for life and enables you to convert unmarketable, non-income-producing property into a source of income.

Until relatively recently, private annuities also provided a vehicle for disposing of appreciated assets and deferring the capital gain over the life of the annuity. Proposed regulations issued in 2006 (although not yet finalized) effectively eliminated this benefit, requiring you to recognize the gain immediately. It’s still possible, however, to defer capital gain by structuring the transaction as a sale to a defective grantor trust in exchange for the annuity.

Another potential benefit: Because the transferee’s obligation to make the annuity payments ends when you die, your family will receive a significant windfall should you fail to reach your actuarial life expectancy. In other words, your family will have acquired the property, free of estate and gift taxes, for a fraction of its fair market value. On the other hand, as discussed below, if you outlive your life expectancy your family will end up overpaying.

Keep in mind that private annuities can’t be “deathbed” transactions. If your chances of surviving at least one year are less than 50%, the IRS actuarial tables don’t apply and the transfer will be treated as a taxable gift.

What are the risks?

A disadvantage of many popular estate planning techniques is “mortality risk.” For example, the benefits of a grantor retained annuity trust are lost if you fail to survive the trust term. Private annuities, on the other hand, involve “reverse mortality risk.” If you outlive your life expectancy, the total annuity payments will exceed the property’s fair market value, causing your family to overpay for the transferred property and potentially increasing the size of your taxable estate.

To avoid this result, consider a deferred private annuity, which delays the commencement of annuity payments, reducing reverse mortality risk. (See the sidebar “U.S. Tax Court approves deferred private annuity.”)

There’s also a risk that your child or other transferee will be unable or unwilling to make the annuity payments. Private annuities are unsecured obligations, and if the recipient defaults, the IRS may challenge the arrangement as a disguised gift.

A powerful tool

Affluent families looking for ways to reduce estate and gift taxes should consider a private annuity. Under the right circumstances, this tool allows you to transfer substantial wealth to your children or other loved ones at a minimal tax cost.

Sidebar: U.S. Tax Court approves deferred private annuity

Last year, in Estate of Kite v. Commissioner, the U.S. Tax Court approved a deferred private annuity transaction, even though the annuitant died before the annuity payments began. As a result, her children received a significant amount of wealth free of estate and gift taxes without having to make any payments.

Virginia Kite sold interests in a family limited partnership to her three children in exchange for three private annuities. The annuity agreements, which were executed in 2001 when Mrs. Kite was 74 years old, called for each child to pay just over $1.9 million per year to Mrs. Kite’s lifetime revocable trust beginning in 2011 and ending on Mrs. Kite’s death. Mrs. Kite died in 2004, so her children were never required to make any payments.

The IRS challenged the arrangement, seeking to collect more than $11 million in federal estate and gift taxes. It argued that there was no real expectation of payment, so the transaction was merely a disguised gift.

The Tax Court rejected this argument, finding that the annuities served as adequate consideration for the transfer. Although Mrs. Kite had serious health issues in 2001, a letter from her physician stated that he didn’t believe she had “an incurable illness or other deteriorating physical condition” which would bring about her death within one year, and that there was “at least a 50% probability that she will survive for 18 months or longer.” Therefore, it was appropriate to rely on IRS life expectancy tables in determining the value of the private annuities. The court found that there was a real expectation of payment, noting that Mrs. Kite’s life expectancy in 2001 was 12.5 years and that her children had the financial means to make the payments when they came due.

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