No doubt you have heard about the kind of annuities that stop paying when the annuitant dies. They are called “Life Income Annuities” and they provide the annuitant with a maximum annual income that won’t run out no matter how long the annuitant lives. Most large company pension plans use this kind of annuity to make payments to the retiree. The typical life income annuity is issued by an insurance company - but it doesn’t have to be. An annuity can be issued by anyone - even an individual. The “catch” is that the tax benefits require that the annuity be an unsecured contract. For that reason, hardly anyone ever enters into an annuity contract with anyone other than an insurance company or a large charity.

But some people enter into annuity contracts with their heirs in order to transfer assets to their heirs at a minimal estate tax cost. The transfer of assets to your heirs with a private annuity removes those assets from your estate because the payments to you cease at the time of your death. The assets you sold belong to your heirs - and they have been transferred to your heirs free of any federal estate tax. 

A private annuity is a much discussed but little used device to eliminate estate taxes and to transfer appreciated property to your heirs with deferred capital gains taxes. It works best when it’s combined with a gifting program and/or with a charitable remainder trust . It works even better if you have family members who are not U.S. residents or citizens. And it’s most effective when the buyer of your property is in a very low or zero tax bracket.

You can sell appreciated assets to a private individual or entity (as contrasted to an insurance company) in exchange for what is called a "private annuity". This is like a life income annuity from an insurance company. When you die, the payments cease. But don't panic. If you make the annuity agreement with an heir (like a son or daughter), you will have avoided part of the capital gains tax and the federal estate tax as well. 

This tactic is most appropriate (financially) when there is a great likelihood of a pre-mature death at an early age ... and where there is a near certainty of a large estate tax.  For example, father has a terminal illness and isn't likely to live more than a few years, but is expected to live more than one year. He has substantial assets that are likely to be subject to the top estate tax rate of 50%. An alternative is to sell some of  the property to his children (assuming they are of legal age) in exchange for a private annuity. If he is 55 years old, the annual annuity payment would be about 12% of the value of the property each year. If father dies within two years, he will have transferred 76% of his estate to his children free of any estate taxes. The private annuity can zero out an estate in as little time as it takes to draw up the contract. (And there are ways to deal with the assets coming back into the estate.)

The heirs who are buying the property have a cost basis equal to the present value of the future annuity payments. When father (the annuitant) dies, the cost basis is recomputed based on the total payments actually made to the annuitant. At that point, the heirs can pursue a variety of ways to minimize the capital gains tax - like a charitable trust.

From an asset protection perspective, the property no longer belongs to dad. It now belongs to the kids. However, the annuity payments the children are paying to dad will be subject to the claims of any creditors.

I have been asked to counsel with people who have been approached with the idea of selling the stock in their business (or other highly appreciated assets) to a foreign person or company in exchange for a private annuity. As long as the U.S. person does not control the foreign person or entity, the tax benefits can be realized. BUT -- remember that the private annuity MUST be an unsecured contract. Do you really want to sell your most valuable asset to a foreign person you don't know in exchange for a promise to pay you an income for the rest of your life? And, when you die, the assets now belong to the foreign person.

Also be sure that the person or company that is issuing the annuity contract is not in the business of issuing annuity or insurance contracts. The reason is because the private annuity tax benefits are not available when the annuity payor is in the business of issuing annuity or insurance contracts.

Vern Jacobs
June 25, 2003

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