PRIVATE ANNUITIES: ESTATE TAX MAGIC

By Drew Grey, CPA, Partner
dgrey@srgcpas.com

All estate tax planning involves moving assets from the parents to the children.  There are many ways to move the assets: the parents can give the assets; they can sell the assets; they can make a part-gift, part-sale.  The gift can be accomplished using an outright gift or a grantor retained annuity trust.  The sale can be accomplished using a self-cancelling installment note or a private annuity.  The question is: among all the ways in which the assets can be moved, which technique is most attractive for a particular family?

In an era of extremely low interest rates, private annuities are worth an extra look.  At any time, no matter the interest rate, private annuities are truly estate tax magic.  However, because the word “annuity” is in the name, people are concerned that the technique involves the purchase of something from an insurance company.  That is not true.  The word “private” refers to the fact that it is a transaction with a party – typically a children’s trust – that is not in the business of issuing annuities.  The children’s trust pays the parents based on two factors: (i) an interest rate required by the IRS; and (ii) a mortality factor (based on the parents’ ages).

Take this example: Mom and Dad, ages 65 and 70, sell an asset worth $1,000,000, with a zero basis, to a trust for their children (which is ignored for income tax purposes).  The private annuity payments will continue until both parents are dead.  Based on the September, 2012, interest rate, the children’s trust would have to pay $53,674 per year.  The advantage for the children is that, on the surviving parent’s death, nothing is included in the taxable estate.  The advantage for the parents is that the payments continue during their entire lifetimes.

Private annuities are traditionally attractive when the parents are unlikely to live to the expectancy used by the annuity table.  In this example, the table assumes a 23.1 year survivor expectancy.  So, if both parents are in poor health, the use of a private annuity is a “good bet.”  However, with the interest rate required by the IRS only 1%, a private annuity is especially attractive because the payments required of the children are almost purely for the mortality component.

Of course, as the parents get older, the required payments increase.  If the private annuity begins when the parents are ages 70 and 75, the required annual payment is $64,986.  If they wait until the parents are 75 and 80, the required payment is $81,096.  Given the availability of valuation discounts for investment property, these payments are not as significant as they might appear.  For example, assume that the asset to be transferred is an apartment building worth $1,500,000, generating cashflow of 5% ($75,000).  If contributed to a family limited partnership, it may have an aggregate value of $900,000 for purposes of the private annuity transaction.  In that case, the $75,000 cash flow is the equivalent of an 8.33% annuity, more than enough for parents aged 75 and 80.

Private annuities are not, of course, for every family situation.  However, they are attractive for many families where the parents wish to keep the cash flow for their entire lives and they wish the chance to hit an estate tax homerun.  Please call us so that we can review all of your facts, and all of your goals and objectives.  We can help you meet your estate planning goals.

 

The above is not tax advice for any client or matter; it is provided as a topic of general interest to our readers and should not be used for tax planning purposes.  Each client’s situation contains unique facts.

If you are interested in exploring how these rules could benefit you, please contact Drew Grey at (818) 995-0090 or at dgrey@srgcpas.com to receive advice on your specific matter.

 

 

 

October 10, 2012 Posted in Estate Tax Planning, Tax