by Steve Goodman
CPA, MBA – President & Chief Executive Officer
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A private annuity is a means of transferring an asset from its current owner to a preferred future owner. Its common use is to transfer ownership of a privately held company or an investment property to the future generation of owner-manager. The mechanism for the transfer is relatively simple, though it comes with multiple requirements, restrictions, and regulations.
A Self-Canceling Installment Note (SCIN) in a similar investment vehicle to the private annuity. There are differences that are discussed later in this article.
Both the private annuity and the SCIN are methods of transferring assets from a parent’s estate to a child. The basis for the transfer is to reduce estate taxes. While there are many ways to transfer assets to children or grandchildren, these two techniques are optimal when one condition holds: the seller has a life expectancy that is less than that predicted by IRS life expectancy tables.
The seller’s medical condition cannot be such that death is imminent. The IRS will challenge a transaction in which the seller dies soon after the transaction is consummated. If they find that the seller was aware that he/she was likely to die in months, they will negate the sale of the asset. People with non-fatal pre-existing conditions should obtain the notarized opinion of one or more doctors to that effect. If, however, the seller suffers from a condition that statistically favors death earlier than an average person of his/her age, then the private annuity or SCIN is the proper asset transfer tool.
The Private Annuity Overview
Fred owns a business. Fred’s cost basis for the business is $600,000. The business is worth $3 million (based on a professional valuation analysis). Fred is 72 years old. Fred wants to transfer ownership to William, his son, who has been working in the business for several years. Fred may or may not be concerned about possible estate taxes given the now higher estate tax exemptions. If this is a concern, Fred has one more reason to remove the business from his estate.
Fred sells the business to William. William agrees to pay Fred an annual payment for as long as Fred lives. That is, William offers to provide an annuity payment to Fred in exchange for the business owner. This is the basis for the private annuity.
From Fred’s perspective, the benefits as follows:
- The value of the business is removed from Fred’s estate.
- All appreciation and earnings from the business are no longer a part of Fred’s estate.
- Upon Fred’s death, the annuity obligation ends for William.
- If Fred lives a shorter life than the IRS tables anticipate, William may pay less for the business than the business is worth.
- Selling the business generates cash for the rest of Fred’s life.
- There are no gift considerations for Fred or his estate providing that Fred does not die from a pre-existing condition soon after the transaction commences.
- Fred can keep the business in the family.
- Fred can transform his illiquid business investment into a stream of cash.
- Fred can move the business of his books for possible Medicaid considerations down the road.
- Fred’s estate removes the business asset from probate consideration.
- If Fred has any concerns over asset protection, the business is no longer his to be attachable.
- By selling the business, Fred ensures that the sale to William cannot be contested upon his death.
From William’s perspective, the benefits as follows:
- He knows the asset is his. It is not subject to a will or trust provisions. The deal is structured as a sale and it is permanent.
- William knows precisely what the transaction will cost per year. He does not know for how long he will need to pay, but provided the asset throws off more cash than the payment every year, William should be able to make the payments.
- The payments are fixed for the life of the annuity. There is no cost of living provision. If the asset can at least maintain its profitability in current dollars, the annual payments will essentially shrink by the rate of inflation each year.
- William can sell the asset any time he wants. He is not restricted with a minimum holding period.
- William can borrow against the asset as necessary.
- If Fred should die before his anticipated life expectancy, William will pay less for the asset than anticipated. When Fred dies, the payments stop.
Rules and Regulations
Private annuities are the subject of considerable legislation and IRS rulings. The last major change to the private annuity structure was made in 2009 by Congress. Private annuities have become a staple of estate planners.
The mechanics of the transaction
- The asset to be transferred needs a valuation. As this may be challenged by the IRS, a valuation by someone certified in the field is generally required.
- The buyer and seller must be in a trusting relationship. The seller must trust the buyer to make the payments. The transaction is specifically designed for people with family and long term extended personal relationships.
- Once the valuation is determined, the details of pricing the annuity are defined by IRS regulations. Three pieces of information are required to set the annuity payment:
- The seller’s life expectancy based on the seller’s age.
- The current interest rate
- An annuity factor
The three numbers, plus the valuation of the property, determine the annual payment required for the annuity. The buyer is required to pay the seller at least annually for as long as the seller lives.
Taxation – seller
The income tax implications to the seller are unsettled. This is because the IRS issued proposed regulations in 2006 which changed the traditional tax treatment of these transactions. Because the proposed regulations were never finalized, advisors debate whether they must be followed. Some proposed regulations do carry weight similar to final regulations, while others do not.
- The 2006 proposed regulations
Taxation to the seller under the 2006 proposed regulations is simple – the seller is treated as if he/she sold the asset and used the cash to buy the private annuity. Thus, the seller is taxed on any capital gain that would have been generated by this deemed sale. The amount of the sale is deemed to be equal to the fair market value of the annuity. In other words, the seller is taxed on the difference between the fair market value of the annuity and the seller’s cost basis in the asset transferred, all up front, in the year in which the transaction is made.
Following the transfer, each annuity payment will be taxed to the seller similarly to a commercial annuity, in that it will consist of two parts:
- A return of the seller’s cost basis (which is equal to the deemed selling price as determined above).This is not taxable income to the seller.
- Any excess is considered interest. This is taxable to the seller at ordinary tax rates.
The Internal Revenue Code identifies how to determine the two portions of the annuity payment.
- Revenue Ruling 69-74
Revenue Ruling 69-74, which was the official IRS position prior to the 2006 proposed regulations, instructs taxpayers to take a different approach in determining the seller’s tax treatment. Under this method, so long as the annuity obligation is not secured, the seller does not recognize all the capital gain up-front in the first year. Instead, the capital gain is spread out over the seller’s life expectancy. Therefore, under this method, each annuity payment made to the seller consists of three parts:
- A return of the seller’s cost basis (which is equal to the amount of money invested into the asset by the seller).This is not taxable income to the seller.
- A return of the capital gain (assuming the sale price is greater than the cost basis, which is usually the case).Unless the seller requires collateral, the capital gain is spread over the seller’s life expectancy. This is taxable income at capital gains rates.
- Any remainder is considered interest. This is taxable to the seller at ordinary tax rates.
Revenue Ruling 69-74 also identifies how the three portions of the annuity payment are calculated.
Taxation – buyer
The buyer pays the annual annuity payment each year that the seller is alive. None of the payment is deductible, even the portion that the seller recognizes as interest income.
The seller has no way to know the final cost of the asset he/she has purchased at the time of the transaction. The buyer assumes ‘reverse mortality risk’. That is, if the seller outlives the IRS life expectancy tables upon which the annuity payments are based, then the cost of the asset can exceed its fair market value. Should this situation occur, not only does the buyer overpay for the asset, but the seller may increase any estate tax problem he/she may have tried to solve by selling the asset? This is not a riskless transaction for either party.
The buyer’s basis in the asset purchased is the amount paid to the seller plus the prevent the value of the future payments due if the seller dies before his/her life expectancy. The buyer wants as high a cost basis as possible to minimize capital gains taxes when he/she sells the asset. Under a private annuity strategy, the buyer’s cost basis is never less than the value of the asset (when transferred) and could be higher if the seller lives past his/her life expectancy.
The penalty for failing to account for the full value of the asset in the annuity is to create a gift of the difference. Say an asset is worth $1 million, but the annuity valuation is $850,000. The IRS would treat the $150,000 difference as a gift from the seller to the buyer.
The seller can obtain a life insurance policy on the buyer as he/she has an insurable interest. However, the life insurance policy cannot be a requirement in the contract if the seller is attempting to defer gains under Revenue Ruling 69-74. If it is, then the entire capital gains tax will be incurred in Year 1.
While this article assumes the buyer and seller are people, the buyer and seller can be an LLC, trust, or other legal structure with rights of ownership.
If the asset is not income producing, the seller may have to tap other assets to make the required annuity payment. Most assets sold via a private annuity are income producing assets such as investment properties and privately held businesses.
Disadvantages of a Private Annuity
- The buyer takes on ‘reverse mortality risk’. If the seller lives longer than expected, the buyer could pay considerably more than the fair market value for the asset he/she bought.
- If the buyer stops paying, the seller generally has no collateral. Not only could the seller be left with no income stream, but the IRS could also reclassify the transaction as a gift for tax purposes if the seller does not pursue legal action against the buyer.
- If the seller dies before his/her life expectancy, he/she will receive less than the fair market value of the asset. In most cases, the seller is comfortable assuming this risk as estate maximization was not a goal of the transaction.
- The buyer cannot take an interest deduction for the interest portion of each annuity payment. As a potential offset, the buyer may be able to begin depreciating the asset.
Closely related to the private annuity is the Self-Canceling Installment Note. The principal difference between the private annuity and the SCIN is that payments for the SCIN are set for a fixed period of years. If the seller dies before completion of the payments, the note is considered paid in full.
Comparing the payment terms between a private annuity and a self-canceling installment note, one would immediately favor the SCIN for maximum estate reduction. The IRS has designed the transaction details to equalize the risk/reward between the alternatives.
- A SCIN utilizes a promissory note for a fixed number of years.
- If the seller dies before the term of the note is completed, the buyer has no obligation to continue paying. (It should be obvious that sellers enter into these transactions with the express desire to create a favorable transaction for the buyer.)
- The note must reflect a premium to compensate for the possibility that the seller will possibly collect less than the total loan amount but never more. The expected value of the note is less than the present value of the payment stream. In compensation, the IRS expects that the annual amount paid reflects a premium to a conventional installment loan.
- The seller must make as complete a break with the business as possible. The seller can use the asset as security but may not have an interest in running the business or sharing in its income or growth. A seller with a retained interest could be interpreted by the IRS as an incomplete sale thereby triggering estate taxes.
- The term of the note should be less than the seller’s life expectancy. Otherwise, it will be recharacterized as a private annuity.
Comparing Private Annuities to SCINs
- Security – A private annuity is generally not allowed to collateralize the transaction.SCINs allow for collateral.
- Actuarial Risk – With a private annuity, the buyer assumes ‘reverse mortality risk’. If the seller lives longer than expected, the buyer could pay more than anticipated. With a SCIN, the worst a buyer can do is pay the full price of the asset plus the premium as previously described. The buyer assumes no real risk. The seller and his/her estate assume the risk that they may not be paid in full, though the presumption in entering into the transaction is that this outcome is acceptable.
- Seller Income – Private annuities are designed to provide ongoing income to the seller (and possibly the spouse) for the balance of their lives. SCIN’s transactions intentionally favor the buyer. The seller is assumed to not need the income stream for basic needs.
- Estate Freezing – Both the private annuity and the SCIN eliminate asset growth from the seller’s estate.
- Interest Deduction – With a private annuity, the buyer cannot deduct the interest thereby raising the after-tax cost of the transaction compared to a SCIN or standard installment loan.SCIN payments are structured as standard installment loans. They include identifiable principal and interest. The interest is deductible for the buyer.
- Tax Basis for Buyer – SCINs value the asset at the transaction price upon inception. Private Annuity basis may be more or less than the fair market value of the asset upon inception depending upon the timing of the seller’s death.
- Taxation of Gain – The gain associated with the SCIN is taxed over the term of the note. The treatment of the gain for the private annuity is unsettled, but might be taxed over the life expectancy of the seller.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.