Editor's Note: The IRS and Treasury Department have enacted regulations that severely limit the effectiveness and use of private annuity trusts as an income and estate planning strategy. The regulation covers all private annuity trusts created after October 18, 2006. All trusts created before this date are grandfathered and will continue to receive the tax benefits of the trust.
The biggest change is the elimination of the deferral of capital gains taxes on all future private annuities. Without that feature, many individuals will be forced to look at other strategies to determine what would be best for their situations. Therefore, before you implement any strategy discussed in this article, be sure to consult a legal and tax professional.
Do you own a highly appreciated asset that you have put off selling? Maybe you wish it produced more income? Do you have an asset that makes up a significant portion of your net worth, prompting you to think that you need greater diversification? In any one of these cases, you would have to sell the investment to accomplish your goals. But selling comes with a cost - namely, paying capital gains tax. One way to get around the tax is to hold on to the investment until you die. Then your beneficiaries could take advantage of the step-up in basis provision and eliminate the capital gains tax altogether. But what if you want to remove that asset from your taxable estate as well as receive more income? Here we'll look at the private annuity trust, a tool that can help you to spread capital gains taxation out over many years, avoid gift and estate taxes, and gain some income in the process.
How the Process Works
A private annuity is not a product that you can purchase. Rather, it is a process in which an annuitant exchanges an asset - for instance, some securities or a family business - for a lifetime annuity income. This arrangement is between two parties, neither of which is an insurance company. It is established by contract and frequently exists between family members. (To learn more about annuities, see An Overview Of Annuities.)
The issuer of the contract agrees to pay the annuitant a periodic payment for the annuitant's life in exchange for a payment of cash or for the transfer of property to a trust. The payment period can extend over the life of the annuitant's spouse as well. The annuitant receives the entire principal and all of the accrued interest under actuarial assumptions. In other words, the annuitant is given "full and adequate consideration" for the property over his or her lifetime. Therefore, the property transfer to a trust is not a gift and is not subject to gift taxation. Furthermore, when the annuitant dies, there are no estate taxes because the property was sold.
Setting It Up
If you are interested in this kind of private annuity arrangement, the first thing you need to do is set up a trust and list the beneficiaries. Then, whatever asset you want to remove from your taxable estate is transferred to the trust. In exchange for that asset (or assets), the trust gives you a private, lifetime annuity contract.
Next, the trust sells the asset to a third party without incurring an income tax liability because the sales price is the same as the purchase price. Finally, the proceeds are reinvested as directed by the trustee, and earnings within the trust accumulate tax-deferred until money is withdrawn.
You can think of the private annuity arrangement as a type of insurance policy for your gift and estate tax planning. As long as you - the annuitant - are alive, you will continue to receive payments to help with living expenses, but the balance of the annuity property is out of estate. (For further reading, see Getting Started On Your Estate Plan.)
What the Annuitant Gets
When you transfer your assets to another party through a private annuity trust, you as the annuitant can expect to receive the asset sales price and income which is determined based on IRS life expectancy and interest rate tables. Therefore, the longer you wait to begin the payments, the larger they will be. As long as you are under age 70.5, you can start receiving income from the trust whenever you wish. However, payments must begin by age 70.5. The amount of income you receive is fixed, but if you need more money, you can borrow from the trust.
Part of each payment is a return of the original cost basis, and is therefore tax-free. Part of it is the capital gains from the sale, and it is taxed at the capital gains rate. And the balance of the payment consists of earnings within the trust, taxed as ordinary income. If you live beyond your life expectancy, you will have received all of your cost basis and capital gains. Future payments will then be treated as ordinary income.
The private annuity trust's cash flow will stop when there is no more money, or when you die. And if you die before the trust is depleted, whatever remains will go to your beneficiaries without estate or gift tax liability. Plus, it avoids probate. (For further reading, see Skipping Out On Probate Costs.)
Here are a few of the situations in which someone might consider a private annuity:
- A business owner wants to retire and shift control to a key employee or family member without facing a large income tax liability.
- An investor wants to remove a sizable asset from his or her estate.
- A grandparent wants to give an asset to a grandchild and avoid the generation-skipping transfer tax.
- An investor wants to convert non-income producing real estate into assets that provide a regular income without paying a lot of capital gains tax.
A private annuity can help you reduce taxes (income, estate and gift), receive a steady income and diversity your portfolio. But before you give up your rights to your property to save tax dollars, there are a few points to keep in mind. First, once payments begin, they cannot be changed. Second, the capital gains tax rate could increase in the future. Therefore, you could end up paying higher tax rates on part of your annuity payment than you would if you just paid the tax today.
Finally, it is important to know that you cannot serve as the trustee of the private annuity trust, nor can you have any control over the trust's management. Furthermore, a private annuity trust is irrevocable, so make sure you've done your homework before you enter into this kind of arrangement.