Private Annuities Can Still Save Estate Taxes

By Sol Schwartz, CPA, CSEP, Sol Schwartz & Associates, P.C., San Antonio, TX

Editor: Michael D. Koppel, CPA, PFS

In October 2006, the IRS issued Prop. Regs. Secs. 1.72-6(e) and 1.1001-1(j), which propose to substantially reduce the income tax benefits of private annuities (REG-141901-05). Basically, the proposed regulations require the annuitant (the person transferring the property) to recognize the entire gain or loss on the transferred property immediately on entering into an annuity contract. In the past, under Rev. Rul. 69-74, this gain was spread over the life expectancy as the obligor made annuity payments. Under the proposed regulations, the gain is measured on the difference be-tween the annuity contract’s fair market value (FMV) determined under Sec. 7520 at the time of the exchange and the taxpayer’s basis in the property transferred. This gain is added to the annuity’s tax basis for purposes of computing the annuitant’s investment in the contract. As a result, only a portion of the annuity payments made in the future would be subject to ordinary income tax rates because the capital gain portion has already been recognized.

Without this big tax benefit, one would think that private annuities would no longer be beneficial. However, there still can be an estate tax savings.

Example: D has an estate worth $3 million, with the lifetime exemption of $2 million (for 2007) still intact. The estate tax would be $450,000 (at the 2007 tax rate of 45%). D acquires bonds for $1 million. He then transfers these to his heirs for a private annuity valued under Sec. 7520 so that the annuity’s value equals the value of the assets. Before dying, D receives only $100,000 of payments from the annuity, which were unspent at the time of D’s death and on which there would be an estate tax of $45,000. The estate tax savings would be $405,000. The obligor would have a tax basis of $45,000 in assets worth $1 million, which, when sold as a long-term capital gain, would be taxed at 15%, or $143,250, giving the family a net tax savings of $261,750.

The problem, of course, is not knowing when the annuitant will die. In addition, a private annuity does not work for persons who do not have at least a 50% chance of living for one year. Persons known to have an incurable illness or other deteriorating physical condition should obtain a written opinion from a physician stating that they have at least a 50% chance of surviving for 12 months. If the individual survives for at least 18 months after the date of the transaction, that individual is presumed not to have been terminally ill unless the contrary is established by clear and convincing evidence (Regs. Secs. 1.7520-3(b)(3) and 20.7520-3(b)(3)).

Like any tax planning, the facts must support the proper tax treatment, but private annuities should not be dismissed without exploring possible tax benefits.

If you would like additional information about these items, contact Mr. Koppel at (781) 407-0300 or
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