Sale for a Private Annuity Case Study
Estate Plan Concerns
Susan owns an asset worth $1,000,000, which is expected to generate high levels of income and appreciation for the foreseeable future, resulting in a total after-tax annual return of 15%.
► Asset Generates Income; Would Use Entire Gift Exemption
Understanding that the value of this asset will be includible in her taxable estate tax purposes if she owns it at the time of her death, Susan really likes the idea of gifting the asset, now, to her son, Mark. However, she hesitates to do this because she isn’t comfortable giving up all the income that the asset could provide for her. Moreover, she has been informed that the gift would constitute a $1,000,000 taxable gift for gift tax purposes, requiring her to use her entire gift tax exemption to shelter the gift from federal gift tax.
► Desire to Reduce Gift Tax and Retain Income
Susan wonders whether there might be a way to move the asset out of her taxable estate at a low gift tax value, while she continues to enjoy an annual income.
Estate Plan Solution
After consulting with her advisor, Susan decides to use an estate planning technique known as a "Sale for a Private Annuity," in which Susan will sell the asset to her son , Mark, in return for Mark's promise to pay her a specified annuity payable annually for as long as she lives.
Sale for a Private Annuity Process
- Susan and her son, Mark, enter into an agreement in which Susan will sell the asset to Mark in return for his promise to pay her an annual annuity for as long as she lives.
- Susan sells the asset to Mark. Because the transfer is a sale, it is not treated as a gift for federal gift tax purposes. Consequently, it is not necessary to use any of Susan’s gift tax exemption.
- Mark pays Susan an annual annuity equal to $94,796. For income tax purposes, the annuity is treated as part tax free return of her original investment; part taxable as capital gain (eligible for preferential capital gains tax if asset was held for more than a year); and part taxable as ordinary income (the “annuity” element). No portion of the annuity payment is tax deductible by Mark.
- At Susan’s death, the annuity automatically ceases and Mark owns the asset. The value of the asset, including all appreciation in value, escapes inclusion in Susan’s taxable estate and thereby avoids estate taxes.
- No Gift and Estate Tax: Asset can be transferred to succeeding generations free of gift and estate tax
- Preserves Exemptions and Exclusions: Allows donor to transfer wealth without the need to use gift tax exemptions and exclusions.
- Fixed Income Continues: Donor receives a continuing fixed income after the asset is transferred.
- Possible Income Tax Elimination: Income tax consequences of sale may be eliminated with use of a trust that qualifies as a "defective" grantor income trust for federal income tax purposes.
- Integrates with Other Formulas: This technique can be used with other estate planning techniques to enhance overall asset transfer benefits.
A Sale for a Private Annuity is an estate planning technique that allows an individual to transfer wealth gift and estate tax free to his or her family.
► Asset Sale Includes Annual Annuity
Generally, this result is accomplished by the sale of a selected asset to another person (e.g., the seller’s child) in return for an annuity (payable annually or more frequently) that will be paid to the seller for as long as he or she lives. If the sale is properly structured as an arm’s length transaction, there will be no adverse gift tax or estate tax consequences. Note that in a Private Annuity the asset cannot be pledged to the seller as collateral to secure the payment of the annuity. Consequently, the seller must rely on the “credit worthiness” of the buyer for future annuity payments.
► Seller's Estate Does Not Include Asset or Annuity
At the seller’s death, the asset (including all capital appreciation) that was transferred to the buyer escapes inclusion in his or her gross estate for federal estate tax purposes. Also, no value from the annuity is includible in the gross estate because it was structured as a "life only" annuity that terminates at death.
► Capital Gains Tax Limited
For income tax purposes the seller will not recognize taxable gain at the time of the sale. Instead, any gain from the sale of the asset will be recognized over the life expectancy of the seller as the annuity payments are received. Generally, each annuity payment would be treated as part tax free return of the seller’s original investment; part taxable as capital gain (eligible for preferential capital gains tax if asset was held for more than a year); and part taxable as ordinary income (the "annuity" element). After the seller’s tax free investment and taxable capital gain have been accounted for (at life expectancy), all future annuity payments would be fully taxable as ordinary income. No portion of the annuity payment would be tax deductible by the buyer.
► Irrevocable Trust Can Neutralized Income Tax Liability
It may be possible to neutralize the income tax consequences of the transaction through use of an irrevocable trust that qualifies as a so-called "defective" grantor income trust for federal income tax purposes. Generally, this technique would involve the sale of the asset to the trust, instead of to a child of the seller. This strategy could eliminate income tax on the annuity payments, but would require the seller income tax on all taxable income of the trust (which can be a beneficial wealth transfer technique).
► Calculations Will Vary According to Current Market
Unless otherwise stated, actuarial calculations are based on the assumptions that the client is 65 years old and the Applicable Federal Rate (AFR) is 5.00%.
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