Taxation of Annuities


The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13.61 million.
For individuals that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the estate and gift tax. One method that may potentially be utilized to plan for the estate and gift tax are private annuities. This article discusses how private annuities may be utilized to avoid the estate and gift tax.
Introduction
A private annuity is a transaction in which one individual sells another individual an item of property in exchange for an annuity, often measured by the seller’s lifetime. The annuity must be unsecured to avoid immediate taxation of gain arising from the sale. The seller can retain no interest in the transferred property, nor should payment of the annuity be tied to income from the property.
The following example will be used in this article to explain the effects of a private annuity.
Let’s assume that Mom sells real property to her Son in exchange for Son’s promise to pay her $100,000 per year for the remainder of her life. At the time of the sale, Mom is 51 years old, and the 7520 rate is 8.2 percent. The “7520 rate” is 120 percent of the applicable federal midterm rate, rounded to the nearest 2/10 of one percent. See IRC Section 7520.
If the value of Son’s promise (according to the tables issued under Internal Revenue Code Section 7520) equals the value of the real property transferred by Mom to Son, Mom does not make a taxable gift to Son. And, when Mom dies, the real property is not included in her estate for purposes of the estate tax.
The actuarial tables are very important to determine if it makes sense to utilize a private annuity. The use of a private annuity is considered a “good deal” if the transferred asset is expected to outperform the 7520 rate at the date of the sale. For example, let’s assume that the real property Mom transferred to Son value has increased by 10 percent each year. If the real property is worth $999,450 at the time the private annuity transaction is entered into, and Mom lives for 5 years, she will have excluded property worth $1,606,624 from her estate for purposes of the estate tax at the cost of including $589,004 in her estate for estate tax purposes (assuming Mom reinvested each of her $100,000 annuity payments and earned the 7520 rate (8.2 percent)).
When the annuitant has a shorter life expectancy than indicated in the actuarial tables. The other situation that calls for consideration of a private annuity is one in which a person is not expected to live for his or her full life expectancy, but whose life expectancy may still be valued under the actuarial tables.
A determination of whether Mom has made a gift on the initial sale will depend on her life expectancy at the time. For instance, if the real property transferred by Mom to Son is worth $3,997,800 and Mom sells it to Son in exchange for an annuity of $400,000 a year for Mom’s life. Mom’s life expectancy according to the tables is 30 years, but Mom has advanced cancer and is only expected to live for five years. Mom still can use the tables. However, the probability is that only five payments will be made. If, in fact, Mom dies after receiving only five payments, Mom will have made a transfer gift tax free of $1,997,800 ($3,997,800 less $2,000,000).
Potential Gift Tax Consequences of a Private Annuity
In order for a private annuity transaction to avoid gift tax consequences, annual payments to acquire property being transferred through an annuity transaction will need to be higher than they would have been under an installment sale for a term exactly equaling the seller’s life expectancy. This is so because the parties must account for the possibility that the seller will die during the term and for the fact that the annuity is discounted at the Section 7520 rate.
Potential Estate Tax Consequences of a Private Annuity
If no gift is made at the outset, and the annuity terminates on the transferor’s death, the original property that the seller sold in exchange for the annuity will not be includable in his or her estate at death, since the seller’s interest vanishes at that time. However, any annuity payments (and income or appreciation) which the seller has received but not consumed will be includable in his or her estate. If the private annuity agreement contemplates payments to a beneficiary who survives the seller, the value of the remaining payments due to the beneficiary will be includable in the seller’s estate for purposes of the estate tax.
Income Tax Consequences to the Seller
The income tax consequences to the seller are set out in Revenue Ruling 69-74 and Internal Revenue Code 72. Each payment is divided into three elements: recovery of basis, gain, and interest (called the annuity element). Revenue Ruling 69-74 provides that the portion of each payment which will be treated as a nontaxable recovery of basis (the “excluded portion”) is the “investment in the contract” divided by the “expected return on the contract.” Under the ruling, the “investment in the contract” is the adjusted basis of the property sold (or the present value of the annuity, if less than the basis). The “expected return” is obtained from the annuity tables under Internal Revenue Code Section 72 by multiplying one year’s annuity payments by the life expectancy multiplied provided in tables discussed in Treasury Regulation Section 1.72-9. The capital gain portion of a payment is the amount of gain divided by the annuitant’s life expectancy on the date of the sale. The amount of gain is the excess of the present value of the annuity over the adjusted basis of the property.
Conclusion
The use of a private annuity transaction may be a valuable tool for estate and gift tax planning. The use of a private annuity is not a one-size fits all transaction. Careful consideration must be given to each case to determine if a private annuity can be used to reduce or eliminate estate or gift.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
