Private Annuity

March 13, 2024

603 / What is a private annuity?

<div class="Section1">A private annuity is an unsecured promise of one person (the obligor) to make fixed payments to another person (the annuitant) for life in return for the transfer of property from the annuitant to the obligor. According to a general counsel memorandum, an unsecured promise to make fixed payments until a stated monetary amount is reached or until the annuitant’s death, whichever occurs first, will be treated as a private annuity (instead of an installment sale with a contingent price) if the stated monetary amount would not be received by the annuitant before the expiration of his or her life expectancy (as determined under the appropriate annuity table and as determined at the time of the agreement).<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> A private annuity must be distinguished from a commercial annuity issued by a life insurance company and from an annuity payable by an organization (e.g., a charity) that issues annuities “from time to time” ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="607">607</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="609">609</a>). The typical private annuity involves the transfer of appreciated property (usually a capital asset) from parents or grandparents to one or more children or grandchildren who make annuity payments in return. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     GCM 39503 (5-7-86). </div></div>

March 13, 2024

604 / How are payments received under a private annuity issued after October 18, 2006 taxed?

<div class="Section1">Proposed regulations, which are currently in effect, have dramatically altered the tax treatment of private annuities. Under the current rules, the receipt of an annuity contract for property will be treated as the receipt of property in an amount equal to the fair market value of the annuity contract.<a href="#_ftn1" name="_ftnref1">1</a> The fair market value of an annuity contract is determined under the rules of IRC Section 7520 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>). Therefore, all of the gain on the property will be recognized at the time of the exchange. The private annuity’s investment in the contract will be the amount paid for the contract. Thus, where the value of the property exchanged and the value of the annuity are the same, the investment in the contract will be the fair market value of the property exchanged for the private annuity. <hr> Planning Point: The general outcome of these rules is that subsequent payments will still be taxable to the payee under the rules for amounts received as an annuity, but the investment in the contract will be based on the fair market value of the property received in exchange for the annuity contract.<a href="#_ftn2" name="_ftnref2">2</a> <hr> These proposed regulations were intended to be effective for exchanges of property for private annuity contracts that occur after October 18, 2006. For certain transactions, however, the proposal was for a later effective date for transactions occurring after April 18, 2007. This delayed effective date was for exchanges where: (1) the issuer of the annuity is an individual; (2) the obligations under the contract are not secured; and (3) the property transferred in the exchange is not sold or otherwise disposed of during the two year period beginning on the date of the exchange. A disposition includes a transfer to a trust or any other entity, even if wholly owned by the transferor. For tax consequences to the obligor, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="606">606</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     Prop. Treas. Reg. §§ 1.1001-1(j); 1.72-6(e). <a href="#_ftnref2" name="_ftn2">2</a>.     Prop. Treas. Reg. § 1.72-6(e). </div></div>

March 13, 2024

606 / What are the tax consequences to the obligor in a private annuity transaction?

<div class="Section1">Annuity payments made by the obligor are treated as capital expenditures for the acquisition of the property. No interest deduction is allowed with respect to the payments.<a href="#_ftn1" name="_ftnref1">1</a> Depreciation deductions may be taken, however, if the property is depreciable. The initial basis for depreciation is the present value of the annuity, as determined by the appropriate Estate and Gift Tax Valuation Tables ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>). When actual payments exceed the initial basis, the basis for depreciation is the actual payments made less prior depreciation.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> When payments exceed the initial basis, loss is not deductible until the property is sold.<a href="#_ftn3" name="_ftnref3">3</a> If the property is sold after the annuitant’s death, the obligor’s basis for determining gain or loss is the total of annuity payments made less depreciation taken, if any. If the property is sold before the annuitant’s death, the obligor’s basis for gain is the total payments actually made plus the actuarial value, as of the date of sale, of payments to be made in the future. The obligor’s basis for loss is the total amount of payments made as of the date of sale. If the selling price is less than the basis for gain but more than the basis for loss, the obligor realizes neither gain nor loss. Adjustment for annuity payments made after the sale may be made by deducting loss or by reporting additional gain.<a href="#_ftn4" name="_ftnref4">4</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     Garvey, Inc. v. U.S., 1 Cl Ct. 108, 83-1 USTC ¶ 9163 (U.S. Cl. Ct. 1983), aff’d, 84-1 USTC ¶ 9214 (Fed Cir.), cert. denied, 469 U.S. 823 (1984); Bell v. Commissioner, 76 TC 232 (1981). <a href="#_ftnref2" name="_ftn2">2</a>.     Rev. Rul. 55-119, 1955-1 CB 352. <a href="#_ftnref3" name="_ftn3">3</a>.     Perkins v. U.S., 701 F.2d 771, 83-1 USTC ¶ 9250 (9th Cir. 1983). <a href="#_ftnref4" name="_ftn4">4</a>.     Rev. Rul. 55-119, supra. </div></div>

March 13, 2024

605 / How are payments taxed that are received under a private annuity issued before October 19, 2006?

<div class="Section1">The basic rules for taxing the payments received by the annuitant under a private life annuity issued before October 19, 2006, are set forth in Revenue Ruling 69-74.<a href="#_ftn1" name="_ftnref1">1</a> According to this ruling, the payments must be divided into three elements: (1) a “recovery of basis” element; (2) a “gain element” eligible for capital gain treatment for the period of the annuitant’s life expectancy, but taxable as ordinary income thereafter; and (3) an “annuity element” that is taxable as ordinary income. Each of these is discussed below.<div class="Section1"> <blockquote>(1)     The portion of each payment that is to be excluded from gross income as a recovery of basis is determined by applying the basic annuity rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a>). Thus, an exclusion percentage is obtained by dividing the investment in the contract by the expected return under the contract. The investment in the contract in a private annuity situation is the adjusted basis of the property transferred. If the adjusted basis of the property transferred is greater than the present value of the annuity, the annuitant’s investment in the contract for purposes of IRC Section 72(b) is the present value of the annuity on the date of the exchange.<a href="#_ftn2" name="_ftnref2">2</a> Expected return and annuity starting date are the same as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="534">534</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="536">536</a>.Thus, expected return is obtained by multiplying one year’s annuity payments by the appropriate multiple from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made.</blockquote> If the annuity starting date is before January 1, 1987, the amount calculated to be excludable from income as a recovery of basis (as explained above) is excluded from all payments received, even if the annuitant outlives his or her life expectancy. If the annuity starting date is after December 31, 1986, then the exclusion percentage is applied only to payments received until the investment in the contract is recovered. Thereafter, the portion excludable under the percentage is included as ordinary income.<a href="#_ftn3" name="_ftnref3">3</a> <blockquote>(2)     The capital gain portion, if any, is determined by dividing the gain by the life expectancy of the annuitant. Gain is the excess of the present value of the annuity (it may not be the same as the fair market value of the property) over the adjusted basis of the property. The present value of the annuity is obtained from the Estate and Gift Tax Valuation Tables (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>). The life expectancy of the annuitant is obtained from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made. This portion is reportable as capital gain for the period of the annuitant’s life expectancy, and thereafter as ordinary income. Recovery of capital gain may not be deferred until the entire investment in the contract has been recovered.<a href="#_ftn4" name="_ftnref4">4</a> (3)     The remaining portion of each payment is ordinary income.</blockquote> If the fair market value of the property transferred exceeds the present value of the annuity (as determined from the applicable Estate and Gift Tax Valuation Tables), the difference is treated as a gift to the obligor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="586">586</a>).<a href="#_ftn5" name="_ftnref5">5</a> <blockquote>Example. Mrs. White is a widow, age 66, with two adult children. She owns a rental property with an adjusted basis of $30,000 and a fair market value of $135,000. On January 1, she transfers this building to her children in exchange for their unsecured promise to pay her $1,000 a month ($12,000 a year) for life beginning January 31.</blockquote> Assume that the valuation table interest rate for January is 5.0 percent. Therefore, the present value of the annuity equals $126,078: $12,000 × 10.2733 (annuity factor) × 1.0227 (annuity adjustment factor). The fair market value of the property exceeds the present value of the annuity by $8,922: $135,000 – $126,078. This is a gift by Mrs. White to her children and subject to gift tax. Mrs. White’s life expectancy is 19.2 years. <blockquote>(1)     Mrs. White will exclude from gross income as a recovery of basis $130, or 13 percent of each payment (until she recovers $30,000, because her annuity starting date is after December 31, 1986). The 13 percent exclusion percentage is obtained by dividing $30,000 (investment in the contract) by $230,400 (expected return: 19.2 × $12,000) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="537">537</a>). (2)     She will report $417 of each payment as capital gain for 19.2 years. This portion is obtained by dividing her gain of $96,078 (excess of present value of annuity [$126,078] over adjusted basis of the property [$30,000]) by 19.2, her life expectancy ($96,078 ÷ 19.2 = $5,004 a year or $417 a month). After 19.2 years, she will report this $417 as ordinary income. (3)     She will report the balance of each payment, or $453 ($1,000 – ($130 + $417)) as ordinary income. (Because her annuity starting date is after December 31, 1986, she also will report as ordinary income the portion of each payment no longer excludable as recovery of capital after her investment in the contract has been recovered.)</blockquote> In Katz v. Commissioner, the Tax Court held that a taxpayer who had exchanged shares of common stock and put options for a private annuity (on February 3, 2000) was entitled to defer recognition of capital gain relating to the transfer until the taxpayer received annuity payments.<a href="#_ftn6" name="_ftnref6">6</a> According to the Tax Court, Revenue Ruling 69-74 is not applicable if the promise to pay the annuity is secured; securing the promise will cause the entire capital gain on the transfer of the property to be taxable to the annuitant in the year of transfer. The investment in the contract would be the present value of the annuity, but not more than the fair market value of the property transferred.<a href="#_ftn7" name="_ftnref7">7</a> In a private letter ruling, a private annuity arrangement was still taxed as such despite the presence of a cost-of-living adjustment applicable to the monthly annuity payments and a minimum payment provision that stated that if the annuitant had not received a specified dollar amount prior to her death, the remaining amount would be paid to her estate. The annuitant also had the option to accelerate the payments and receive a lump sum amount equal to the minimum payment amount less annuity payments previously received.<a href="#_ftn8" name="_ftnref8">8</a> When a private annuity became worthless, the determination that the loss was a capital loss and not an ordinary loss was upheld in McIngvale v. Commissioner.<a href="#_ftn9" name="_ftnref9">9</a> Whether a transfer to a trust will be treated as a sale in exchange for a private annuity or a transfer in trust with a right to income retained depends on the circumstances in the case. Properly done, a transfer to a trust will be treated as a private annuity transaction.<a href="#_ftn10" name="_ftnref10">10</a> However, purported transfers in trust were found to be sham transactions in Horstmier v. Commissioner.<a href="#_ftn11" name="_ftnref11">11</a> Amounts received under a private annuity contract are not subject to withholding because such amounts are not paid under a “commercial annuity,” that is, one issued by a licensed insurance company. For estate tax implications of a private annuity, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="630">630</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       1969-1 CB 43. <a href="#_ftnref2" name="_ftn2">2</a>.       LaFargue v. Commissioner, 800 F.2d 936, 86-2 USTC ¶ 9715 (9th Cir. 1986), aff’g, TC Memo 1985-90; Benson v. Commissioner, 80 TC 789 (1983). <a href="#_ftnref3" name="_ftn3">3</a>.       IRC § 72(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>.       Garvey, Inc. v. U.S., 1 Cl. Ct. 108, 83-1 USTC ¶ 9163 (U.S. Cl. Ct. 1983), aff’d, 726 F.2d 1569, 84-1 USTC ¶ 9214 (Fed. Cir. 1984), cert. denied. <a href="#_ftnref5" name="_ftn5">5</a>.       Benson v. Commissioner, supra; LaFargue v. Commissioner, supra. <a href="#_ftnref6" name="_ftn6">6</a>.       Katz v. Commissioner, TC Memo 2008-269, citing Rev. Rul. 69-74, 1969-1 CB 43. <a href="#_ftnref7" name="_ftn7">7</a>.       Estate of Bell v. Commissioner, 60 TC 469 (1973); 212 Corp. v. Commissioner, 70 TC 788 (1978). <a href="#_ftnref8" name="_ftn8">8</a>.       Let. Rul. 9009064. <a href="#_ftnref9" name="_ftn9">9</a>.       936 F.2d 833 (5th Cir. 1991), aff’g, TC Memo 1990-340. <a href="#_ftnref10" name="_ftn10">10</a>.     Estate of Fabric v. Commissioner, 83 TC 932 (1984); Stern v. Commissioner, 747 F.2d 555, 84-2 USTC ¶ 9949 (9th Cir. 1984); LaFargue v. Commissioner, 689 F.2d 845, 50 AFTR 2d 5944 (9th Cir. 1982) (followed by the Tax Court in Benson v. Commissioner, supra, because an appeal would go to the Ninth Circuit). <a href="#_ftnref11" name="_ftn11">11</a>.     TC Memo 1983-409. </div></div>