A private annuity is an annuity contract issued by an individual rather than a commercial insurance company. In the past, it was used most often to transfer appreciated property to family members. There is every reason to suggest it may be as effective for transferring cash from a cash rich estate, to assure income and for saving on estate taxes.

As a contract, a private annuity is quite simple. 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. The annuitant cannot be in imminent danger of death, nor can the annuity contract be collateralized or otherwise secured. If it is known on the valuation date that the annuitant will die from an illness in a very short time, the value of the annuity is based on that fact.

The value of the contract is based upon the IRS published interest rates and life expectancy tables as provided in IRC Sec. 72. The present value of the annuity contract is then calculated using the annuity payment amount, the interest rate, and the annuity factor. Any difference between the consideration paid by the annuitant and the value of the contract is considered a gift.

Exhibit I assumes a transfer of $100,000 by a 70 year old individual for a $12,200 yearly annuity and compares it with the same amount in the individual estate. The unilife life expectancy for the annuity is 16 years and the interest rate is 9.6%. The annuity factor 6.558 is calculated from IRC Table R(l) by dividing .096 into (1-.37043), where .37043 is the single life remainder factor and .096 is the interest rate.

The difference between the present value of the annuity and the $100,000 is considered a $19,992 gift. The gift portion of this transfer should be handled separately from the annui.ty portion. However, both are illustrated here because the financial impact is the same. No gift tax should be payable if the gift portion qualifies for the annual gift exclusion.

The investment return is assumed to be 8.51%. Income taxes are calculated using a rate of 31% for the transferor and 28% for the transferee.

If no annuity is taken, and using the fifth year, the estate would have paid $66,487 in estate taxes on $132,973 left in the estate (columns 10 & 9 ). If the annuity were used and the transferor died in the fifth year, the annuitant would have to pay $5,322 income taxes on the gain (column 3), the transferor would get a deduction on the final return producing a tax benefit of $17,052 (column 7), and the estate would pay taxes of $30,031 (column 6).

Total taxes under the annuity alternative would be $18,302 ($5,322 plus $30,032 less $17,052), compared to estate taxes without the annuity of $66,487, a savings of $48,185. The difference between the tax savings of $48,185 and the net benefit of $40,919 in column 11 is due to the fact that the IRS requires the use of a 9.6% interest factor which is higher than the assumed investment return of 8.5%. This results in a lower exclusion ratio and more of the annuity payment being taxed to the transferor.

The transferee receives no immediate tax benefit from paying the yearly annuity since under IRC Sec. 1012 the payments are considered a purchase of property. If the annuitant dies before receiving the full $80,008, the transferee has an underwriting gain which is subject to tax. Once the transferee has paid the annuitant more than the value received, a loss on the contract occurs and the transferee is entitled to deduct the loss on the current tax return as a loss from an activity entered into for profit under IRC Sec. 165.

The annuitant needs to pay tax on the taxable portion of the annual annuity, which again is computed based upon the present value of the contract. If the annuitant dies before the normal life expectancy, he or she is entitled to a tax deduction on the final tax return for the unrecovered basis in the contract under IRC Sec. 72(b)(3). Column 5 shows that the transferor's estate starts growing again once the annuity payments are received. By the fourteenth year there is $222,403 (column 5) in the estate assuming the annuitant does not use any of the annuity payments.

Start All Over Again

A private annuity contract could again be made at the end of the 14 years, thereby transferring the $222,403 to the transferee and starting the process all over.

While the regulations require the use of a unisex lffe expectancy to calculate the annual amount of the annuity to be excluded, the real life expectancy of the individual may be somewhat lower. For example, the actual life expectancy of a 70 year old male is 12.1 years and a 70 year old female is 15.0 years.

The annuity contract might also provide that the annuity will be payable for life or a specified number of years. This temporary annuity gives protection to the transferee and can have almost all the financial benefits shown on the example for someone who is age 70. (However, as the person's age increases, the percentage difference between the expected return multiple for a life annuity and a temporary annuity increases significantly, so it is not as beneficial as the person gets older).

Since the estate tax rates exceed income tax rates, there is an opportunity with the private annuity to reduce overall taxes. It has more benefit in the early years of the contract if the annuitant dies and lessens as the annuity contract gets older. However, there appears to be little risk in taking out a second annuity if the annuitant lives as long as originally projected, provided the cash is available in the estate.

EXHIBIT1

EXAMPLEOFAPRIVATEANNUITYOF$100,000

Facts:

Valuetransferred...................100,000

Yearly.annuity........................12,200

Transferee'sage...........................70

Lifeexpectancy..........................16.0

Basis,presentvalue..................80,008

Capitalgain.................................0

Valueofgift..........................19,992

Exclusion...............................5,000

Taxableannui,ty........................7,200

Annualcapitalgain.........................0

Annualtaxannuity......................2,232

Transfereetaxrate......................28%

Transferortaxrate......................31%

Capitalgainsrate.......................28%

Estatetaxrate..........................50%

Annuityfactor.......................6.5580

Annuityinterest........................9.6%

Invest.return..........................8.5%

After-Taxreturn:...........................

Transferee.............................6.12%

Transferor.............................5.87%

Year051014

1.Transferee

Growth100,00065,64419,408(28,852)

2.Transferee

Basis061,000122,000170,800

3.Transferee

TaxBenefit(22,402)(5,322)12,69231,067

4.Transferee

NetCashFlow(1+3)77,59860,32232,1002,215

5.Transferor

AnnualGrowth060,063139,930222,403

6.AfterEstateTax030,03169,965111,202

7.TransferorTax

BenefitonBasis24,80217,0529,3013,100

8.CombinedNet

Wealth102,400107,405111,366116,517

9.Basis+Return*100,000132,973176,817222,092

10.AfterEstate

Tax*50,00066,48788,409111,046

11.Benefit(8-10)*52,40040,91822,9575,471

*NoAnnuity

Row Descriptions:

1. Amount transferee has remaining after paying yearly annuity and assuming the stated investment return.

2. The transferee's basis in the contract increases each year as payments are made.

3. Transferee's income taxes paid or saved if the annuitant dies in that year.

4. The addition of columns 1 and 3.

5. The growth in the annuitant's estate after paying tax on the taxable partion.

6. The amount remaining in the annuitant's estate after paying estate taxes an the amount in column 5.

7. The tax benefit annuitant receives on final tax return if he dies before recovering total contract investment.

8. The addition of columns 4, 6 and 7.

9. The amount in the estate assuming a private annuity is not purchased and assuming the stated investment return.

10. The amount remaining in the estate after paying estate taxes on the amount in column 9.

11 Column 8 reduced by column 1 O, i.e., net savings.