Private annuities and self-canceling installment notes. (Estates & Trusts)by Zerah, Richard S.
The use of private annuities and self canceling installment notes (SCIN), ff structured properly, can achieve all the above desired results. Generally, these planning devices are used for transferring assets to family members, relieving the transferee of his or her obligation to the transferor upon the transferor's death. This technique, however, is not limited to transfers to related individuals.
Despite the many similarities between the two instruments, private annuities and SCIN's differ in such respects as income tax ramifications, basis in the hands of the transferee, security rights in the assets transferred, and potential duration.
Private annuities and SCIN's share certain characteristics. With a private annuity, the transferor (annuitant) transfers complete ownership of property to the transferee (obligor of payments). Traditionally, the transferee promises to pay the transferor for the transferor's lifetime, or the joint lifetime of the transferor and the transferor's spouse.
Similarly, with a SCIN, the transferor transfers complete ownership of the property to the transferee in exchange for an installment obligation. The SCIN has a fixed term which is less than the life expectancy of the transferor. In addition, the debt instrument contains a provision that automatically voids all future payment obligations at the transferor's death (this cancellation feature distinguishes itself from the traditional installment obligation, which requires payments for a fixed term irrespective of the transferor's death).
Estate Tax Treatment. One advantage associated with SCIN's and private annuities is the ability to avoid estate taxes at the death of the transferor. When considering SCIN's, the Tax Court has held that if the installment obligation instrument itself contains a cancellation provision as part of its agreed upon terms negotiated at arms length for adequate consideration, there is no interest remaining in the notes at the death of the transferor(Estate of Moss, (1980) 74 TC 1239). The Tax Court, however, has held that if the note is merely canceled by a provision in the decedent's will, or the will bequeaths the unpaid balance to the obligor, the Note will be includable in the decedent's gross estate (Estate of Buckwalter (1966) 46 TC 805).
As for private annuities, payments over a single life will escape estate taxes, since the taxable estate only includes property in which the decedent had an interest or which was beneficially owned by him at the time of death. If payments are made over joint lives, the present value of the remaining payments (based on the life expectancy of the surviving spouse) will be includable in the decedent's (annuitant's) gross estate. Present value is determined by using the actuarial tables in IRC Sec. 7520 and interest rates equal to 120% of the midterm applicable Federal rates (AFR). The use of the marital deduction, however, would eliminate estate tax on the value of the annuity in the decedent's estate.
Gift Tax Treatment. Gift tax considerations enter into the picture when property is transferred at less than fair market value. For private annuities, a gift is deemed to be made to the extent the present value of the annuity is less than the fair market value of the asset transferred. The potential for gift tax with SCIN's is less common, since the obligation and purchase price is ostensibly negotiated and bargained for at arms length. However, to the extent the obligation is less than the transferred asset's fair market value, a gift tax is assessed. In addition, due to the possibility of the premature death of the transferor, a risk premium should be bargained for at arms length in establishing fair market value. This premium can either be in the form of an increased selling price, or through the use of above-market interest rates.
It appears that both private annuities and SCIN's stay clear of the gift tax ramifications of the recent Chapter 14 regulations involving intra- family transfers. Both planning devices avoid retained interest features (IRC Sec. 2701), are not transfers of an interest in trust (IRC Sec. 2702), do not involve an option or buy-sell agreement (IRC Sec. 2703), and do not contain lapsing rights or restrictions (IRC Sec. 2704).
Income Tax Treatment. The need to convert non-income producing assets into a periodic income stream, as well as the desire to defer taxes on highly appreciated property are satisfied with private annuities and SCIN's. Under IRC Sec. 72, each private annuity payment is considered partially taxable income and partially income tax free. An exclusion ratio is developed by comparing the basis in the property transferred to the present value of the annuity. This relationship determines the gain recognized on each payment. If a capital asset is transferred, the payments will consist of return of investment, capital gain, and ordinary annuity income. If the transferor exceeds his life expectancy (and therefore recovers his entire basis), all further payments would be considered ordinary income.
The income taxation of a SCIN is determined under IRC Sec. 453 and is similar to the taxation of private annuities in that a portion of the payment will be partially taxable income and partially tax free. However, a significant difference arises between private annuities and SCIN's as to the income tax treatment of any remaining payments at the death of the transferor. For private annuities, all income tax recognition terminates upon the transferor's death (other than the final payment), which is not the case for SCIN's. Under IRC Sec. 453 B (f), the cancellation of a SCIN is treated as a "disposal in a transaction other than a sale or exchange," resulting in income taxation of the deferred installment gain at the transferor's death. In the Estate of Frane |(1992) 98 TC No. 26, the Tax Court held that the taxable income is not considered income in respect of decedent (taxable to the estate or beneficiary), but rather is recognized on the decedent's final income tax return. Although the income tax consequences can be substantial, the impact is mitigated to a certain extent since the liability can be deducted as a claim against the decedent's gross estate pursuant to IRC Sec. 2053 (a)(3).
Caveat to Choosing A Private Annuity
At first glance, this difference appears to be a compelling reason to choose a private annuity arrangement over a SCIN. However, this advantage brings with it the disadvantage that a transfer using a private annuity is not considered a completed sale, as is the case of a SCIN. Consequently, under no circumstances can a private annuity be secured with the asset transferred, or any other collateral. Such a security interest would deem the transaction as closed on the date of transfer, triggering a taxable event on the entire gain realized on the transfer. In addition, the IRS could contend that the retention of a security interest constitutes property transferred with a life estate, which would obviate the ability to avoid estate taxes at the death of the transferor.
Clearly, when considering private annuities, the transferee's ability to make the required periodic payments (i.e., ample cash flow can be generated from the asset transferred or other sources) should be thoroughly reviewed to reduce the risk of non-payment. Another concern to the transferor is the possible premature death of the transferee, which also could jeopardize the future annuity payments. Insuring the life of the transferee is an available option; however, any connection of the life insurance policy to the private annuity will be deemed as a secured transaction.
Examining a transfer from the point of view of the transferee raises several interesting considerations. With private annuities, there is no income tax deduction for any portion of the payments made to the annuitant. Such payments are considered payments on the purchase price of the property, even if they exceed the present value of the property transferred (i.e., the annuitant outlives his life expectancy). However, the entire payment, including the "interest element" will increase the transferee's basis in the property (pursuant to Rev. Rul. 55-119). The actual amount paid for an asset (purchase price), as well as the transferee's basis in the asset is ultimately determined by the transferor's actual life span (or joint life span). With SCIN's, the basis in the hands of the transferee is the bargained for purchase price. Generally, the interest element of the payments are tax deductible (subject to the normal limitation rules) to the transferee.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.