Private Annuities and Self-Canceling Installment Notes

Private annuities and self-canceling installment notes (“SCINs”) are both effective wealth transfer planning techniques. There is a present lapse in the estate and generation-skipping transfer taxes, but it’s likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%. While similar in many respects, each technique has its advantages and disadvantages when compared to the other. Following is a brief description of private annuities and SCINs.

Private Annuities.

In the typical private annuity transaction, a parent (the “annuitant”) sells property to a child (the “obligor”), in exchange for the child’s unsecured promise to make periodic payments (the “annuity”) to the parent for the balance of the parent’s lifetime. The amount of the annuity is computed using the fair market value of the property sold, the annuitant’s life expectancy, and the IRS’s published interest rate for the month of the sale.

As long as the present value of the annuity received is equal to the fair market value of the property sold, there is no taxable gift. Where a hard to value asset is sold (i.e., an interest in a closely held business) an independent appraisal must be obtained.

In addition to avoiding gift taxes, a private annuity removes all appreciation on the property sold from the annuitant’s estate, and even some of the property sold itself, depending on when the annuitant dies. The reason for this is that private annuities are designed to cease making payments at the annuitant’s death. Unless there is a 50% probability that the annuitant will die within one year, the parties are permitted to use the government’s actuarial tables to determine the present value of the annuity. For, an annuitant who is not in good health, but likely to live at least one year, the government’s mortality tables will be more advantageous (from an estate planning perspective) than using the annuitant’s actual life expectancy.

Until April 18, 2007, the annuitant was able to report the built in gain on the property sold piecemeal as part of each annuity payment when received. Under current law, the entire amount of the annuitant’s gain or loss (if any) must be recognized at the time of the sale. To avoid having the annuitant come up with cash to pay the capital gains tax, the sale could be structured with a down payment (to cover the capital gains tax) and the balance in annuity payments (which are divided into tax-free return of capital and ordinary income).

Self-Canceling Installment Notes.

A SCIN is a promissory note (usually between family members) that by its terms is canceled at the death of the seller-creditor. The advantage of a SCIN over an ordinary promissory note is that if the seller dies before the note is paid, the unpaid balance of the note is not included in his/her estate.

In order to avoid a taxable gift at the time of sale, the purchaser must pay a risk premium to the seller for the cancellation feature. The premium can be in the form of a higher purchase price or a higher interest rate. Unfortunately, there is little authority as to how to calculate the premium, but the premium will be a factor of the seller’s life expectancy, the term of the note, and the IRS’s published interest rate for the month of the sale.

Summary.

The ideal candidate for both private annuities and SCINs is a person with a taxable estate and a life expectancy that is shorter than the IRS published life expectancy for an individual of the same age. The planned objectives for both techniques are three-fold: (1) removing the future appreciation in the assets sold from the annuitant’s/seller’s estate; (2) removing the unpaid balance of the sales price from the annuitant’s/ seller’s estate (in the event of his/her premature death); and (3) avoiding any gift tax on the sale.

Each technique, while similar, has downsides and costs that must be understood. Therefore, it is essential to weigh the pros and cons of each alternative.

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Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.