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The Premier VI Private Annuity was developed by The National Association of Financial and Estate Planning (NAFEP). NAFEP is a private association with professional members located throughout the U.S. NAFEP Associate members are attorneys, CPAs, financial planners, investment advisors, etc. NAFEP creates estate and tax planning programs for the clients of these Associate members.

First, we need to provide an overview of the capital gains tax. Very simply, this is a tax on the profit we make when we sell assets. The tax applies only to sales of assets owned for one year or longer (referred to as long term gains). The asset may be real estate, personal property, investments and securities, a business, an art collection, etc. Any long term asset sold at a profit is subject to the capital gains tax.

Figure 1 illustrates this concept. The left side represents the price paid or the cost of the asset. This cost is called the "Basis". Moving to the right side of the graph is a progression thru time. Over time the asset grows in value or appreciates. The right side of the graph represents the point of time at which the owner wants to sell the asset.

The problem with the capital gains tax is that it takes a big bite out of the profit. The federal rate on capital gains is a flat 28%. Most states tack more on top of that so that the total tax ranges from 33% to 40% of the profit. To make matters worse the tax must be paid within ninety days of the sale of the asset.

Another taxing problem is depreciation. The full amount of any depreciation that was taken on the asset must be treated as immediate and ordinary income when the property is sold. This means that the depreciation is "recaptured" and is subject to ordinary income taxes, due within 90 days.

Congress may reduce the capital gains tax rate in the future, but don't forget that most states have their own tax on top of the federal rate. So even with a federal reduction the overall tax will likely remain in the 25% to 30% range. Also, it is very unlikely that depreciation recapture will be eliminated or even changed.

With that background we will begin our overview of the Premier VI Private Annuity. The process starts with a property owner, depicted on the left of Figure 2. We'll refer to this property owner as the "annuitant" in the rest of this discussion. We are assuming that the annuitant owns property worth $250,000, as illustrated in the lower part of the diagram. We know that 250,000 is the fair market value because the annuitant previously located a buyer who offered that amount for the property. Before the annuitant completes a sale to that buyer, the annuitant transfers ownership to a trust.

The trust is represented by the bank safe. The owners of the trust are the heirs of the annuitant, probably his children. They are the beneficiaries of the trust. The trust, representing the beneficiaries, becomes the owner of the property once it is transferred to the trust.

Next, the trust "pays" the annuitant for the property. The payment isn't in cash, but with a special payment contract called a "private annuity". A private annuity is not an annuity issued by an insurance company. It is strictly a private arrangement between the trust and the annuitant. A private annuity is something like an installment sale. Instead of specifying an exact number of payments as in an installment sale, the private annuity promises to make payments to the annuitant for the rest of his life. Since the property was worth $250,000, the face value of the annuity contract is also 250,000. The amount of the life time annuity payments will be in direct proportion to this face value. The annuity payments may begin immediately or they may be deferred for some period of months or years.

Let's assume in this example that the annuitant is 45 years old, has other income to live on, and doesn't need the cash right now from the sale of the property. Since he has no immediate need of the cash, he arranged for the first annuity payment to be deferred until he was 65 years old, twenty years from now. Let's further assume that the annuitant bought the property several years ago for $50,000, and that is his current basis.

The next step in the private annuity process (Figure 3) is optional. Usually the trust, as the new owner, sells the property to the previously identified buyer. In the example we are discussing in Figure 3, the outside buyer pays the trust $250,000 cash for the property.

Under Federal tax laws the process of exchanging property for a private annuity is a complete and valid sale between the annuitant and the trust. In our example the IRS recognizes the exchange as a tax deferred sale. There is no taxable event at the time the annuity transaction occurs. This is a non-taxable sale for the trust because it paid 250,000 for the property when it issued the 250,000 private annuity. That means that both the cost and the selling price are the same amount to the trust. The trust has no gain on the sale of the property and no taxes to pay.

The trust is free to use the entire sale proceeds to invest in anything that is prudent. The trustee of the trust must have a reasonable expectation that the investment will be adequate to take care of the annuity payments. But the trustee's range of investment choices is nearly limitless.

There is no immediate taxable event for the annuitant either. (See Figure 4.) Even though the annuitant paid only 50,000 for this property, he does not have to recognize or report any gain or profit until he receives a payment. When payments are received he only has to recognize a proportional share of the gain.

Let's explain this deferred gain recognition by an example. When the annuitant reaches age 65 he will have a twenty year life expectancy according to IRS life expectancy tables. It is at this age that his annuity payments begin in our example. Assume that the total capital gains tax owed on the original private annuity transaction was $60,000, deferred until payments begin. At age 65 the annuitant has a twenty year life expectancy over which to receive annuity payments. The IRS wants the 60,000 tax spread equally over that twenty year period. The tax paid each year by the annuitant will be 3,000 (3,000 X 20 years = 60,000). But the annuitant pays no taxes at all from age 45 to age 65, and then only 3,000 per year. See Figure 5 for a time line illustration of this process.

It is important to understand that payment of the capital gains tax to the IRS is done with an "easy installment plan". There is no interest or penalty on these deferred payments. On top of that the tax payments will be made with depreciated dollars. The tax dollars will be worth far less than they are today due to inflation. Yet the underlying investment will grow in value, probably at more than the rate of inflation.

The $250,000 property placed in the trust was sold for cash by the trust. The trust accrues interest to the annuitant on the 250,000. (The interest rate is dictated by the IRS under Section 7520 of the Tax Code.) So the annuitant has the entire untaxed value of the sale, 250,000, growing and earning interest for him. He will earn much more money than he would if he sold the property and paid the tax up-front. This is due to both the twenty year deferral to age 65 and the spreading of the tax payments over an additional twenty year period.

Once the annuity payments start each one will consist of three parts. One part is a return of the annuitant's basis or cost, a return of principal. This part of his payment is tax free to the annuitant. A second part of each payment represents the capital gains or profit on the original transfer. In our example, each year the annuitant will pay 1/20 of the total amount of capital gains taxes that are owed on the original transfer. That is $3,000 in the example cited above. The balance of each payment is ordinary income to the annuitant, subject to his rate. This income amount comes from the interest that accrues at all times on the unpaid balance of the private annuity.

Let's examine some actual numbers from the example we have discussed and compare the annuity transaction to a straight forward, taxed sale (see Figure 6). We start with the $250,000 property value. The annuitant's basis is 50,000 leaving a gain of 200,000. We are estimating combined federal and state capital gains taxes at 66,000 which is about 33% of the profit. This leaves net cash of 184,000 in a direct sale vs. 250,000 in the annuity deferral sale. We are assuming that the net investment cash earns 7.4% before income taxes for the next 20 years. The property owner or annuitant is age 45 at the beginning, so he will be 65 when he starts to take payments from either of these plans. Under the direct and taxed sale the property owner receives annual payments of 80,832 vs. 109,827 under the annuity plan. This yields an estimated life payout of 1,616,640 under the taxed plan vs. 2,196,540 with the annuity strategy. That is an advantage of 579,900 more money to the annuitant. This advantage is due to the larger amount of net cash that was initially available to invest for the annuitant.

The deferral of capital gains taxes can produce a dramatic increase in cash in your pocket. But, that is far from being the only benefit from using a Premier VI Private Annuity. Let's discuss some of these other benefits:

1. The entire value of the property is removed from the taxable estate of the annuitant. When the annuitant dies the payments to him cease and the annuity becomes null and void. This leaves nothing in the estate. Whatever is left in the trust will pass to the beneficiaries completely free of estate and gift taxes. (If the annuitant dies before receiving all the payments from an installment sale, the balance of the unpaid payments will be in his taxable estate.)

2. If the capital gains tax rate is reduced at the Federal level (a likely probability), the balance of the annuity payments received by the annuitant will pay capital gains taxes at the lowered rate. If the property is sold in an outright and taxed sale, the seller will pay today's much higher rate. Furthermore, if the annuitant moves to a State with no capital gains taxes at any time, the rest of his payments will be free of State capital gains taxes.

3. The family of the annuitant controls the trust and all the money. Everything from the sale proceeds and all trust earnings either goes to the annuitant or to his heirs. When the annuitant dies everything left in the trust will go to his heirs.

4. The trust can make a cash sale. It is not forced to make an installment sale to the outside buyer in order to spread out the capital gains tax. This is an advantage because you never know whether the outside buyer will make all the payments on an installment sale.

5. The private annuity also defers depreciation recapture. Depreciation recapture must be treated as current income with either an installment sale or a cash sale.

6. The private annuity works equally well for a married couple. The annuity can be written as a joint, last to die contract.

7. The private annuity is the equivalent of a tax free loan from Uncle Sam. The $66,000 of deferred taxes in our example was used by the annuitant for a period covering 40 years.
8. The private annuity is a type of forced retirement plan. In a direct and taxed sale of the property the owner might lack the discipline to consistently invest the cash for his retirement needs.

9. With a competing strategy known as a "charitable remainder trust", the annuitant must give a large portion of trust assets to charity in order to avoid the capital gains tax. While this does avoid the tax altogether, it reduces the amount of payout to the annuitant significantly compared to the private annuity. In most side-by-side comparisons the annuitant will pocket more after tax cash with the private annuity.

There are benefits for the property, too:

1. As mentioned above, the property is removed from the taxable estate of the annuitant. It is never subject to estate taxes.

2. This arrangement does not trigger any gift tax consequences no matter how much the property is worth. The private annuity is treated by Federal tax laws as an arms length buy-sell transaction.

3. The property will not need to go through probate when the annuitant dies. The property is removed from the annuitant's estate by the buy-sell annuity transaction.

4. The property will not be subject to Medicaid claims should the annuitant ever require Medicaid assistance with nursing home care. The annuity payments can be subject to Medicaid claims during the life of the annuitant, but not the assets in the trust.

Another important use of a Premier VI Private Annuity is in the transfer of large estates to the next generation free of gift and estate taxes. To better understand this strategy let's first discuss some basics of gift and estate tax planning. An individual may transfer or give away $600,000 of property to his or her heirs and the gift will be exempt from gift taxes. A married couple can transfer twice that amount, or 1,200,000. To take advantage of these exemption amounts the transfer must be treated as a real gift. This gift escapes both gift taxes now and estate taxes later, but at the expense of losing the property. Once the gift is made it is gone and cannot be retrieved.

The private annuity also results in a complete transfer of the property, but a lifetime income based on the full value of the property is retained. The annuitants will receive all the principal and all the accrued interest if they live to life expectancy. The annuitants do not have to give up all the benefits of property ownership as they do with a pure gifting strategy.

Activity Inside The Trust

So far, our discussion has focused mainly on the annuitant. Now, we want to discuss what happens to the trust. During any deferral period the money in the trust is invested for growth. During this period the trust can pay out any excess earnings to the beneficiaries. This would be any earnings that the trustee deems to be in excess of what is needed to pay the annuity obligation. The trust will have to pay taxes on its earnings, but various strategies can be employed to minimize that.

Figure 7 illustrates the flexibility of investments that can be made with the trust's money. The money can be invested in real estate, securities, mutual funds, commercial annuities, etc. Trust funds may also be used to purchase an existing business or even to start a new one. The business might be used to provide employment for family members, including the annuitant.

Questions And Answers

Q. How can I know the amount of my payments?

A. NAFEP or one of its Associates can provide that answer quickly from three facts: (1) Annuitant(s) age, (2) Selling price of the property minus any mortgages that the trust must pay off, (3) The length of deferral, if any, until payments begin. Annuity payments are designed to exactly return all of the principal and all interest accrued on the unpaid balance in a term of years which exactly equals your life expectancy. (Life expectancy is based on IRS tables.) There is no charge or obligation for an illustration of your private annuity interest.

Q. What happens if I live longer or less than life expectancy?

A. Payments go on until you (or the surviving spouse with a married couple) die, no matter whether that is sooner or later than life expectancy. Life expectancy is just the number used to calculate the size of the payments.

Q. What if I want to change the payment amounts?

A. The payments are locked in to a fixed amount and paid either monthly, quarterly or annually for the rest of your life. The amount cannot be changed. You may borrow from the trust if you need to, provided that the transaction is structured as a real loan and is based on market interest rates.

Q. How much interest will I earn on the unpaid balance?

A. Every month the IRS issues the "Annual Federal Mid Term Rate" (AFMR). This rate is calculated from an arbitrary formula created by the IRS. It fluctuates each month with the normal ups and downs of the credit markets. Your annuity will use the AFMR rate that was current in the month the annuity was created. That rate is fixed for your annuity and won't change.

Q. What guarantee do I have that the annuity payments will be made?

A. One important feature of the private annuity is that it must be unsecured. That means that the trust cannot pledge its assets to the annuitant as a guarantee of the annuity. If the annuity is secured the tax strategy is not allowed by the IRS. This is not actually a problem though. The trustee's only role is to make sure your payments are made and that the beneficiaries get whatever is left. The trustee has no way to personally benefit from the property. That makes the annuity as secure as the investment of trust funds. Part of the trustee's job is to make sure that the investments are prudent and reasonable. If the investment is in mutual funds the annuity payments are as safe as the stocks held in that fund. There really is no other variable that affects the security of your payments.

Q. How does this compare to an installment sale?

A. An installment sale will spread the capital gains tax over the life of the note. But, there are three problems:

First, an installment sale won't defer depreciation recapture.

Second, when you make the sale to an outsider there is always a chance the deal will go bad, that the payments won't be made, or that the property will be allowed to degrade in value. With the annuity you can get tax deferral without the trust being forced to make an installment sale. The trust can sell for cash if it chooses.

Third, with an installment sale the unpaid balance of the note will be included in your estate when you die, which makes that balance subject to estate taxes. But when the annuitant dies there is nothing left in his taxable estate from the entire annuity transaction. The beneficiaries own whatever is left.

Q. Who serves as trustee?

A. Annuitants cannot be the trustee nor have direct control of any kind over the trust. The trustee may be any adult trust beneficiary or any person who is independent of the annuitants. For example, an adult child who is also a beneficiary may be the trustee. The annuitants' accountant, attorney, financial advisor, family friend or a relative who is not in the immediate family are all possible choices. Another option is a NAFEP corporate trustee furnished by a NAFEP Associate member. No matter who the trustee is, a co-trustee can be appointed as an extra measure of security or comfort to the annuitants and beneficiaries. When a co-trustee is used all trust transactions require the signature of both the trustee and co-trustee. In all cases the beneficiaries have the ability to fire and replace the trustee.

Q. How can I have my tax advisor analyze the private annuity idea?

A. NAFEP or one of its Associates would like to provide your tax advisor with the additional information they need to properly advise you. This is done routinely by NAFEP Associates as part of the process. Most CPAs and tax advisors are enthusiastic about the strategy after they understand it.

Q. How long can the deferral period be, and can it be changed once the private annuity is setup?

A. Deferral can be for any amount of time left in your life expectancy. But, it is generally advisable that payments begin by the time you are 70 years old. If you are already older than that the deferral perhaps should be limited to five years or less. If the trustee agrees, the deferral period can be changed. If you setup a fifteen year deferral initially, but decided later to have the payments begin in seven years, this change can be readily accommodated. The annuity would be recalculated based on the amount accrued at the end of seven years and based on the original interest rate.

Q. What risks or other negative factors are there?

A. The only risk to your money is from the stability of the investment. Prudent investment strategies make that risk negligible, though.

There is an unrelated negative factor. The annuity face amount should be something less than the fair market value of your property, by 5% to 10%. This provides the trust with some backup or reserve capital. Without a reserve the value of the property that went into the trust and the obligation to make the annuity payments are theoretically equal. The net worth of the trust would be zero, its assets and liabilities are equal. That could lead to a disallowance of the transaction by the IRS on the grounds that the trust lacks economic substance. Reserve capital needs may be covered either by a gift of some additional property to the trust (from either the annuitant or beneficiaries) which provides the reserve, or by decreasing the face value of the annuity by 5% or 10%.

Q. How much does it cost to arrange a Premier VI Private Annuity?

A. Most private annuity transactions cost between $2,000 and 2,500 for a plan to be fully implemented, including attorney costs.

Q. I am interested in having one of these plans put together, what should I do next?

A. Your next step is to  CONTACT US . We will talk to your tax advisors if you want that. We will also provide an illustration of your annuity payments. To get the program put together, we will help you fill out an information form. Then an attorney who is expert with the private annuity will review the information to determine whether this strategy is appropriate for you. If it is he will put the documentation together. Then we will assist you and your advisor with implementation.
 

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