Private Annuities and Self-Canceling Installment Notes (Portfolio 805)

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Tax Management Portfolio, Private Annuities and Self-Canceling Installment Notes, No. 805-3rd, describes the advantages and disadvantages of private annuities and self-canceling installment notes (SCINs). 

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Tax Management Portfolio, Private Annuities and Self-Canceling Installment Notes, No. 805-3rd, describes the advantages and disadvantages of private annuities and self-canceling installment notes (SCINs). This Portfolio also examines the income, estate, gift, and generation-skipping transfer tax consequences of private annuities and SCINs, with special emphasis on planning opportunities.
A private annuity represents the obligation of an individual or entity that does not engage in the business of issuing annuities to make periodic payments to one or more individuals. The person or entity making the transfer purchases the annuity by transferring money or other property to the transferee, which may be an individual, corporation, trust, foundation, or other entity.
Transferors enjoy a number of advantages with properly structured private annuities, including estate tax savings and a lifetime income stream. Private annuities yield a number of potential disadvantages, particularly to the transferee, such as the transferee's inability to deduct any part of the annuity payments as interest. In addition, satisfying the annuity payments may impose a substantial economic burden on the transferee. The transferee assumes an investment risk — the risk that the transferred property fails to generate the requisite income to satisfy the annuity obligation. The transferee also assumes the longevity risk — the risk the transferor will live beyond his or her actuarial life expectancy.
The removal of the transferred property from the seller's gross estate serves as the primary advantage of a SCIN. The seller receives an economic benefit similar to an installment sale but without the adverse estate tax ramifications if the seller dies during the term of the note. The disadvantages to these arrangements include the possible recognition of gain upon the seller's death, the uncertainty of the income tax effect on the buyer, and the risk of challenge by the IRS. In addition, the periodic payments required of the buyer may be burdensome, though this effect may be mitigated by the buyer's ability to deduct interest paid under the SCIN.
For a more detailed discussion of the estate taxation of commercial annuities, see 821 T.M., Federal Tax Issues of Employee Plan and Commercial Annuities. For a more detailed discussion of the income tax aspects of installment sales, see 565 T.M. Installment Sales (U.S. Income Series).
This Portfolio may be cited as Wojnaroski, 805-3rd T.M., Private Annuities and Self-Canceling Installment Notes.


Edward P. Wojnaroski, Jr., Esq., M.S. (Tax), CFP®

Edward P. Wojnaroski, Jr., B.A., Washington & Jefferson College, J.D., University of Pittsburgh School of Law, M.S. (Tax), The American University; Certified Financial Planner™; Fellow, American College of Trust and Estate Counsel; author, 821 T.M., Federal Tax Issues of Employee Plan and Commercial Annuities, “Planning with Annuities,” 30 Tax Mgmt. Est., Gifts & Tr. J. 337 (Nov./Dec. 2005), “Family Owned Business Exclusion,” 146 Pittsburgh Legal J. No. 6 (June 1998), “Tax Aspects of Private Annuities, Part I,” 22 Tax Mgmt. Est., Gifts & Tr. J. 119 (May/June 1997), featured article: 12 Tax Mgmt. Financial Planning J. No. 8 (July 19, 1997), “Tax Aspects of Private Annuities, Part II,” 22 Tax Mgmt. Est., Gifts & Tr. J. 120 (July/Aug. 1997), featured article: 12 Tax Mgmt. Financial Planning J. No. 9 (Aug. 19, 1997); Adjunct Professor, Duquesne University's Master of Science in Taxation Program; member, Duquesne University's Master of Science in Taxation Advisory Board; member, Pennsylvania, District of Columbia, and Georgia Bars; member, Pennsylvania and Allegheny County Bar Associations; United States Marine Corps (1988–1996); United States Marine Corps Reserve (1996–present); member, U.S. Supreme Court, U.S. Court of Appeals for the Third Circuit, U.S. Court of Federal Claims, U.S. Tax Court, U.S. Court of Appeals for the Armed Forces, U.S. District Court for the Western District of Pennsylvania.

Table of Contents

Detailed Analysis

I. Foundation

A. Introduction

B. Framework

C. Similarities and Differences Between Private Annuities and Commercial Annuities

D. Private Annuity Distinguished from Other Types of Annuities

E. SCINs Compared to Other Types of Installment Sales

F. Typical Situations for Private Annuities

G. Typical Situations for SCINs

II. Advantages and Disadvantages of Private Annuities

A. General

B. Advantages

1. Estate Tax Savings

a. Removal of Transferred Property from the Transferor's Gross Estate

b. Shift of Future Appreciation

c. Analytical Factors - Estate Tax Savings

(1) Superior Investment Results

(2) Shorter than Average Life Expectancy

(a) Terminal Illness

(b) Cases on Terminal Illness

(3) Valuation Discounts

(a) Fair Market Value

(i) Discounts for Fractional Interests

(ii) Discounts for Minority Interests

(iii) Discounts for Lack of Marketability

(iv) Discounts for Blockage or Market Absorption

(v) Discounts for Built-in Capital Gains and Other Tax Effects

(vi) Discounts for Securities Law Restrictions on the Transfer of Securities

(vii) Discounts for Loss, Retirement, or Disability of Key Persons

(viii) Discounts for Risks of Litigation

(ix) Discounts for Actual or Potential Environmental Hazards

(x) Discounts for Land Use Restrictions, Zoning, Easements, and Rights of Way

(xi) Discounts for Tiered Entities

(xii) Premiums for Control

(xiii) Chapter 14 Adjustments

(xiv) Other Discounts Given the Unique Nature of the Property Interest

(b) Burden of Proof

(c) Appraisal

(d) Appraiser

(4) Declining Interest Rates

(5) Frequency of Payments

(6) Changing Consumption Patterns after the Transaction

(7) Planning with Private Annuity Payments

2. Income Tax Benefits

a. Income Tax Deferral

b. Imputed Interest Rules

c. Other Income Tax Benefits

3. Income-Splitting

4. Gift Tax Avoidance

5. Commercial Annuity Not Attractive

6. Lifetime Income

7. Family Control

8. Estate Liquidity

9. Family Succession Plan

10. Retirement Planning Tool

11. Alternative to Rushing Trust

12. Conserving Assets in Anticipation of a Catastrophic Illness

13. Utilization of Capital Loss Carryovers

14. Disguised Gifts from Wealthy Child to Parent

15. Medicaid Eligibility

a. Background

b. Planning

16. Avoid Probate

17. Ancillary Probate

18. Asset Protection Device

19. Inflation

20. Diversification of Portfolio

21. Favorable Estate and Income Tax Benefits

C. Disadvantages

1. Investment Risk

2. Potentially Lower Income Tax Basis

3. Mortality Risk

4. No Interest Deduction

5. Recognition of Gain

6. Risk of Default

7. Economic Burden on Transferee

8. Income Taxes

9. Total Tax Burden

10. Valuation Risk

III. Advantages and Disadvantages of SCINs

A. General

B. Advantages

1. Estate and Gift Tax Savings

2. Income and Security

3. Interest Deduction

4. Retirement Planning Tool

5. Basis

6. Tax Planning Options

7. Recognition of Loss

C. Disadvantages

1. Potential Recognition of Gain upon Seller's Death

2. Uncertainty of Income Tax Effect on Buyer

3. Risk of Challenge by the IRS

4. Imputed Interest

5. Burden of Payments on Buyer

6. Restrictions on Alienability

7. Limited Term

IV. Comparison of the Private Annuity with SCINs

A. Estate Tax Consequences

B. Gift Tax Consequences

C. Income Tax Consequences

D. Summary

V. Estate and Gift Tax Aspects of Private Annuities

A. Estate Tax Aspects

1. Section 2033

2. Section 2035

3. Section 2036

a. Income Equal to Annuity

b. Retained Life Estate

4. Section 2037

5. Section 2038

6. Section 2039

7. Section 2043

B. Gift Tax Aspects

C. Generating-Skipping Transfer (GST) Tax Aspects

VI. Income Tax Consequences of Private Annuities

A. General Rules

1. Historical Background

2. Income Taxation of Private Annuities Under Rev. Rul. 69-74

a. General

b. Method in Rev. Rul. 69-74

c. Comparison of Rev. Rul. 69-74 with Rev. Rul. 239

d. Cases That Have Considered Rev. Rul. 69-74

e. Application of the 1980 ISRA to Private Annuities

f. Tax Reform Act of 1986

B. Exceptions to General Rules

1. Gifts

a. Valuing the Gift

b. Absence of Donative Intent

2. Valuation Adjustments for Atypical Private Annuities

a. Beginning or End of Term Adjustments

b. Cost-of-Living Adjustments

c. Adjustments for Refund Feature

3. Organizations That Issue Annuities “From Time to Time”

a. Meaning of “From Time to Time”

b. Judicial Authority

c. Effect of Rev. Rul. 69-74 and Regs. § 1.1011-2(c) on Rev. Rul. 62-136

d. IRS Annuity Valuation Tables

4. Transfer of Depreciable Property in Taxable Transactions

a. Personal Property

(1) Amount of Depreciation Recaptured

(2) Timing of Recapture

b. Real Property

c. Section 1239

d. Impact of Repeal of Capital Gains Deduction

5. Losses in Annuity Transactions

a. Adjusted Basis Exceeds Value

b. Loss Recognition When Transferor Dies Prematurely

6. Secured Transactions

7. Exchanges of Private Annuities

a. Income Tax Consequences

b. Estate Tax Consequences

8. Rescission of Private Annuities

9. Contingent Payment Sales Election

C. Transferee

1. General

2. Basis for Depreciable Property

a. Before Transferor's Death

b. After Transferor's Death

3. Sale of Property Transferred

a. Before Transferor's Death

(1) Gain

(2) Loss

(3) No Gain or Loss

b. After Transferor's Death

4. Payments After Sale of Property

a. General

b. Gain Recognized on Sale

c. Loss Recognized on Sale

d. No Gain or Loss Recognized

e. Character of Subsequent Income or Loss

f. Planning to Avoid Gain

5. Gifts

6. Deduction of Interest

7. Death of Transferee Before Transferor

a. General

b. Failure to File Claim

c. Administrative Problems

d. Claim for Refund

e. Sale of Property

VII. Tax Aspects of SCINs

A. Seller's Income Tax Consequences: General Rules

1. Historical Background of the Taxation of SCINs

2. A Hybrid Form of Deferred Payment Sale

3. Installment Sales Reporting Applied to SCINs

4. Treatment of Deferred Gain upon Seller's Death

a. Rev. Rul. 86-72 and GCM 39503

b. Frane Est. v. Comr.

c. Is There an Alternative to Frane?

d. Planning for Potential Recognition of Gain

5. Loss Recognition by Seller

6. Effect of OID and Imputed Interest Rules

B. Buyer's Income Tax Consequences

1. Deductibility of Interest

2. Basis

3. Cancellation of Indebtedness

4. Valuation Penalties

C. Gift Tax Consequences

1. Adequacy of Risk Premium

2. How to Arrive at an Adequate Risk Premium

3. When Is the Gift Complete?

D. Estate Tax Consequences of SCINs

E. SCINs and Chapter 14

VIII. Valuation Tables

A. In General

B. Background

C. Administrative History

D. Treasury Regulations

1. 1994 Regulations

2. 1995 Regulations

3. 2000 Regulations

E. Application

F. Examples

1. Single Life Annuity

2. Joint and Survivor Annuity

3. Private Annuity for a Stated Term

G. Lottery Payments

IX. Private Annuities and Chapter 14

A. Historical Background

B. Section 2701

C. Section 2702

D. Section 2703

E. Section 2704

F. Planning Techniques

X. Joint and Survivor Private Annuities

A. In General

B. Income Tax Consequences

C. Gift Tax Consequences

1. Joint and Survivor Private Annuities Between Spouses

2. Joint and Survivor Private Annuities Between Nonspouses

D. Estate Tax Consequences

1. Section 2039

2. Section 2056

XI. Transactional Planning Opportunities with Private Annuities and SCINs

A. Introduction

1. Analytical Approach to the Use of a Private Annuity

2. Analytical Approach to the Use of a SCIN

B. Private Annuities and SCINs Involving Individual Transferees and Individual Buyers

C. Transfer of Business or Investment Interests Using Private Annuities and SCINs

1. Introduction

2. Stock Redemptions

a. General

b. Effect on Earnings and Profits

c. Use of the PAST with Stock Redemptions

D. Private Annuities and SCINs with Trusts Treated as Separate Taxable Entities

1. Cases and Rulings

2. Exhaustion Regulations

3. Planning Guidelines

4. Form

E. Private Annuities/SCINs and Grantor Trusts

1. Advantages and Disadvantages of Grantor Trust Transactions

2. Effect on Basis

F. Private Annuities and SCINs with ESOPs

G. Private Annuity Sale of a Remainder Interest

1. Introduction

2. Case Law

H. Marital Trust Private Annuity

I. Rushing Trust Variation

J. Deferred Private Annuities

K. Financing the Private Annuity/SCIN Purchase

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Rev. Rul. 69–74, 1969–1 C.B. 43

Worksheet 2 Rev. Rul. 86-72, 1986-1 C.B. 253

Worksheet 3 GCM 39503 (May 7, 1986)

Worksheet 4 Private Annuity Agreement for Real Estate

Worksheet 5 Single Life Private Annuity Agreement

Worksheet 6 Joint and Survivor Private Annuity Agreement

Worksheet 7 Joint and Survivor Private Annuity Attachment to Form 706

Worksheet 8 Sample Client Letter-Private Annuity

Worksheet 9 Self–Canceling Promissory Note

Worksheet 10 Self–Canceling Installment Sales Agreement

Worksheet 11 Sample Client Letter-SCIN

Worksheet 12 Step-By-Step Guide to Taxation of Private Annuities Single Life Private Annuity

Worksheet 13 Calculation of the § 7520 Rate

Worksheet 14 Calculation of Risk Premium in a SCIN

Worksheet 15 Where to Find the Actuarial Tables

Worksheet 16 Regs. § 1.72-9 Table V-Ordinary Life Annuities One Life-Expected Return Multiples

Worksheet 17 Life Table Table 90cm Applicable After April 30, 1999

Worksheet 18 Excerpt from H.R. Rep. No. 1337, Ways and Means Comm., 83d Cong., 2d Sess. A286 (1954)

Worksheet 19 Summary of Advantages and Disadvantages of a Private Annuity

Worksheet 20 Case Analysis

Worksheet 21 Comparison of SCINs and Private Annuities





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