Private annuities can still save estate taxes.

• Author: Schwartz, Sol

In October 2006, the IRS issued Prop. Regs. Secs. 1.72-6(e) and 1.1001-1(j), which propose to substantially reduce the income tax benefits of private annuities (REG-141901-05). Basically, the proposed regulations require the annuitant (the person transferring the property) to recognize the entire gain or loss on the transferred property immediately on entering into an annuity contract. In the past, under Rev. Rul. 69-74, this gain was spread over the life expectancy as the obligor made annuity payments. Under the proposed regulations, the gain is measured on the difference between the annuity contract's fair market value (FMV) determined under Sec. 7520 at the time of the exchange and the taxpayer's basis in the property transferred. This gain is added to the annuity's tax basis for purposes of computing the annuitant's investment in the contract. As a result, only a portion of the annuity payments made in the future would be subject to ordinary income tax rates because the capital gain portion has already been recognized.

Without this big tax benefit, one would think that private annuities would no longer be beneficial. However, there still can be an estate tax savings.

Example: D has an estate worth $3 million, with the lifetime exemption of $2 million (for 2007) still intact. The estate tax would be $450,000 (at the 2007 tax rate of 45%). D acquires bonds for $1 million. He then transfers these to his heirs for a private annuity valued under Sec. 7520 so that the annuity's value equals the value of the assets. Before dying, D...