Tax attorneys use the phrase "transfer tax" to refer to the combination of estate and gift taxes which is imposed on the transfer of wealth, whether occurring during lifetime or at death. Nevertheless, use of the phrase "death tax" makes it a bit easier to see why investments whose return is a function of the timing of one’s death are such an important aspect of modern estate planning.

Life Insurance

The most obvious of such investments is life insurance, which can be thought of as a bet on the timing of the insured’s death. If death occurs shortly after the purchase of the policy, the life insurance company loses the bet, and the policy owner wins the bet. In contrast, the insurance company makes a profit if the insured lives a long time or the policy lapses before death, which means it is fair to say that the owner loses the bet.

The key to understanding the transfer tax consequences of an investment in life insurance is that the insurance proceeds are included in the insured’s taxable estate only if the insured possessed an "incident of ownership" in the policy within three years of his or her death. Roughly speaking, an "incident of ownership" is any right to control the policy (e.g., determine who gets the proceeds or when or how the proceeds are distributed.)

The ILIT. A typical planning technique is to establish the title and beneficiary designation of life insurance in an irrevocable trust for the benefit of the insured’s family (often referred to as an irrevocable life insurance trust, or "ILIT".) Sophisticated tax attorneys often recommend so that the insured’s spouse serves as trustee. Properly structured, the proceeds can thus be made exempt from transfer taxation in both the insured’s estate and the spouse’s estate.

Premium payments. Typically, the insured makes the premium payments on the policy owned by the trust. Since the insured gets no benefit therefrom, the premium payments are considered gifts. And since no one benefits from the gifts until after the insured dies, the gifts are considered "future interests." The problem is that only "present interests" (i.e., gifts where the donee can take immediate possession) qualify for the $10,000 per donee annual exclusion from taxable gifts. (The rationale for the annual exclusion is to avoid a requirement that everyone report common small gifts, such as birthday or Christmas gifts.)

To qualify a premium payment for the annual exclusion, the typical irrevocable life insurance trust provides that one or more trust beneficiaries have the right to withdraw from the trust an amount of money equal to the premium payment for a period of, say, 30 days after the payment is made, which right typically expires without exercise. To be meaningful, the holder of the power to withdraw must have knowledge of the existence of the withdrawal right. This is typically accomplished via what is referred to as a "Crummey letter", named in honor of an old Tax Court case.

Life Annuities

Insurance companies also sell life annuities, which are promises to pay money to the owner for so long as the insured is living. Life annuities can be considered as bets which are the reverse of life insurance. Just as life insurance premiums are higher if the insured has a short life expectancy, annuity payments are higher if the insured has a short life expectancy. If the insured lives a long time, the insurance company loses.

Transfer tax consequences. The first key to understanding the transfer taxation of life annuities is that since the life annuity terminates on death, there is nothing to include in the insured’s taxable estate. On the other hand, the annuity payments and the earnings thereon, if retained by the insured-annuitant, are included in the insured-annuitant’s taxable estate. Transfer taxes can thus be higher than they might otherwise be if the insured-annuitant lives a long time.

Private annuities. From an estate planning standpoint, the "trick" with life annuities typically involves a terminally ill client. Instead of purchasing the annuity from an insurance company, the insured purchases the annuity from his intended beneficiary(ies.) Such a transaction is referred to as a "private annuity" to distinguish it from a commercial annuity purchased from an insurance company.

The ultimate goal of a private annuity transaction is to transfer property to the beneficiary without receiving the annuity payments in exchange and without triggering a transfer tax - even though the beneficiary ends up with the property without paying for it.

How it works. The primary transfer tax issue in a private annuity transaction is whether the annuitant made a taxable gift upon transferring the property to the beneficiary in exchange for the right to receive the annuity payments from the beneficiary. A taxable gift arises if the value of the promise to pay is less than the value of the property transferred. For such purpose, the value of the promise to pay is measured via actuarial tables which do NOT take into account the annuitant’s actual life expectancy IF the annuitant has a greater than 50% chance of surviving for more than one year at the time of the property transfer.

By permitting the use of actuarial tables in such situations, the IRS allows an artificially high valuation of the private annuity, which means a taxable gift is avoided even though property is transferred without receiving a commensurate value in return. This artificial valuation rule effectively allows many terminally ill taxpayers to transfer unlimited amounts of property free of estate and gift taxation.

Income taxes. The income tax consequences of a private annuity transaction are bad, especially for the person paying the annuity. The income tax consequences for the annuitant is based on the rule that each payment received by the annuitant is treated as having three elements, to wit: (i) an ordinary income element to reflect interest, (ii) a capital gain element to reflect the gain on sale, and (iii) a return of capital element.

The person paying the annuity does NOT get an interest deduction and only has a basis in the property equal to the total annuity payments made (adjusted for depreciation, etc. after the purchase), as opposed to getting a basis equal to the value of the promise to pay. (In comparison, the buyer of property in exchange for an installment note has the face value of the note included in his or her basis.)

Summary. The net effect of the above set of rules is that the private annuity transaction should only be contemplated by persons who are motivated by a desire to eliminate all estate taxation burdens on their beneficiaries and who have a terminal illness which leaves them with a greater than 50% chance of living more than one year, but an insignificant chance of living a considerable time thereafter.

©2007 Steven M. Chamberlain, Esq. All rights reserved. Republication with attribution is permitted.