What it means
The seller hands over an asset and the buyer, usually a child or a trust for the children, promises to pay a set amount each year until the seller dies. Payments stop at death, whenever that happens, so nothing further is owed to the seller's estate.
The attraction is that the asset leaves the seller's estate and any future growth in its value belongs to the buyer. If the seller lives longer than expected the buyer ends up paying more than the asset was worth, and if the seller dies early the buyer pays less.
The annuity is normally set so that the sale is at fair market value, using life expectancy tables and an interest rate published by the tax authority. If the payments are set too low, part of the deal can be treated as a gift, which is why valuation evidence matters.
The buyer's promise is usually left unsecured, meaning no asset is pledged to guarantee payment. In some tax systems, securing the promise can cause the seller to be taxed on the whole sale straight away, so the seller ends up relying on the buyer's ability and willingness to pay for decades.
Rules differ widely between countries and change over time, and the tax treatment of each payment, often split between return of capital, gain and interest, can be complicated. Anyone considering one needs specialist advice before signing anything.
In practice
Real-world examples.
Example
A founder of a family-owned manufacturer sells a 30% stake worth $1,500,000 to a trust for her children in exchange for a lifetime annuity. The stake's future growth now accrues to the trust instead of her estate. The company's dividends fund most of the annual payments.
Example
A retired landlord sells an apartment building valued at $2,400,000 to his son, with an annuity factor of 16. The annual payment is $150,000, and the building's rental income is expected to cover it. The father gets a predictable income and the son gets the property.
Example
A farm owner in her late seventies sells the land to a nephew who already works it. The nephew promises annual payments and keeps the harvest profits. The farm owner no longer carries the property on her estate but depends on the harvest holding up to fund her payments.
Formula
Calculation
Annual payment = fair market value of the asset / annuity factor
The annuity factor comes from life expectancy tables and the interest rate set by the tax authority, and it is higher for younger sellers.
Suppose a father sells shares in the family business, valued at $600,000, to his daughter, and the annuity factor for his age is 12. The annual payment is 600,000 / 12 = $50,000 per year for as long as he lives.
If he lives exactly 12 more years, total payments are 12 x 50,000 = $600,000, which equals the value of the shares. If he lives 20 years, total payments are 20 x 50,000 = $1,000,000, so the daughter has paid $400,000 more than the shares were valued at. If he dies after 5 years, total payments are 5 x 50,000 = $250,000, so she has paid $350,000 less than the valued amount.Case study
Seen in the real world.
Meridian Fabrication is an illustrative, fictional engineering firm owned by 72-year-old Anwar Qadir. He wanted his daughter to run the company and benefit from its growth, but a gift of the shares would have triggered a large tax bill and a sale for cash was beyond her means.
His advisers valued the shares at $800,000 and structured a private annuity with an annuity factor of 10, giving annual payments of $80,000. The company paid dividends of about $120,000 a year, so the daughter could meet the payments from her share of profits and still have money left over.
Over the following years the business grew sharply and its value rose well beyond $800,000. In this illustrative story the growth passed to the daughter, while the father kept a steady income. The story also shows the risk: had the dividends dried up, she would still have owed the payments for as long as he lived.
Watch out
Common mistakes.
- Treating a private annuity like a commercial annuity bought from an insurer, when the payer is a person or trust who can run out of money.
- Assuming it automatically saves tax, when a poorly valued deal can be reclassified partly as a gift or taxed in unexpected ways.
- Forgetting that the buyer must find the payments even if the asset produces little income, which can strain family finances.
Questions
People also ask.
What happens if the seller dies early?
The payments simply stop and nothing more is owed, which is the main way the buyer can come out ahead.
Can the buyer's promise be secured by the asset?
It can, but in some tax systems that can cause the seller to be taxed on the whole sale straight away, so it is normally left unsecured.
Is a private annuity the same as a self-cancelling instalment note?
They are similar, but a self-cancelling note runs for a fixed number of years and cancels if the seller dies before the end, whereas a private annuity runs for the seller's whole life.
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