The following overview is applicable to those living in jurisdictions, like the US and many Western countries, where capital gains taxes on appreciated assets would otherwise be levied. This solution provides a viable way of postponing and spreading out such taxes, whilst providing a host of other valuable benefits.
A Private Annuity Contract (PAC) is a contractual arrangement between an individual (referred to as the 'Annuitant') and an entity, that is not in the business of selling annuities, typically a foreign corporation (known as the 'Obligor').
In a PAC transaction, the Annuitant transfers cash or other property to the foreign Obligor in exchange for the Obligor's promise (which is documented by the annuity contract) to make periodic payments to the Annuitant for a specific number of years, usually for the remainder of the Annuitant's life.
Assets may be 'Appreciated Property' and the recognition of any taxable gain (capital gains or ordinary income) inherent in the asset may be postponed even though the assets (stocks or real estate for example) may be 'cashed-in' and the funds invested elsewhere.
The periodic payments, more commonly referred to as annuity payments, may be made to the Annuitant on a monthly, quarterly, semi-annual or annual basis. These payments may be deferred as long as the Annuitant wishes, so that with appropriate estate planning, the value of the appreciated foreign property may be eventually transferred to heirs and beneficiaries without the payment of estate tax.
The PAC Obligor may invest anywhere in the world, including the U.S., and has investment advantages that are not offered to US investors. For example, there are various tax provisions only available to foreign persons to encourage investment in the US and the use of US banks and savings institutions. As a result, the PAC Obligor may invest tax-free in US stocks and financial accounts. The Obligor may sell appreciated stocks utilizing a PAC with no tax recognition and reinvest the funds back in the US on a private and tax-free basis.
A Wealth of Benefits Provided by PAC
The PAC offers a wide range of benefits that no other single business and estate planning device can match. These include the following benefits:
Income Tax Savings
Similar to the taxation of instalment sales, a PAC permits the Annuitant to defer gain on the sale of any type of property by spreading it ratably over the life expectancy of the Annuitant and, in the case of a PAC subject to a term, over a stated term rather than reporting the entire amount of the gain in the year of sale. In the U.S. the Tax Reform Act of 1986 made instalment sales much more difficult, and in many cases impossible. For example, instalment sales are not allowed for certain assets, such as publicly traded stock. In contrast, a PAC permits the Annuitant to receive a tax deferral on any appreciated asset, including publicly traded stock. Appreciated assets may be transferred to the Annuity Obligor and converted into investment funds without payment of any income tax on capital gains or ordinary income.
Estate Tax Savings
A PAC also allows the removal of the transferred property from the Annuitant's gross estate without triggering any U.S. gift tax. Therefore, upon the death of the Annuitant, the transferred property as well as any future appreciation in such property will not be included in the decedent's gross estate. If the annuity is a PAC based on a single life as opposed to two lives, the annuity payments are also excluded from the Annuitant's gross estate for estate tax purposes. With appropriate estate planning, appreciated foreign investments may be passed to beneficiaries with estate tax consequences.
Furthermore, since property that is properly transferred in a PAC transaction is no longer considered owned by the Annuitant, the transferred property is beyond the reach of creditors and lawsuit or bankruptcy judgments. A PAC holds property away from U.S. jurisdiction, thus providing automatic asset protection against future creditors, ex-spouses, and attack from government agencies.
Capital Gains Deferral
One of the primary tax benefits of a PAC is its ability to defer payment of Capital Gains taxes. For example, the sale of appreciated capital assets normally requires the immediate and full payment of Capital Gains taxes in the year of the sale. If, instead, an individual transfers the capital assets in exchange for a PAC, only portions of the Capital Gains taxes are paid in the year the annuity payments are actually received by the Annuitant. A 20-year PAC could allow 20 years of Capital Gains tax deferral.
Tax-Advantaged, Private International Investing
Since property in a PAC transaction is transferred free of income taxes on capital gains or ordinary income (at least, until the annuity payments are received by the Annuitant), the transferred property can be used to earn greater investment returns. There is no reporting of the interim growth or U.S. tax payable at any time on PAC investments; since taxes may be paid at some time in the future, when and if the Annuity is activated and funds flow back to the US. If well planned, such foreign investments can result in both privacy and tax-free returns. A PAC may invest anywhere in the world without the oversight of the U.S. Government. In contrast, U.S. persons are not allowed to invest internationally unless the investment has been approved by the SEC. Consequently, a large number of the most successful mutual-fund and bank investments are outside North America, and therefore are not available to U.S. persons.
Flexibility of Use - Offshore Commerce
A PAC can be structured to operate an international business venture, with indefinite life, and yet the profits are not taxed in North America unless they derive from business activity there.
Lifetime Income without Losing Family Control of Property
A PAC is extremely useful for an Annuitant who desires the security of a fixed income for life and wants control of the asset or business to remain in the family but does not wish to exercise that control personally. By transferring property to a family member utilizing a PAC, the Annuitant is able to shift management of the property to descendants rather than waiting to bequeath it subject to the possible burden of estate taxes.
Gift Tax Savings
A PAC also allows the Annuitant to remove property from his gross estate without the loss of the unified tax credit.
Financial Security/Fixed Income for Life
A PAC provides financial security to the Annuitant since the annuity payments are fixed, usually, over the life of the Annuitant. Increased profits from the international investments can increase the value of the annuity payments.
Conserving Assets in Anticipation of a Catastrophic Illness while Avoiding Disqualification for Federal or State Assistance
In anticipation of a catastrophic illness or escalating medical costs incident to old age, a person may want to transfer property to prospective heirs in order to minimize the amount of shrinkage that will occur in the estate due to medical, hospital or institutional costs. Retaining assets or an outright gift of assets may disqualify that individual for federal or state assistance (i.e., Medicaid, Medi-Cal, etc.). In certain cases, the PAC may be used to allow a client to dispose of these assets to their intended heirs while avoiding disqualification for federal or state assistance.
Q. What is an International Private Annuity?
A. A contractual arrangement between an individual and a foreign company in which the individual transfers property to the foreign company in exchange for the foreign company's agreement to pay the individual an annuity for his or her lifetime.
Q. Will I be taxed when I transfer property to the foreign company?
A. No. When properly structured, an International Private Annuity allows an individual to transfer or dispose of property without paying any taxes currently.
Q. If I don't report any taxes upon the transfer or subsequent sale of the transferred property, when do I incur U.S. taxes in an International Private Annuity transaction?
A. The individual receiving the annuity payments will report the income as it is received from the company making the payments.
Q. How am I taxed on the annuity payments?
A. Part of each payment is returned to you tax-free as a return of your investment. The remainder of each payment is taxed partially as capital gains and partially as ordinary income.
Q. Would it be more beneficial to report the sale of appreciated assets under the instalment sales rules?
A. In many cases, the instalment sales rules are not applicable. For example, the sale of publicly traded stock is not allowed to be reported under the instalment sales method and therefore there is no opportunity to defer the gain recognized on the transfer of appreciated publicly traded stock unless it is transferred for an international private annuity.
Q. Why do I need an International Private Annuity?
A. A properly structured International Private Annuity will provide significant estate tax savings while affording asset protection, diversification of your portfolio using pre-tax dollars, tax deferred portfolio growth, increased investment opportunities and increased financial privacy.
Q. Can a private annuity transaction be done domestically and obtain the same benefits?
A. While private annuities can be done domestically, the Obligor company will be subject to taxation on its investments while a foreign obligor would not be subject to tax. This means the use of an International Private Annuity will provide true tax deferred growth for the Annuitant.
Q. Is this a loophole that will be closed by the IRS?
A. The IRS originally determined that certain transactions would be treated as private annuities in 1969. Since that time, the IRS has attempted to reduce the opportunities to abuse private annuities but has never suggested eliminating private annuities as a whole.
Q. What happens if the IRS does close the loophole?
A. When US tax laws change, they are very rarely made retroactive. So, if there is a law change, most likely, it will not affect pre-existing Private Annuities.
Q. Will I be more likely to be audited if I enter into a Private Annuity transaction?
A. No. There is nothing in the transaction that should cause an audit flag, but if there is an audit, it should be remembered that the transaction is 100% legal.
Q. Who is the annuity issuer?
A. The annuity issuer (known as 'the Obligor') may be an individual, corporation, trust, foundation, or other entity.
Q. Who owns the Obligor?
A. It is dependent upon the situation. In some cases, an obligor may be established specifically for purposes of issuing the annuity and owned by family members of other trusted individuals. In most cases, the Obligor will be owned by foreign persons unrelated to the Annuitant.
Q. What is the difference between a private and commercial annuity?
A. A commercial annuity is issued by an insurance company or another company in the business of issuing annuities while a private annuity is issued by a foreign company.
Q. Why is a private annuity a better planning tool than a commercial annuity?
A. Transfer of property for a commercial annuity will cause the person making the transfer to pay tax immediately on the transfer of property while allowing less flexibility in the terms of the annuity.
Q. Who is responsible for making the annuity payments?
A. In order for the annuity to be properly classified as a private annuity, the obligor company is responsible to make all payments regardless of the income generated by the property the company received from the annuitant.
Q. Can the Annuitant control the property once it is transferred to the Obligor?
A. The annuitant may appoint members of management of the obligor company as well as nominate an independent person to oversee management of the company.
Q. Can the Annuitant control the investments?
A. The Annuitant may appoint an investment advisor who will manage any investments made by the Obligor.
Q. What happens to the property if I die?
A. In most cases, additional planning will allow the value of the property to pass estate tax and income tax-free to the heirs of the Annuitant.
Q. Can I take a loan from the Obligor?
A. In most cases, a loan can be arranged from either the Obligor company or a bank using the annuity as collateral.
Q. What is my recourse if the Obligor does not make the annuity payments?
A. The annuitant has the same legal recourse against the Obligor company as is available in a commercial annuity.
Q. How can I check on the status of the Obligor after property is transferred to it?
A. In most cases, the Obligor will provide financial information directly to the Annuitant or post financial information on the Private Company Registry.
Q. Once an international private annuity is entered into, can it be cancelled?
A. Under certain circumstance, including default on the annuity by the Obligor company, the annuity can be cancelled.
Q. Can my heirs cancel an international private annuity after it has been entered into?
A. It is possible to include a clause in the annuity contract that allows your executor or heirs to void the annuity contract in the event you pass away before the annuity begins payment.
Q. Is it possible to defer collecting annuity payments until my retirement?
A. An Annuitant can ordinarily decide to defer collecting annuity payments until retirement age.
Q. Can I choose to discontinue collecting annuity payments once they begin?
A. Once payments begin, they must continue for the term of the annuity.
Q. Are the annuity payments secured?
A. In limited circumstances, the annuity can be secured without causing adverse tax consequences.
Q. Can I have the Obligor company make annuity payments to a trust, LLC, or other structure?
A. It is possible to have annuity payments made to either a trust or an LLC in certain cases, but not to a corporation. However, the tax consequences of such a transfer should be examined prior to making such a decision.
Q. Once an annuity is established, can additional property be added?
A. Yes, additional property can be added to the annuity after it has been established.
Q. Can real estate be transferred for an international private annuity?
A. While it is possible to transfer real estate for an international private annuity, the complexities of the taxation of foreign owners of U.S. real property requires additional planning.
Q. Are the assets transferred for Private Annuity safe from creditors?
A. Generally speaking the assets will be completely safe from creditors upon completion of the transaction.
Q. Can the transfer of assets be challenged under fraudulent conveyance laws?
A. As long as the present value of the annuity is equal to the fair market value of the property transferred for the annuity, the transfer will not be overturned under the fraudulent conveyance laws.
Q. Are the payments received from the Obligor company safe from creditors?
A. The laws of many states provide an exemption for some portion of annuity payments.
Q. Will the transferred assets be included in my estate for Medicare?
A. Generally, the transferred assets will not be included in the annuitant's estate for Medicare purposes.
Q. Is there a limit to the amount of property that can be transferred for an International Private Annuity without causing tax to be recognized?
A. No. You may transfer any amount of assets to the Obligor in exchange for the Annuity without causing a taxable event.
Q. Are there contribution limitations as there are in a 401(k) program?
A. No. This makes the International Private Annuity an excellent choice for establishing what can be thought of as a private pension plan or retirement account.
Q. Can the Obligor of the international private annuity be a trust?
A. There is no prohibition against using a trust as an Obligor for the annuity. However, the complexity of the taxation of offshore trusts makes it a more complex structure and might result in the present taxation of the Annuitant on the transfer of any appreciated property.