T—Installment Sale and Private Annuity

Both the installment sale and the private annuity are used to transfer future appreciation through sale of property (e.g., a business interest) from one individual to another, in our example, from parent to child. There are, however, substantial differences in both the tax implications and resulting rights and obligations.

INSTALLMENT SALE.The primary distinguishing characteristic of the installment sale, as compared to the private annuity, is thefixed scheduleof payments made by the buyer. The parent (as seller) can spread a large gain and the resulting income tax liability over a number of years, while at the same time transferring future appreciation to the child (as purchaser).

The child’s obligation to the parent may besecured, which also distinguishes the installment sale from the private annuity. With respect to the parent, each payment is divided into gain, interest income, and a nontaxable recovery of basis. If the parent dies, payments continue to the parent’s estate. Although the child’s obligation could be cancelled by the parent’s executor, or passed by will to the child, previously unreported gain would still be taxable to the estate.

PRIVATE ANNUITY.The private annuity obligates the child to make payments for thelifetimeof the parent, and the obligation may not be secured in any way. Unlike the installment sale, the parent must recognize the entire amount of the gain or loss at the time of the transaction, and the child cannot deduct any part of the payments. Each payment is divided into interest income and a nontaxable recovery of basis. Because payments terminate at the parent’s death, the annuity is considered to have no value and should escape taxation in the parent’s estate.

In considering a private annuity, both parties must recognize that if the parent lives for many years, the child could end up paying more for the asset than would have been paid with an installment sale. The parent must also recognize that the expected income could be in jeopardy if the child were to die. However, providing for insurance on the child’s life sufficient to meet the annuity obligation can usually eliminate this risk. For most taxpayers, the temporary gift and estate tax exemption increase to $12,060,000 (projected in 2022, double that for husband and
wife) does away with the tax need to transfer property other than by gift (or bequest). But, for parents who need the cash flow created by installment sales and private annuities – these planning tools remain important alternatives. The health (and anticipated life expectancy) of the parents as well as the amount of potential taxable gain are the two primary issues to consider when deciding between these planning options.