Over time assets ordinarily appreciate, and as assets grow larger in value so do estate taxes. To prevent appreciating estates from creating a serious tax problem some techniques can be used to "freeze" asset values by moving appreciation out of the estate and others, like the private annuity, can freeze an estate and move an entire asset out of an estate in one day. 

Let's consider a hypothetical fact pattern. Dad wants to leave his business, currently worth $10 million, to his adult children but neither he, the children, nor the business have the liquidity to pay the associated $5 million estate tax bill. The business is growing well, Dad cannot even gift away the appreciation, thus his potential estate tax bill grows larger each year. Dad is reluctant to sell the business because he would have to pay millions in capital gains tax, would still have estate tax concerns, and more importantly, he would like the business to stay in the family. Is there a way to keep the business in the family and avoid estate tax? 

A private annuity can do just that. A private annuity is the sale of an asset for an income stream of equal value. In essence, Dad sells the company to his children in return for an income stream for the rest of his life (an annuity). Annuity payments are calculated using IRS tables that consider age, interest rates, and purchase price. The adult children, for the most part, use the income generated by the company, and their own resources to make the annuity payments. 

Dad will still enjoy his accustomed lifestyle because he receives substantial annuity payments each month. But, the day he establishes the private annuity the company is out of his estate - estate tax on the business is now $0. While there are several techniques that are highly effective in reducing estate taxes, most require time to implement (e.g. gifting programs), whereas the private annuity can remove a substantial asset from an estate in one step. Additionally, all future business appreciation benefits the children, since the children now own the business, and avoids dads estate tax entirely. 

The capital gains tax is deferred since dad must only recognize a portion of the gain with each payment. If Mr. Gordon dies before receiving the full value of the business, all the deferred gain is forgiven. For example, if dad dies after just one payment, having recognized virtually none of his capital gain, the remaining 99% of the capital gain is forgiven and never burdens his estate or heirs.

What if the reverse occurs and dad lives to be 105? His children are now making payments that exceed the fair value of the company. Can we limit the number of payments? We can with a variation known as a private annuity for a term of years (PATY). A PATY is identical to a traditional private annuity except annuity payments have a time limit (e.g. 10 years), which dad and his children decide upon. If dad passes away prior to the time limit the result is the same as with a traditional private annuity; but if he survives beyond the term the children will not overpay for the company. If dad outlives the term of years what income will he have? Dad will have income from his other assets (the private annuity was for the business only) and if he requires more income he can act as a consultant to the company in return for consulting fees.

A private annuity, while not practical for all assets (e.g. non-income producing), but can be highly effective in avoiding estate taxes and retaining family control. Thus, private annuities are a potent technique which should be considered in the course of a thorough professional planning effort.