When using the annuity exemption in your asset exemption plan, an additional planning opportunity exists because the exemption usually extends to private annuities. This is an arrangement, established by contract, between two individuals, who are usually family members.

Private annuities are frequently used in estate planning. Usually, an older family member (e.g., a parent) "sells" property, such as interests in the family business or other securities, to the younger family member (e.g., a child) in exchange for a private life annuity.

The transfer eliminates gift and estate taxes on the amount transferred. Because the older family member receives a private annuity of equal value in return for the transfer, no gift tax is due on the transfer. In addition, the value transferred is removed from the taxable estate of the older family member, because the life annuity held by the older family member terminates upon his or her death. The gift and estate tax savings created by the transfer can be significant.

For many parents, the process of reducing the size of their taxable estate presents a dilemma. To reduce their estate taxes, parents must, many times, transfer wealth to children during the parents' lifetime. Yet, they are reluctant to give up all rights in the property, because they believe they may need some of these resources in the future. The private annuity solves that dilemma.

John Smith has operated a very successful business for many years. He now owns a stock portfolio valued at $1 million. He transfers $500,000 of the securities to his daughter in exchange for a private annuity that will pay him $1,000 per month for life. (It is assumed here that the $1,000 per month makes the exchange of equal value). The $500,000 has been removed from Smith's taxable estate. This transfer, alone, could have saved Smith $200,000 or more in estate taxes, depending on the value of other assets he owns. In addition, no gift taxes are due, because no gift was made, as there was an even exchange. Finally, Smith has now converted the $500,000 of securities, which formerly were within the reach of his creditors, to an exempt asset.

You should consider a private annuity if you hold substantial nonexempt assets and live in a state that exempts annuities, or if federal estate taxes are an issue for you. These assets can be transferred to a child or other family member in exchange for a private annuity, which would convert nonexempt assets to exempt, as well as eliminate estate and gift taxes.

While this may not be a first-line strategy for the average business owner, as time passes and more wealth is generated by the business, it becomes a very attractive strategy. The annuity contract must be drafted, and the annuity valued, so that no gift tax is due on the transfer. This will normally require the services of an estate planning attorney.

The private annuity is also a common strategy used to transfer interests in a business from parents to children. Nonvoting interests can be transferred in this way to reduce that parent's taxable estate, while allowing the parent to maintain control of the business.

Finally, it must be remembered that the assets transferred will be owned by the transferee (e.g., the child), and thus within the reach of that individual's creditors. Even here, however, the assets can be protected if the transfer is made to a trust (with a spendthrift clause) that will manage the assets for the beneficiary (see our discussion of asset protection trusts).

It's important to note that if the annuity you establish is especially valuable, you would have to claim your state's exemptions in a bankruptcy proceeding, because there is no federal exemption for annuities.