In Estate of Virginia V. Kite et al. v. Commissioner, T.C. Memo. 2013-43, the court confronted the sale of a partnership (“KIC”) in 2001 by Mrs. Kite to her children, in exchange for a private annuity that would begin in 10 years. Mrs. Kite was then 74 and had a greater than 50% chance of living for more than 18 months and in fact she had a 12.5 year life expectancy. However, Mrs. Kite died in 2004. The Court upheld the transaction as being bona fide for full and adequate consideration, stating as follows:
Before participating in the annuity transaction, Baldwin [another limited partnership], which was wholly owned by the Kite children or their trusts, contributed approximately $13.6 million of assets to KIC. As a result, the Kite children did not need to rely on the assets already held by KIC to make the annuity payments. In addition, the Kite children did not transfer the assets underlying the KIC interests back to Mrs. Kite after the annuity transaction was completed. In fact, they did not make any distributions from KIC, but allowed the KIC assets to accumulate in order to have income available when the annuity payments became due. The Kite children therefore expected to make payments under the annuity agreements and were prepared to do so.
Mrs. Kite also demonstrated an expectation that she would receive payments. Mrs. Kite actively participated in her finances and over the course of her life demonstrated an immense business acumen. Accordingly, it is unlikely that Mrs. Kite would have entered into the annuity agreements unless they were enforceable and, more importantly, she could profit from them. In addition, Mrs. Kite, unlike the surviving spouse in Estate of Hurford, was not diagnosed with cancer or other terminal or incurable illness. In fact, the record, which includes a letter from Mrs. Kite’s physician, establishes to the contrary — that Mrs. Kite was not terminally ill and she did not have an incurable illness or other deteriorating physical condition. Mrs. Kite and her children reasonably expected that she would live through the life expectancy determined by IRS actuarial tables, which was 12.5 years after the annuity transaction. Indeed, if Mrs. Kite lived to her life expectancy as determined by IRS actuarial tables, she would have received approximately $800,000 more in annuity payments than the value of her KIC interests. At a minimum, Mrs. Kite would have made a profit with the potential of a greater return if she lived longer.
Mrs. Kite’s profit motive is further underscored by her access to other financial assets, making her interests in KIC dispensable and available for a potentially risky investment. After executing the annuity agreements, Mrs. Kite was still the current income beneficiary of eight trusts holding approximately $20.8 million of marketable securities and her net worth exceeded $3.5 million, which was held primarily by Mrs. Kite’s lifetime revocable trust. Her lifetime revocable trust also had a line of credit of up to $800,00030 of which she borrowed $779,984 from six family ancestor trusts in 2003. Mrs. Kite therefore did not need her income interest that flowed from KIC interests to maintain her lifestyle and, instead, opted to risk those interests for the potential profit from the annuity transaction.
Accordingly, based on the unique circumstances of these cases and, in particular, Mrs. Kite’s position of independent wealth and sophisticated business acumen, the Court finds that the annuity transaction was a bona fide sale for adequate and full consideration.
Was the economic condition of the children critical? The court appears to conclude they had sufficient assets to make the payments in the discussion above. However, the opinion states elsewhere:
If Mrs. Kite died within the 10-year deferral period, her annuity interest would terminate and, as a result, her interest in KIC, and indirectly her interest in the Baldwin notes, would be effectively removed from her gross estate. However, if Mrs. Kite survived the 10-year deferral period, her children would be personally liable for the annuity payments due on each annual payment date. What is more, if Mrs. Kite survived for 13 years or longer, her children could be insolvent after the first three years of payments, in view of their then-current personal assets.
Footnote 19 contains an unhelpful observation: “Needless to say, after finalization of the proposed annuity transaction, the net value of the Kite children’s personal assets would increase substantially.”
Under current law, a transaction directly with children would be a sale of all the transferred assets immediately which, absent good basis, is undesirable. A sale to a grantor trust avoids the income tax problem but creates a gift tax problem because of the “exhaustion test” of Treas. Reg. §20.7520-3(b)(2)(i) which requires that the annuity may be paid if the annuitant survives until age 110. Consider a deferred private annuity with a long deferral period undertaken by the surviving spouse immediately after the death of the first spouse.