Private annuities are an underused succession planning device.Consider the situation of a typical closely held corporation Noun 1. closely held corporation - stock is publicly traded but most is held by a few shareholders who have no plans to sell corp, corporation - a business firm whose articles of incorporation have been approved in some state , whose founder, although nearing retirement age, is still a majority or 100% shareholder. He has one or more children active in the business and wants them to succeed him as officers and owners. A substantial portion of his estate is made up of the value of this closely held A phrase used to describe the ownership, management, and operation of a corporation by a small group of people. In a closely held corporation, the same people often act as shareholders, directors, and officers, and no outside investors exist. stock. He wants a succession plan that will provide him with lifetime income, minimize estate taxes and transfer the ownership of the company to his children in a way they can afford to pay for it. (This situation may be all too typical.) Often, succession plans involve combinations of stock gifts, insurance-funded cross-purchase arrangements and specific bequests in the client's will. However, a private annuity may be the best overall solution and seems to be an underused succession planning Management Succession Planning In organizational development, succession planning is the process of identifying and preparing suitable employees through mentoring, training and job rotation, to replace key players — such as the chief executive officer (CEO) — device. A private annuity is a method by which a transfer of property is made in return for a promise by the transferee to make fixed, periodic payments to the transferor for the remainder of the transferor's life. In fact, many private annuity transactions involve the transfer of appreciated property to a younger generation family member in exchange for lifetime payments to the older generation transferor. The mechanics of a private annuity transaction are illustrated in the example on page 746. There are both advantages and disadvantages to transferring stock using a private annuity. Advantages * Estate tax savings: The property is immediately removed from the transferor's estate, but he still receives the same lifetime economic benefit as if he had retained the property. * Income taxes: The transferor's income from the annuity is payroll tax-free, partially a tax-free return of basis and partially a long-term capital gain Long-term capital gain A profit on the sale of a security or mutual fund share that has been held for more than one year. . * Lifetime income: The transferor receives lifetime income while management, control and future appreciation of the business are shifted to the next generation. * No deferred gain at death: Unlike a self-canceling installment note An installment note is a form of promissory note calling for payment of both principal and interest in specified amounts, or specified minimum amounts, at specific time intervals. This periodic reduction of principal amortizes the loan. , any deferred gain at the transferor's death is not income with respect to a decedent An individual who has died. The term literally means "one who is dying," but it is commonly used in the law to denote one who has died, particularly someone who has recently passed away. in the seller's estate. Disadvantages * Income taxes: The biggest disadvantage is that the transferee must make the annuity payments out of after-tax dollars. There is no interest deduction Interest deduction An interest expense, such as interest on a margin account, that is allowed as a deduction for tax purposes. for any portion of the payments as in an installment sale Installment sale The sale of an asset in exchange for a specified series of payments (the installments). installment sale A sale in which the buyer is scheduled to make a series of payments over a period of time. . * Security: The private annuity contract Annuity Contract The written agreement between an insurance company and a customer outlining each party's obligations in an annuity coverage agreement. This document will include the specific details of the contract, such as the structure of the annuity (variable or fixed), any must be an unsecured promise to pay. Although the transferee has personal liability for the payments, the property transferred cannot be used as collateral for the payments. If a private annuity is secured, any gain is recognized immediately. * Retained life estate: The property must be transferred with no strings attached, to avoid any potential retained life estate problems under Sec. 2036. For example, a father could not transfer the stock but retain the voting rights Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. through a proxy. * Valuation and gift taxes: Valuation at the time of the transfer is very important. Any excess of the property's value over the annuity's present value generally constitutes an immediate gift. * No basis step-up: The transferee's basis is equal to the sum of all payments made up to the death of the transferor. Since the stock is excluded from the transferor's estate, the transferee does not get the basis step-up he would have received had he inherited the stock. There are obvious estate tax advantages of transferring an asset by use of a private annuity when a transferor lives less than his actuarial life expectancy Life Expectancy 1. The age until which a person is expected to live. 2. The remaining number of years an individual is expected to live, based on IRS issued life expectancy tables. . A medical condition, however, could affect the use of the actuarial tables. In Est. of McLendon, TC Memo 1993-459, the court held that the transferor's medical condition at the time of the transfer had declined to the point that his actual life expectancy was sufficiently predictable and the actuarial tables could not be used to determine the annuity payments. Considering this case, it may behoove be·hoove v. be·hooved, be·hoov·ing, be·hooves v.tr. To be necessary or proper for: It behooves you at least to try. v.intr. To be necessary or proper. the transferor to have a medical examination prior to the transactions, to negate any IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. assertion after a seller's premature death Premature Death occurs when a living thing dies of a cause other than old age. A premature death can be the result of injury, illness, violence, suicide, poor nutrition (often stemming from low income), starvation, dehydration, or other factors. that there was a known incurable incurable /in·cur·a·ble/ (in-kur´ah-b'l) 1. not susceptible of being cured. 2. a person with a disease which cannot be cured. in·cur·a·ble adj. ailment ail·ment n. A physical or mental disorder, especially a mild illness. at the time the private annuity agreement was entered. Rev. Rul. 80-80 has stated that the actuarial tables should be used unless "the individual is known to have been afflicted af·flict tr.v. af·flict·ed, af·flict·ing, af·flicts To inflict grievous physical or mental suffering on. [Middle English afflighten, from afflight, , at the time of transfer, with an incurable physical condition that is in such an advanced stage that death is clearly imminent." In summary, in the right situation, private annuities may be excellent succession planning devices. They can provide an affordable purchase option to the buyer, lifetime income to the seller and significant estate tax savings. Example: Private Annuity Transaction Father F, age 60, sells stock in his closely held business valued at $1,000,000 to his son, S, in exchange for a private annuity. F's basis in the stock is $100,000.
1. Age of transferor 60
2. Fair market value of property at time of transfer $1,000,000
3. Applicable interest rate under Sec. 7520(a)
(120% of the Federal midterm rate for the month
of valuation) 6.4%
4. Annuity factor pursuant to Sec. 7520 (Table S)
using interest rate in line 3 10.1962
5. Annual payments to transferor (line 2 [divided by]
line 4) $98,076
6. Transferor's life expectancy
(Regs. Sec. 1.72-9, Table V) 24.2
7. Expected return (line 5 x line 6) $2,373,439
8. Transferor's basis in property $100,000
9. Exclusion ratio (line 8 [divided by] line 7) 0.042
10. Excluded amount (line 5 x line 9) $4.119
11. Capital gain (line 2 -- line 8) $900,000
12. Annual capital gain amount (line 11 [divided by]
line 6) $37,190
13. Annual ordinary income amount $56,767
S, therefore, will make annual payments of $98,076 to F for the remainder of F's life. Of the $98,076 F receives, $37,190 will be taxed as a long-term capital gain, $4,119 will be a tax-free recovery of basis and $56,767 will be taxed as ordinary income. If, prior to F's retirement, he was receiving an annual salary of around $100,000, the same dollars would be available for S to make the annuity payments. Instead of all F's income being taxed as ordinary income and subject to payroll taxes, it would now be partially tax free and partially capital gain. If the company is an S corporation and S already takes a reasonable salary, he could take payroll tax-free accumulated adjustments account distributions to make the annuity payments. Once the stock is transferred, its total value is removed from F's estate, regardless of how long he lives. |
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