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Annuity structure: private annuity transactions can help clients cash out, defer gains.

In the increasingly scrutinized world of tax planning, practitioners are finding it more difficult to deliver on their clients' expectations of selling an appreciated asset without triggering an income tax.

What can practitioners do to help fulfill this request? Try private annuity transactions, a favored planning tool of practitioners for more than 70 years.


Using a typical model, assume that Paul wants to sell his sole proprietorship, valued at $5 million, and he has $2 million of taxable built-in gain.

He forms a legal entity, such as a corporation or limited liability company, which we'll call the "Company," that will be owned primarily by his sons and partially by Paul.

Paul then sells his business to the Company for $5 million, payable as a lifetime income stream. The Company operates the business, finds a buyer and sells the business for $5 million in cash.

The end result is that Paul has cashed out of his business. While he did not receive the cash directly, the cash paid by the buyer is owned by an entity that Paul controls and that is, in turn, owned by him and his sons.

Variations on this structure may include an entity owned entirely by one of Paul's children or an entity owned only by Paul.


Tax consequences of the transaction relate to:

* Paul on the sale of the business to the Company in exchange for a stream of payments over his lifetime;

* the Company on the purchase from Paul; and

* the Company on the sale of the business.

When a stream of payments is paid over someone's lifetime and not for a fixed term, it's known as an annuity, not an installment sale.

Annuities are taxed under Internal Revenue Code Sec. 72 in a manner similar to the installment method of IRC Sec. 453. Each annual payment consists of a tax-free return of basis; a capital gain; and interest income (Rev. Rul. 69-74, 1969-1 C. B. 43).


Annuity tax treatment, however, avoids triggering the gain on a subsequent resale by a related party. IRC Sec. 453(e) provides that if A sells assets to B (a related party) on the installment method, and B resells the assets within two years, A recognizes all of the gain that was originally deferred.

Consequently, when Paul sells to the Company in exchange for a lifetime stream of payments, he will be taxed as each annual payment is received, and the subsequent resale by the Company will not accelerate the $2 million gain.

The amount of each payment will be determined up front based on Paul's life expectancy, or possibly the joint life expectancy of Paul and his spouse.

The Company will pay Paul $5 million for the business (the present value of the lifetime stream of payments) and that will be the Company's tentative tax basis in the business. The actual payment received over Paul's lifetime may be more or less depending on how long he survives.

When the Company resells the business, little or no gain will be recognized. The final tax basis will be computed upon Paul's death, when the actual amount paid by the Company will be known. Then, if the Company already sold the business, it may realize a gain or a loss based on the difference between the final tax basis and the tentative tax basis.


Other advantages of private annuities include:

* Removing the assets sold through the private annuity and any future appreciation of such assets from the transferor's taxable estate without gift tax implications;

* Shifting taxable income to family members in lower tax brackets; and

* Serving as possible asset protection devices.

The biggest disadvantage is that each annual payment Paul receives includes an ordinary income component that is economically equivalent to interest, but does not constitute interest because Original Issue Discount rules do not apply to private annuities.

This component will be taxable to Paul, but not deductible by the Company.


Private annuity transactions are used to defer gain on sales of appreciated assets, including real estate, businesses and stocks. Sales can be structured to irrevocable trusts for family members, partnerships, limited liability companies and corporations.

Despite the possibility of favorable tax treatment, extreme caution should be exercised with private annuity structures.

First, practitioners should establish a viable non-tax business purpose for the annuity structure. Transferring assets into a limited liability entity to obtain liability protection, or engaging in succession planning, are good business reasons.

Second, because private annuity transactions may always be challenged under the step transaction doctrine, timing is critical. This means if the client is already shopping their asset, it is probably too late to implement this structure.

Finally, beware of pre-packaged private annuity trusts. This "one size fits all" may land the client in trouble.

Jacob Stein, Esq. is a certified tax law specialist and partner with Boldra, Klueger & Stein, LLP in Los Angeles. He also is an instructor with the Education Foundation. You can reach him at

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Article Details
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Author:Stein, Jacob
Publication:California CPA
Geographic Code:1U9CA
Date:Jun 1, 2006
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