The private annuity can be an effective way to transfer appreciated property in exchange for lifetime payments to the older generation.
In many closely-held businesses, the goals of a succession plan often include providing the owner with lifetime income, minimizing estate taxes, and transferring ownership to children under terms which they can afford.
Consider Gwen Wyatt, a 100% shareholder in retailer Wyatt Furniture Inc. She has two children active in the business and since she is nearing retirement, she would like them to succeed her as officers and owners. Furthermore, since the closely-held stock comprises the bulk of her estate, she is looking to the business to provide most of her retirement income.
Gwen and her children could structure a private annuity which would provide periodic fixed payments to Gwen over her lifetime. In return for transferred ownership of the business. A private annuity is an arrangement whereby one person (the transferee or obligor ) who is not in the business of writing annuities agrees to make periodic payments to another person (the transferor or obligee), usually for the obligee's life, in exchange for a property transfer.
If the value of the property transferred and the value of the annuity (actuarially Determined using IRS tables) were equal, there would be no gift. If the property transferred was worth more than the promised annuity, the excess would be deemed a gift and could have gift tax consequences. Upon Gwen's death, the obligation of her children would end, and nothing relating to the value of the business would be included in her gross estate.
Estate tax savings: The property is immediately removed from Gwen's estate; future appreciation of the business is shifted to her children.
Lifetime Income: Gwen receives an economic benefit (i.e. lifetime income) as if the transferred property had been retained.
Income Taxes: The income from the annuity is partially a tax-free return of basis and partially a long-term capital gain; there are no payroll taxes associated with the annuity income.
POTENTIAL CONCERNS AND DISADVANTAGES
Income taxes: Gwen's children must make the annuity payments with after tax dollars; there is no interest deduction for any portion of the payments as there would be in an installment sale.
Security: The private annuity contract must be an unsecured promise to pay in order to achieve the benefits of the annuity tax rules and avoid an immediate tax on the gain.
Valuation and Gift Taxes: Any excess of the property's value over the present value of the annuity will generally constitute an immediate gift. With closely held stock, and other types of property where exact valuation may be difficult, the IRS may challenge the valuation use in creating the annuity contract.
No Basis Step-up: The children do not get the stepped-up basis which would apply if the stock were inherited. Rather, their basis is equal to all the payments made up to Gwen's death.
Estate Taxes: By transferring the property in exchange for the annuity, the property is removed from Gwen's estate. However, if Gwen allows the payments received to accumulate, and she exceeds her life expectancy, the estate tax savings may be illusory unless such income is consumed or otherwise disposed.
In appropriate circumstances, the private annuity has been a valuable intrafamily estate planning tool, enabling the transfer of appreciated property to younger family members in exchange for lifetime payments to an older generation transferor.
However, because the private annuity is typically a transaction between related parties, its use may come under more careful scrutiny of the IRS. Familiarity with Chapter 14 of the IRC (particularly Sec. 2703) will be helpful for anyone considering using this transfer technique.
Steven J. Schacter, Esq. is an attorney who specializes in business and estate planning for furniture retail and manufacturing firms. Question on any aspect of financial planning can be sent to him care of FURNITURE WORLD at email@example.com.