The goals of succession plans in closely held businesses often include lifetime income for the owner, minimizing estate taxes, and transferring ownership to children at affordable terms.
For example, take Fred Smith, a 100% shareholder in Smith, Inc. He has two children active in the business whom he would like to succeed him as officers and owners. Since his closely held stock makes up the bulk of his estate, he also expects to get most of his retirement income from the business.
Fred could set up a private annuity that would transfer ownership of the business to his children and in return, provide him with periodic fixed payments over his lifetime. 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.
Fred's children's obligation to pay him would end upon his death, and nothing relating to the value of the business would be included in his gross estate.
- Estate Tax Savings: The property is immediately removed from Fred's estate and future appreciation of the business is shifted to the children.
- Lifetime Income: Fred still receives income for his lifetime equivalent to what he would receive if the property had not been transferred.
- Income Tax Savings: The annuity income is partly a tax-free return of basis and partly a long-term capital gain, with no associated payroll taxes.
- No "Deferred Gain" Consequences at Death: With an annuity arrangement, any deferred gain at Fred's death is not considered "income with respect to a decedent" in his estate; in contrast, if the property had been sold in installments, any "notes" not yet paid at his death would be included in his gross estate.
Potential Disadvantages and Concerns
- Estate Taxes: When the property is transferred, it is removed from Fred's estate, creating potential estate tax savings. However, if he allows the annuity payments to accumulate and exceeds his life expectancy, he may lose the estate tax savings unless he disposes of the extra income.
- Income Taxes: Fred's children are required to make the annuity payments with after-tax dollars; they cannot take a tax deduction on the interest as they could in an installment sale.
- Characterization as Retained Life Estate: To avoid potential retained life estate problems under Sec. 2036, there can be no strings attached to the transferred property (for instance, Fred cannot keep his voting rights as the owner).
- Security: The private annuity contract must be an unsecured promise to pay in order to benefit from the annuity tax rules and avoid immediate tax on the gain.
- Valuation and Gift Taxes: If the property's value exceeds the present value of the annuity, the difference will be considered an immediate gift for tax purposes. With closely-held stock and other types of property where exact valuation may be difficult, the IRS may challenge the valuation used in creating the annuity contract.
- No Basis Step-up: The children do not get the stepped-up basis that would apply if the stock were inherited; their basis equals all the payments made up to Fred's death.
Private annuities can be valuable tools for intrafamily estate planning, since they allow the transfer of appreciated property to younger family members in exchange for lifetime payments to the older generation. However, because the private annuity is typically a transaction between related parties, its use may be scrutinized more carefully by the IRS. Anyone considering this technique should be familiar with Chapter 14 of the IRC (particularly Sec. 2703).