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Business Law: Transfer Techniques for Family Businesses |
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| Private Annuities |
Structure
An annuity is a contract or agreement by which a person receives fixed payments at specified intervals on an investment for a lifetime or for a specified number of years.
The traditional parties to an annuity are:
A. the issuer or the person or entity promising to make the annuity payment;
B. the owner or the person owning the annuity; and
C. the annuitant/life beneficiary or the person with the right to receive the payments.
The annuitant can be based on a single life or on multiple (usually no more than two - referred to as joint) lives.
Most people are familiar with commercial annuities. In a commercial annuity, the owner transfers cash to the issuer in exchange for the issuer making payments to the annuitant. However, private annuities can be created for specialized purposes.
In estate planning and business succession plans, a private annuity is a sale of family assets by the senior family member to the junior family member(s) in exchange for the unsecured promise by the junior member to make specific, periodic payments to the senior member for the senior member's life. In a private annuity, the owner is the senior member, the issuer is the junior member, and the annuitant is the senior member or the senior member and his or her spouse. The buyer can be individual junior family members or a trust for the benefit of the junior family members. The family assets can be closely held stock or real estate.
Advantages
The advantages of a private annuity sale are:
1. Estate Tax Savings: The annuity converts the annuity property from assets includible in the estate of the owner into a life estate which is not includible in the estate of the owner.
2. Estate Tax Savings: The annuity shifts any future appreciation in the annuity property to the junior family members.
3. Estate Tax Savings: If the rate of return on the investment of the annuity property is greater than the annuity rate, then the estate tax savings are increased.
4. Estate Tax Savings: If a favorable discount is applied to the valuation of the annuity property being transferred, then the estate tax savings are increased.
5. Income Tax Savings: The annuitant recognizes part of each annuity payment over his or her life expectancy as ordinary income, capital gain, and return of capital or principal. This deferral opportunity presents an attractive feature of the private annuity. Unless the annuity payments greatly exceed the income the annuitant previously received from the annuity property, then the annuitant will generally enjoy income tax savings, because part of each payment will represent a tax-free recovery of capital or principal. (NOTE: The IRS issued proposed regulations in October of 2006 which would significantly change the income taxation of private annuities resulting in the realization of capital gains upon the transfer of the annuity property.)
6. Gift Tax Savings: The owner pays no gift tax if the actuarial value of the annuity promise equals the fair market value of the transferred property.
7. Family Control: The annuity property remains in the ownership of the family and therefore ensures continued family control.
8. Succession Plan: The private annuity operates as a form of family business succession plan allowing the senior family member to transfer the family business to the junior members of the family.
9. Lifetime Income Stream: The annuitant receives a lifetime income stream in the form of the annuity payments.
10. Alternative or Supplemental Retirement Plan: The lifetime income stream can serve as an alternative or supplemental retirement plan.
11. Estate Liquidity: The private annuity provides liquidity to the senior family member's estate. For example, if the senior member exchanges stock in a closely held corporation for a private annuity, then the senior member has removed from his or her estate an illiquid asset that could create a substantial estate tax liability (due 9 months after death) without any cash to pay for that liability.
12. Probate Avoidance: The private annuity avoids probate, thereby saving estate administration expenses related to the value of the annuity property.
Disadvantages
The disadvantages of a private annuity sale are:
1. Estate Tax Costs: Annuity payments which are not spent or consumed by the annuitant are includible in the taxable estate of the annuitant.
2. Income Tax Costs: The annuity payments are not deductible as interest. Therefore, the junior member pays income taxes on the income earned to the make the annuity payment with no deduction and the senior member pays income taxes on a portion of the annuity payment received by the senior member as annuitant. In other words, the annuity payments are made from after-tax dollars thereby increasing the overall income tax burden.
3. Investment Risk: Both the senior member and the junior member in a private annuity transaction bear the risk that the annuity property will either decline in value or yield a rate of return at or below the annuity rate. If the annuity property declines in value before the senior member's death, then the senior member's estate may be greater in value than if no private annuity transaction occurred. If the rate of return of the annuity property is less than the annuity rate of return, then the estate tax savings can diminish significantly.
4. Inflation Risk: The annuity payments are not indexed for inflation. Therefore, during periods of inflation, the buying or purchasing power of the private annuity payments will shrink to the detriment of the senior member.
5. Default Risk: The promise to the pay the annuity must be unsecured. Therefore, the senior member bears the risk that the junior member will not be able to make all of the payments due to one or more of the following default factors: waste of the annuity property, inability to yield a rate of return greater than the annuity rate, death of the junior family member, disability of the junior family member, divorce of the junior family member, tort claims against the junior family member, and/or failure of the family business. (NOTE: Senior family members may mitigate the risk of default in a number of ways. First, the senior family member or the family business may purchase adequate disability insurance and life insurance on the junior. Second, a family business may enter into a long-term employment contract with the junior family member to fund the future private annuity payments by salary or salary continuation. Third, the senior family member may gift other assets to the junior family member, especially assets that generate current income to meet the annuity obligation. Fourth, in a private annuity transaction with a trust, the beneficiaries can personally guarantee the annuity payments.)
6. Mortality Risk: If the senior member outlives his actuarial life expectancy, then any retained annuity payments increase the senior member's gross taxable estate. In some instances, the late death of the senior member may even cause the estate tax to exceed what would have been owed if the annuity property had instead been retained in the senior member's estate. This is particularly true with non-income producing property.
7. Valuation Risk: To avoid the payment of any gift taxes, the value of the annuity property must equal the actuarial value of the annuity promise. Although the value of the annuity promise can be readily determined from published IRS tables, the value of any annuity property which does not have a ready identifiable market may be questioned by the IRS. If the IRS succeeds in assigning a higher valuation to the annuity property, then the transfer of the annuity property may result in a taxable gift in excess of the senior member's exemption amount and the annual gift tax exclusions, thereby resulting in a gift tax deficiency, interest, and penalties. (NOTE: The valuation risk can be minimized in several ways. One, the senior member can engage a qualified appraiser. Two, the senior member can file a gift tax return which triggers a three year statute of limitations for the IRS to audit the valuation.)
8. Income Producing Assets: In order to fund the annuity payment, the annuity property must be income producing assets. |
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| SCIN |
Structure
An installment note is a form of promissory note requiring the payment of both principal and interest in specified amounts at specific time intervals over a set period of time, normally a term of years.
A self-canceling installment note (SCIN) involves a sale of property to a buyer in exchange for an installment note that expires upon a certain cancellation event, typically the seller's death. The self-cancelling feature requires that the interest rate under the note contain a premium. In other words, the buyer pays a higher interest rate in exchange for the self-cancelling feature.
The traditional parties to a SCIN are:
A. the seller or the person who transfers the property in exchange for the note; and
B. the buyer or the person who promises to pay the note.
Advantages
The advantages of a SCIN are:
1. Estate and Gift Tax Savings: In general, a SCIN provides the same potential estate and gift tax savings as a private annuity. SCINs remove the sold property from the seller's gross taxable estate. If the sold property appreciates in value, then the SCIN freezes the future estate tax by shifting any excess appreciation in the sold property to the buyer. The estate tax savings diminish if the seller retains the payments in a taxable SCIN transaction. In addition, if the seller dies before the end of the term, then the SCIN produces significant estate tax savings.
2. Security Interest: The SCIN can be secured. The security interest decreases the risk of default thereby secures the income stream.
3. Income Tax Deduction: The interest payments made by the buyer in a SCIN may be income tax deductible.
4. Income Stream: The seller receives an income stream in the form of the installment payments.
5. Alternative or Supplemental Retirement Plan: The income stream can serve as an alternative or supplemental retirement plan.
6. Premium Interest Rate & Shorter Term: Due to the higher "risk" premium interest rate required to support the at-death cancellation feature, and due to a required term of less than the seller's life expectancy, the SCIN payments generally exceed payments made under private annuities, thereby providing a larger income stream for senior family members.
7. Estate Liquidity: The SCIN provides liquidity to the senior family member's estate. For example, if the senior member sells stock in a closely held corporation in exchange for a SCIN, then the senior member has removed from his or her estate an illiquid asset that could create a substantial estate tax liability (due 9 months after death) without any cash to pay for that liability.
8. Probate Avoidance: The SCIN avoids probate, thereby saving estate administration expenses related to the value of the sold property.
Disadvantages
The disadvantages of a SCIN are:
1. Income Tax Costs: The seller recognizes gain on the assets sold over the term of the SCIN. (NOTE: A new technique has been developed by which the property is sold to an Intentionally Defective Grantor Trust (IDGT). The IDGT is a grantor trust for income tax purposes - in other words, the IDGT is the seller for the assessment and payment of income taxes. The theory is that, if the seller sells to himself, then there is no taxable event. Therefore, if the seller sells the property to an IDGT, then no loss or gain is recognized upon the sale.)
2. Income Tax Costs: The seller pays income taxes on the interest received.
3. Income Tax Costs: The income tax consequences of the cancellation feature are not clear under present law. The IRS position is that any remaining deferred capital gain is realized upon the death of the seller, thereby resulting in income in respect of a decedent (IRD) to be reported on the estate income tax return and to be paid by the estate. This position is being litigated at present.
4. Valuation Risk: To avoid the payment of any gift taxes, the sales price and the length of the term must be reasonable, and the value of the sold property must be "substantially equal" to the value of the installment obligation.
5. Premium Interest Rate & Shorter Term: Due to the higher "risk" premium interest rate required to support the at-death cancellation feature, and due to a required term of less than the seller's life expectancy, the SCIN payments generally exceed payments made under private annuities, thereby increasing the burden on the buyer to make the payments.
6. Transfer Restrictions & Realization of Capital Gains: The seller must recognize the deferred capital gain if the buyer disposes of the sold property within two years of the date of the installment sale.
7. Fixed Term: The term of the SCIN may be for a term of years only, not for the lifetime of the seller. |
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