In general, a private annuity is a transaction between two parties where neither is an insurance company. There may be several reasons to set up a private annuity. This article will focus on private annuities as an estate planning tool for closely-held business owners who would like to sell their businesses.
In essence, a private annuity is a deferred payment sale and involves a taxable transaction. There are three types: a life annuity, a stated term annuity, or a maximum payout amount. The life annuity is the most prevalent. A life annuity payment usually stops at the death of the seller, but it may also cover the seller’s spouse.
When a closely-held business owner would like to retire and needs additional funds for retirement, using a private annuity has merit, especially if one of the buyers is from the next generation and already works for the company. It would also apply for key executives who are not family members but are interested in purchasing the business.
The business owner could sell his or her ownership interest to the buyer in exchange for a private annuity. The annuity income payout is based on the fair market value of the entity and the applicable Internal Revenue Service annuity tables and rules are used to determine the payment amounts. The payments are generally higher over the payment period versus an outright installment sale. If the annuitant outlives his life expectancy, the purchaser must continue to make payment for the life of the annuitant or until the agreed upon payout is made.
How is the private annuity taxed? The transaction shifts the future appreciation of the business to the purchaser and out of the seller’s estate for federal estate and most state death taxes. Each payment received by the annuitant has, in part, a tax free return of basis, a capital gain portion, and a portion as ordinary income. Once the annuitant (seller) recovers his sale price, the remaining payments are subject to ordinary income tax rates.
A member of the DuPont family is frequently used to illustrate private annuities. A DuPont transferred property with a fair market value of $13 million to a family-controlled holding company in exchange for payments to himself and his spouse for $900,000 until the death of the survivor. Mr. DuPont lived another 30 years, far beyond his life expectancy, and received $27 million. By the time of his death, the value of the transferred property was more than $500 million and Mr. DuPont was successful in removing hundreds of millions of dollars from his estate.
It must be mentioned that IRS regulations limit the use of their tables mentioned above if the transferor suffers from a terminal illness. A transferor having general infirmities, but not from a specific incurable life-threatening illness, is not deemed to be terminally ill under the rules. The IRS may rebut this, but only by showing clear and convincing evidence. If the IRS cannot show this and the transferor survives 18 months and one day, then the transferor has successfully reduced his estate.
In sum, private annuities are a tool that should be considered in the buyout of a business interest. The major advantages are estate tax savings and a possible lifetime income stream to the transferor. However, the transferee has a number of potential risks. None of the payments can be deducted as interest. There is a risk that the property purchased will not produce sufficient income to meet the annuity payments. And the major risk is that the transferor will live longer than his or her life expectancy.
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