Is it possible to lose a family business or other valuable asset to
estate taxation? After a business owner dies the federal and state death
taxes deplete approximately 50% of the estate - and the tax bill is due
in cash. With only nine months to raise such a large amount of cash,
heirs may be forced into selling assets that were expected to remain in
the family for generations. To make matters worse, some assets will be
difficult to sell and may have to be sold at bargain prices.
assets ordinarily appreciate, and as assets grow larger in value so do
estate taxes. To prevent appreciating estates from creating a serious tax
problem some techniques can be used to "freeze" asset values by moving
appreciation out of the estate and others, like the private annuity, can
freeze an estate and move an entire asset out of an estate in one day.
Let's consider a hypothetical fact pattern. Dad wants to leave his
business, currently worth $10 million, to his adult children but neither
he, the children, nor the business have the liquidity to pay the
associated $5 million estate tax bill. The business is growing well, Dad
cannot even gift away the appreciation, thus his potential estate tax
bill grows larger each year. Dad is reluctant to sell the business
because he would have to pay millions in capital gains tax, would still
have estate tax concerns, and more importantly, he would like the
business to stay in the family. Is there a way to keep the business in
the family and avoid estate tax?
A private annuity can do just that. A private annuity is the sale of
an asset for an income stream of equal value. In essence, Dad sells the
company to his children in return for an income stream for the rest of
his life (an annuity). Annuity payments are calculated using IRS tables
that consider age, interest rates, and purchase price. The adult
children, for the most part, use the income generated by the company, and
their own resources to make the annuity payments.
Dad will still enjoy his accustomed lifestyle because he receives
substantial annuity payments each month. But, the day he establishes the
private annuity the company is out of his estate - estate tax on the
business is now $0. While there are several techniques that are highly
effective in reducing estate taxes, most require time to implement (e.g.
gifting programs), whereas the private annuity can remove a substantial
asset from an estate in one step. Additionally, all future business
appreciation benefits the children, since the children now own the
business, and avoids dads estate tax entirely.
The capital gains tax is deferred since dad must only recognize a
portion of the gain with each payment. If Mr. Gordon dies before
receiving the full value of the business, all the deferred gain is
forgiven. For example, if dad dies after just one payment, having
recognized virtually none of his capital gain, the remaining 99% of the
capital gain is forgiven and never burdens his estate or heirs.
What if the reverse occurs and dad lives to be 105? His children are now
making payments that exceed the fair value of the company. Can we limit
the number of payments? We can with a variation known as a private
annuity for a term of years (PATY). A PATY is identical to a traditional
private annuity except annuity payments have a time limit (e.g. 10
years), which dad and his children decide upon. If dad passes away prior
to the time limit the result is the same as with a traditional private
annuity; but if he survives beyond the term the children will not overpay
for the company. If dad outlives the term of years what income will he
have? Dad will have income from his other assets (the private annuity was
for the business only) and if he requires more income he can act as a
consultant to the company in return for consulting fees.
A private annuity, while not practical for all assets (e.g. non-income
producing), but can be highly effective in avoiding estate taxes and
retaining family control. Thus, private annuities are a potent technique
which should be considered in the course of a thorough professional