Summary: What’s better than a Slap Chop (sorry Vince)? Could it be a private annuity? While your wealth manager that told you never to buy an annuity (that’s another topic for someone else’s newsletter) she wasn’t talking about this estate planning technique. Finally, if you expect the estate tax to roar back with a vengeance in 2011, private annuities may warrant another look.
Who, What, Why: ◙ Who: In a private annuity transaction you sell an asset, say an interest in a family business, to a grantor trust that will benefit your heirs. If this sounds a little funky and differs from the description of a private annuity deal in your old accounting course books, that because the IRS issued proposed private annuity Regulations, Prop. Reg. Sec. 1.72-6; 1.1001-1 that changed how these deals are typically done. These regs remain in the “proposed” mode, because, the IRS often uses the Orson Welles Paul Masson commercial paradigm: “We will finalize no regulation before its time.” ◙ What: The trust will promise to pay you for the business specific, periodic payments for the rest of your life. Yes folks, that’s an annuity, and because it is your trust paying for it, it’s a “private” annuity in contrast to an annuity an insurance or investment firm sells you. You can even structure the deal as a joint annuity to pay for the lives of both you and your spouse. ◙ Why: When you die the annuity payments are over and there should be nothing left in your estate for Uncle Sam to tax (with a $1 million estate tax inclusion on the books for next year, ya better start your tax engines revving).
Buzz: Now, clearly this can’t be an exciting tax technique without some confusing jargon (Hey Dr. Ray, you had to call my knee a patella so don’t bust my chops). You’re called the “annuitant.” The trust who is buying your business is called the “obligor.” More buzz to come. Private annuities may be an excellent tool for removing a significant asset from your gross estate for estate tax purposes, while simultaneously providing you with a lifetime source of cash flow.
The Good, The Bad & The Ugly: You didn’t know that Clint was an estate planner?
◙ The Good: When you’re gone it’s gone! Nothing left to tax in your estate if you spend each year’s annuity payments. If you sold assets to a trust for a note, the value of the note is still included in your estate (unless you use a note that by it terms cancels on your death, called a “SCIN”). You can keep the asset, like a closely held business, within family control through the use of the family trust as the purchaser. But perhaps for most folks, getting a fixed quarterly or annual payment for their lives is exactly the financial simplification and security they want. Mom can sell the family widget business to a trust for the kids and head off to sunny Florida to the carefree golfing lifestyle and just check her mailbox once a quarter. Since the buying trust is a “grantor” trust mom will pay all the income tax on the trust earnings, thus further depleting her future taxable estate.
◙ The Bad: No, it’s not all peaches and cream. Once you’re done wincing at the professional fees, there are some real issues to consider. You’re getting a fixed annuity for life. What if inflation ramps up to 10%+ a year? Have your CPA generate some projections of future cash flows, inflation assumptions and then stress test the model. Be sure you leave enough off the table that you don’t have to ask your son-in-law for grocery money. For the kiddies, if you surprise them and 'dif-tor heh smusma' [for you non-Trekkies that’s Vulcan for live long and prosper] Junior could be paying you a boat load more for the Widget business than he thought. Remember, if you live to 120 Junior pays the annuity to 120 even though the calculations were based on life expectancy tables. Is that a bad thing? The flip side is that if you die earlier than your life expectancy Junior makes out like a bandit. However, if you die too soon after the annuity sale the IRS may argue that the transaction was a set up and the health issues known. Perhaps Junior should not be your health care proxy. What if Junior ruins the business while you’re on the links? But that risk is an issue when any technique is used to transition significant business or investment interests to an heir.
◙The Ugly: Code Section 2036 is Freddy Krueger of the tax world. If your annuity payments are tied to closely to the income from the Widget business sold to the trust, the IRS will argue that the transaction should be treated as if you made a gift to a trust in which you retained an interest in the income for life. Under Code Section 2036 that puts the entire Widget empire back in your taxable estate (think 55% rates next year!). If you succeed in removing family business interests from your estate sounds like a win, but the IRS has the home team advantage. The benefits from removing the family business interests from your estate with a private annuity means those assets will not be available to qualify for estate tax deferral under Code Sec. 6166 (permits paying the estate tax in installments over 14 years), or the alternate valuation rules (value the assets 6 months after death if the value is lower than the date of death value), the use of a Graegin loan (non-pre-payable loan with all interest deducted as an estate administration expense), and other possible estate tax benefits. If the annuitant has a shortened life expectancy, the IRS can argue that the tables normally used to calculate the annuity amount are inappropriate to use. Rev. Rul. 66-307, 1966-2 C.B. 429; Treas. Reg. Sec. 1.7520-3; 20.7520-3(b)(3). This issue can be addressed in appropriate physician letters.
◙ Some practitioners suggest avoiding Freddy by crafting the trust to conform to the requirements of a GRAT by including in the trust the requirements for the private annuity payments to be a “qualified interest” under Chapter 14. Other GRAT terms might include a prohibition of additional contributions, prohibit distributions from the trust to anyone other than the Seller during the term of the interest, and prohibit commutation. Even with the inclusion of these provisions, there is no assurance that the transaction could also meet the requirements of a “qualified interest.”
◙ The Trust has to be characterized as a grantor trust for income tax purposes to avoid your triggering a large tax cost on the sale (with the proposed regs, there is no other way). The most common approach is for the seller to retain a right to substitute property of an equal value to the Trust assets (i.e., the Widget business you sold to the trust). However, the right to substitute raises an issue in the context of a sale for a private annuity to a trust in that it could be viewed by the IRS as a retained interest that could taint the assets sold to the trust as included in your estate. Other mechanisms are used by some practitioners to create grantor trust status (e.g. the right to borrow without adequate security, or the right to add a charitable beneficiary).
◙ If the a typical buyer defaults the seller would, among other remedies, reserve the right to reclaim the assets sold to the trust under a typical contractual default provisions. But in structuring a private annuity one of the estate tax risks is the IRS asserting that you as seller have retained excessive interests in the assets sold to the trust so that they should be included in your estate. Therefore, your planner might suggest expressly excluding this remedy in the sale documents. On the other hand, limiting what might otherwise be a common remedy might make the transaction look less like a typical sale. This could be problematic from the perspective of “bona fide” sale under IRC 2036, etc. In a typical arm’s length sale transaction default provisions, including a right to reclaim the assets sold in the event of default, is the norm.
◙ To qualify as a private annuity no third party should have the ability to render the annuity obligation worthless. See Rev. Rul. 76-491, 1976-2, C.B. 301. If FLP or LLC interests are sold to the trust for the private annuity, consider including provisions in the entity governing documents assuring arm’s length payments of compensation and other fees and expenses to related parties, and requiring the manager to respect his fiduciary responsibility to all of the members. Might this help might help defeat an argument by the IRS that a third party could defeat the private annuity.
◙ Traditionally private annuities were expressly structured without any security. Prior to the proposed Regulations Sec. 1.72-6; 1.1001-1 the use of security arrangements would have caused the transaction to be taxed in full to the Seller at inception. However, under the new paradigm of the proposed Regulations all private annuity transactions are taxed immediately to the Seller in all events (other than a sale to a grantor trust, if respected) so that there appears to be no detriment to adding security interests.
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