Private annuities are an underused succession planning device.

• Author: Gillis, Michael R.

Consider the situation of a typical closely held corporation, whose founder, although nearing retirement age, is still a majority or 100% shareholder. He has one or more children active in the business and wants them to succeed him as officers and owners. A substantial portion of his estate is made up of the value of this closely held stock. He wants a succession plan that will provide him with lifetime income, minimize estate taxes and transfer the ownership of the company to his children in a way they can afford to pay for it. (This situation may be all too typical.) Often, succession plans involve combinations of stock gifts, insurance-funded cross-purchase arrangements and specific bequests in the client's will. However, a private annuity may be the best overall solution and seems to be an underused succession planning device.

A private annuity is a method by which a transfer of property is made in return for a promise by the transferee to make fixed, periodic payments to the transferor for the remainder of the transferor's life. In fact, many private annuity transactions involve the transfer of appreciated property to a younger generation family member in exchange for lifetime payments to the older generation transferor.

The mechanics of a private annuity transaction are illustrated in the example on page 746.

There are both advantages and disadvantages to transferring stock using a private annuity.

Advantages

* Estate tax savings: The property is immediately removed from the transferor's estate, but he still receives the same lifetime economic benefit as if he had retained the property.

* Income taxes: The transferor's income from the annuity is payroll tax-free, partially a tax-free return of basis and partially a long-term capital gain.

* Lifetime income: The transferor receives lifetime income while management, control and future appreciation of the business are shifted to the next generation.

* No deferred gain at death: Unlike a self-canceling installment note, any deferred gain at the transferor's death is not income with respect to a decedent in the seller's estate.

Disadvantages

* Income taxes: The biggest disadvantage is that the transferee must make the annuity payments out of after-tax dollars. There is no interest deduction for any portion of the payments as in an installment sale.

* Security: The private annuity contract must be an unsecured promise to pay. Although the transferee has personal liability for the payments...