Annuity structure: private annuity transactions can help clients cash out, defer gains.

• Author: Stein, Jacob

In the increasingly scrutinized world of tax planning, practitioners are finding it more difficult to deliver on their clients' expectations of selling an appreciated asset without triggering an income tax.

What can practitioners do to help fulfill this request? Try private annuity transactions, a favored planning tool of practitioners for more than 70 years.

PRIVATE ANNUITY TRANSACTION

Using a typical model, assume that Paul wants to sell his sole proprietorship, valued at $5 million, and he has $2 million of taxable built-in gain.

He forms a legal entity, such as a corporation or limited liability company, which we'll call the "Company," that will be owned primarily by his sons and partially by Paul.

Paul then sells his business to the Company for $5 million, payable as a lifetime income stream. The Company operates the business, finds a buyer and sells the business for $5 million in cash.

The end result is that Paul has cashed out of his business. While he did not receive the cash directly, the cash paid by the buyer is owned by an entity that Paul controls and that is, in turn, owned by him and his sons.

Variations on this structure may include an entity owned entirely by one of Paul's children or an entity owned only by Paul.

MULTIPLE TAX CONSEQUENCES

Tax consequences of the transaction relate to:

* Paul on the sale of the business to the Company in exchange for a stream of payments over his lifetime;

* the Company on the purchase from Paul; and

* the Company on the sale of the business.

When a stream of payments is paid over someone's lifetime and not for a fixed term, it's known as an annuity, not an installment sale.

Annuities are taxed under Internal Revenue Code Sec. 72 in a manner similar to the installment method of IRC Sec. 453. Each annual payment consists of a tax-free return of basis; a capital gain; and interest income (Rev. Rul. 69-74, 1969-1 C. B. 43).

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Annuity tax treatment, however, avoids triggering the gain on a subsequent resale by a related party. IRC Sec. 453(e) provides that if A sells assets to B (a related party) on the installment method, and B resells the assets within two years, A recognizes all of the gain that was originally deferred.

Consequently, when Paul sells to the Company in exchange for a lifetime stream of payments, he will be taxed as each annual payment is received, and the subsequent resale by the Company will not accelerate the $2 million gain.

The amount of each payment...