Self-canceling installment debt and private annuities: effective intrafamily stock transfer planning tools.

• Author: Porter, Gregory S.

Many business owners are faced with the question of how to effectively pass stock in a closely held business to the next generation. Unfortunately, a formal succession plan for the transfer of stock is rarely developed; nor is a formal succession plan developed for the transfer of company leadership in many cases. The stock merely passes to the heirs under the terms of a will and the estate is saddled with estate taxes as high as 55%, (1) absent a significant marital or charitable deduction. An election under Sec. 6166 can defer the payment of estate taxes associated with the value of certain closely held businesses over a 15-year period; however, this election creates no reduction in the ultimate estate tax liability. Thus, a liquidation of the stock outside the family may become the only feasible option to pay the estate taxes.

Development of a Viable

Stock Succession Plan

In developing a viable stock succession plan, the tax professional must take into consideration the income, estate, gift and nontax effects of the transfer. Typically, a stock succession plan attempts to achieve the following goals.

* Provide an income stream to the transfer for a substantial duration of time while not burdening the successor with an unreasonable payment schedule.

* Significantly reduce,if not eliminate, the estate and gift tax consequences associated with the lifetime transfer of stock.

* Minimize and defer the income tax consequences of the stock transfer.

* Provide the transferor with sufficient collateral.

The plan should also address the tax and nontax effects of whether the successor acquires the stock interest via stock redemption or a direct purchase.

This article will analyze the goals of a viable stock succession plan in relation to two techniques that have been made more attractive by the retroactive repeal of Sec. 2036(c): (2) the use of a private annnuity and self-canceling installment debt. When Congress opened the door to these techniques with the repeal of Sec. 2036(c), it appears that there was no intent to close it by the enactment of Chapter 14 (Secs. 2701-2704). (3) These new Code sections attack estate valuation freeze attempts at the time of the initial transfer through strict gift tax valuation requirements. Use of private annuities and self-canceling installment debt in stock succession planning do not provide for retained right features (Sec. 2701), are not transfers of interest in trust (Sec. 2702), do not involve an option or buy-sell agreement (Sec. 2703) and do not contain a lapsing right or restriction used to reduce the value of transferred property (Sec. 2704).

Annuity vs. Installment Sale

The Treasure Department describes the key differences between an installment note and an annuity in GCM 39503. (4)

...where the conveyor of property receives a right to periodic payments for the remainder of his life, with no monetary limit ...the payments represent an annuity....

...When the terms of property transaction are structured so that there is a stated maximum payout that will be achieved in a period less than the life expectancy of the transferor (as determined at the time od the transaction in accordance with Table I, [Regs. Sec.] 1.72-9), then the transaction will be characterized as an installment sale with a contingent sale price....

Thus, for purposes of this article, a private annuity stock succession (PASS) is an arrangement under which an individual transfers stock to a successor in exchange for the successor's agreement to make periodic payments in fixed amounts to the transferor for the remainder of the transferor's life. A self-canceling installment debt stock succession (SCIDSS) is a debt obligation created on the transfer of stock from the transferor-creditor to a successor-debtor. The debt instrument has a fixed term less than the life expectancy of the transferor and contains a provision that automatically voids all future payment obligations on his death.

Estate Tax Ramifications

Freezing the value of the older generation's stock, in order to prevent its future appreciation from being subject to estate taxes, is a goal in most stock succession plans. An outright sale or normal installment sale accomplishes that goal and the cash or note (albeit frozen or slowly melting) is considered part of the transferor's gross estate. (5) The primary advantage of a properly structured PASS or SCIDSS is that the annuity or note's value to the transferor at the date of death is zero. Accordingly, there are no estate tax ramifications to holding a PASS or an SCIDS at death. (6)

For a stock succession to qualify as a PASS and not be deemed a gift with a retained life estate includible in the transferor's gross estate under Sec. 2036(a), the following IRS and case law guidelines must be followed.

* The transferor must not retain control over the stock or its...