Cool Tool: Private Annuity

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.

Drafting Considerations

◙ 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.