Henry James Pillows, our mythical family business owner, has celebrated his 75th birthday and has decided “mandatory retirement or not, I’m leaving.” His four children, all of whom work in the business, breathe a sigh of relief that this day has finally come. Collectively, they decide to purchase their fathers stock which is valued at $2,000,000.
The children’s enthusiasm quickly fades to disappointment when they discover that none of their siblings have the financial strength for a significant purchase, let alone one of this size. Although each has been drawing a comfortable salary, the business has never paid any of the family members enough to create wealth outside of the business.
Henry needs the money to live and is disappointed when he discovers that the children are unable to purchase his stock at a fair market value. However, he is savvy enough to also realize that he really does not need to accumulate large financial holdings at his age, only to have them taxed upon his death. The solution, he discovers, may be in a “Private Annuity.”
A private annuity allows Henry to sell his ownership stake in the business to his children in exchange for a lifetime income. Private annuities are similar to insurance annuities but are different in the way they are funded. Instead of an insurance company providing the vehicle, the private annuity is an agreement between two entities or individuals and does not include an insurance company. Here is how it might work:
| Fair Market Value of Henry’s ownership | $2,000,000 |
| Henry’s Basis in Business | 100,000 |
| Annual Payment to Henry | 314,060 |
| Tax Free Portion | 8,333 |
| Capital Gains Portion | 158,333 |
| Ordinary Income Portion | 147,394 |
SOURCE: Chris Fay and Lonnie Brooks of Smith & Frank, Inc., Dallas, Texas
Private annuities are not for everyone; but in the Pillow’s business, Henry can step out with an annual income of $314,060 for the rest of his life, and at the same time, reduce the eventual estate tax burden. In exchange, Henry has to give up control of the business. The major risk for Henry is “What if he outlives the children?” This risk can easily be controlled with appropriate life insurance on the children (obligors). The children assume the financial risk that their father will outlive the financial break-even of the annuity and be required to continue paying the $314,060 until his death. However, should he pass away prior to the break-even, the children stop paying the annual annuity obligation.
If succession planning requires an exit strategy for your family, Private Annuities are one of many options. Don’t key in on one approach until you and your professional advisor have considered what works best in your particular circumstance.
