Creating Instant Equity for the Next Generation

Creating Instant Equity for the Next Generation

by Jim Percy

Does the predicament of Coleridge’s ancient mariner, “Water, water, everywhere, nor any drop to drink,” apply to your business? It may apply if the asset at issue is not water, but money. If it does, the use of a private annuity may be the tool that allows your business to quench your thirst.

A common problem in many family businesses is that parents want to retire, but put it off because of their worries about maintaining a sufficient retirement income. These parents often have children who are poised to take over, but lack the funds to buy the business from their parents. This albatross can hang over many businesses, even those that are well-established and profitable, largely because a lion’s share of the family’s assets are in their business.

In a survey of family business owners done for MassMutual by the Gallup Organization, nearly two-thirds reported that more than half of their net worth was tied up in their businesses. This can make it difficult for parents to fund their retirement without financially weakening, or even liquidating, the business. With the help of a private annuity, parents can “sell” the family business to their children in return for a lifetime income.

What are Private Annuities?

Private annuities should not be confused with commercial annuities, which are investment products that guarantee worry-free retirement income to the buyer. A commercial annuity is usually a contrast between an individual and an insurance company wherein the insurer pledges to provide a steady income stream to the individual sometime in the future, usually at retirement age.

Participants in a family business can set up their own private annuities that will bring about the transfer of the business from the parents to the succeeding generation. In the case of the private annuity, the children essentially function as an insurance company.

It is necessary to understand how an annuity differs from life insurance. Life insurance has as its principal mission the creation of an estate. The annuity, by contract, has as its basic function the systematic liquidation of that which has been created. In application, they serve different functions. Life insurance protects against the absence of income for survivors of those who die prematurely, whereas annuities protect against the absence of income on the part of those “afflicted” with undue longevity.

Establishing a private annuity for the purpose of executing the succession of a family business from the older to the younger generation is a fairly straightforward procedure:

  1. Value the Business First, a professional appraiser provides a valuation of the business. It is crucial that the valuation be accurate. An artificially low valuation, done perhaps in a misguided attempt to minimize estate taxes, risks the wrath of the Internal Revenue Service.

    Do not succumb to this temptation. The IRS has the power to impose crippling penalties, sometimes years after the fact, on businesses that sought artificially low valuations as a scheme to avoid estate and/or gift taxes. Aside from the penalties, the IRS could treat the transaction as a gift with a retained interest, generating both gift and estate taxes.

     

  2. Set up a Payment ScheduleAfter the valuation is complete, establish a payment schedule based on a pre-set formula. This formula uses the value of the business at the time of the transfer, combined with an actuarial-based estimate of how long the parent can be expected to live. The children make payments to their parents based on this formula. The periodic payments can be weekly, monthly, quarterly or whatever the parents and children establish. 
  3. Get On With Your New Lives! The business has now passed to the succeeding generation, the parents have a regular income, and estate taxes have been dramatically decreased.

Risk-Benefit Analysis

As straightforward as establishing a private annuity is, the decision-making is fairly involved. While private annuities work a lot like an installment loan, a crucial difference is that the number of installments is not fixed. If the parents die after just a few payments, the payments stop; if the parents live beyond their life expectancy, the payments continue. This contingency means that private annuities provide both benefits and risks to both the older and younger generation. First, the benefits:

  • Members of the older generation receive a lifetime income and they can choose their own successors.  
  • The younger generation gains control of the business in a timely and orderly fashion, not after a sudden death, for example.  
  • Because the parents passed the business to their heirs before they died, they have reduced the estate taxes that would be payable based on the value of the business. In some cases, this process lessens the tax impact by as much as 60%.

Hurdles

There are a few obstacles that must be cleared before the private annuity can be established.

  • The biggest hurdle is to convince parents to give up control. That can be difficult, but the many benefits of the private annuity can help make the case.  
  • What if the children die before the parents, threatening the stability of the business and, ergo, the parents’ income stream? This can be surmounted by life insurance policies on the children, which will be much cheaper than a policy on their parents, who are older and thus subject to steep premiums.  
  • What about heirs who may not be involved in the business, nor interested in buying the business from their parents? They can be provided for through insurance policies on the parents.

Private Annuities Help Keep the Business in the Family Way

Money is sometimes only one of many reasons why family businesses are unable to move from one generation of leadership to the next. Some of these reasons can be quite complex, but when the obstacle is simply a matter of money, the use of a private annuity can help solve the succession puzzle.

The private annuity is different from life insurance, but it serves the same purpose: It preserves the worth of a business the parents spent a lifetime building, and keeps it in the family.

Jim Percy is Director of Advanced Sales at MassMutual, and a Connecticut native.