Your business has matured, or your real estate has appreciated, time to cash out and sell. It has taken a long time, and since you have held your shares or real estate for greater than one year, the gain qualifies for long-term capital gain taxation. A 15% federal tax rate; not bad!
Yet, 15% of a $10,000,000 gain is $1,500,000. With a $20,000,000 gain it is $3,000,000. That is an awful lot of money.
Is there a way you can still sell the company and legally not pay any taxes today?
Can you not pay taxes without running afoul of the Internal Revenue Service?
You spoke with your accountant and your attorney, but they are telling you how great it is that you are cashing out and capital gain rates are low, so why not pay the tax?
But if you pay $1,500,000 of tax, on a $10,000,000 gain, you have less money to invest, than if you did not have to pay the tax. The investment return on $1,500,000 at a municipal bond rate, now about 4%, is $60,000 a year. Ten years of investment return, without compounding interest on $1,500,000, is $600,000. Do you want to give away that much money?
Is there really a legal way to avoid the tax???
A well established, IRS approved technique, that is in the Internal Revenue Code, case law, revenue rulings and treasury regulations is available. It is a version of a conventional insurance product, an annuity, and it is normally done privately, not through a commercial firm. Hence, it is called a Private Annuity.
Let’s address what an annuity is and how it works.
First, most people are familiar with an insurance product called an annuity. An annuity is a contract, generally with an insurance company, where you provide the company a sum of money. The insurance company agrees to make payments back to you over a set time frame. You would decide when the payments would start and how the long the time period they would continue for. You would also decide if the payments would be measured by your life span, or by the life of yourself and another, such as your spouse.
You would first select a starting date for the annuity payments to be made to you. If the payments begin immediately, this type of annuity is called an immediate annuity. The payments, however, could begin at any point in time you agree to, such as in five years, ten years, next week or next month.
Next, you would select how long the payments would continue for. If you want the payments to continue for your life, the term is referred to as a single life annuity. If you selected the measuring period for payments to be you and a spouse, the term is referred to as a joint life annuity. You could also select a specific time period, or a term certain, such as ten years, twenty years or whatever term of years you require.
Each variable as to the starting date, the amount of time the annuity will be paid for, a certain term, versus a life time, a guaranteed return versus a variable term, all will affect the amount of each payment you receive.
Annuities are approved within IRC §72. It allows a person to transfer property to another and receive back a stream of payments. Each payment that you receive from the annuity company will contain two or sometimes three components. The components are:
return of principal (your cost basis);
capital gain (depending on the property transferred); and
interest or investment income.
Now that you know this exists, why does this device allow your sale to incur no immediate income tax?
What makes this work is two factors:
- The creation of an annuity usually is not a taxable event.
- Every payment of the annuity has a fixed fractional component that consists of your taxable gain, a portion that is your return of capital, and a portion that is ordinary income.
Let’s apply this to your hypothetical sale.
You transfer $10,000,000 of stock or other asset, which cost you $100,000 (for example), for a $10,000,000 annuity. At this point, you have a promise to have money paid to you, but you have not received any money. The company or party you transferred your shares or other assets to, “the annuity company”, now owes you a $10,000,000 annuity. Therefore, the annuity company’s cost basis in your shares or other assets is $10,000,000, the amount they owe you.
The annuity company now sells your shares or assets to the seller that you have previously negotiated with to buy your shares or assets for $10,000,000. The annuity company, not you personally, sells the assets for $10,000,000. As the annuity company has a $10,000,000 basis, the amount it owes you, the annuity company has no taxable gain as it sold the assets for the same amount it agreed to pay you for such assets, $10,000,000.
You would have no taxable gain, as the annuity company has not yet paid you for the assets! Hence, the sale occurred, no tax has been paid and $10,000,000 will be invested, with the principal and earnings available to make annuity payments to you!
In a conventional annuity, you would make a transfer of cash to an insurance company in exchange for the insurance company’s promise to pay you back the funds, with earnings in the future, the annuity. With a business or other asset sale, you would transfer your company shares or other assets to a private annuity company, possibly owned or controlled by younger generation family members, in exchange for the annuity company’s promise to pay you back the funds with earnings in the future. The promise and annuity contract would be similar, whether the transfer is to a publicly held insurance company or a private annuity company. But, with a private annuity company, not only income tax savings can accrue, but with the proper structure, estate tax savings can occur as well! Also, a commercial annuity company will not generally accept closely held corporate stock or real estate as a vehicle to fund an annuity.
A few words of caution:
- The annuity must be properly written;
- The interest rate, fair market value, must be per IRS tables;
- The transfer of assets and control must be actually made; and
- You can not control the annuity company.
If you follow the appropriate steps, have the transaction drafted by a tax law firm familiar with how the structure operates, you can accomplish many goals, save tax to boot, and not have the IRS looking over your shoulder!
Tax Planning is not dead, but the IRS is trying to make it hard to find available vehicles, but also the firms that are able to navigate their way through the murky waters of the Internal Revenue Code!
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.