Because of their advantageous tax-free treatment, structured settlements are typically associated with the payment of personal injury damages. However, some business purchases and buyouts can also benefit from structured settlements using annuity payments from an insurance company.
While payments from these non-personal injury cases are not tax-exempt, the recipient only owes taxes on the amount of money received each year.
To illustrate, let’s suppose a buyer of a private business is unable to obtain financing from a bank. An installment sale is one option to finance the deal, where the buyer puts up a percentage of the purchase price and the seller receives a promissory note for the balance. Payments are to be made monthly or quarterly.
In this case, although the loan is secured by company stock or assets and involves a personal guarantee, the seller must ultimately rely on the buyer’s ability to make the payments, and the seller may be concerned with default.
Structured settlement may be a less risky option. Here, the buyer purchases an annuity from an insurance company, which makes monthly payments to the seller. The transaction reduces the seller’s risk of not getting paid because the payments are secured by the annuity. Plus, the tax consequences are likely to be more favorable than a 100 percent cash sale. It is important to note that this technique only works if the buyer has the cash to purchase the annuity.
Another factor to consider in deciding which option to pursue is that a structured settlement, by its terms, only gives the recipient a right to receive money in accordance with the schedule set out in the settlement document. The recipient and the payer do not receive any ownership interest in the funding asset, thus preventing creditors of either party from levying upon the structured settlement funds.
Time Value of Money
Because the underlying annuity or government obligation is purchased with today’s dollars, the out-of-pocket cost is less than the total amount of money that the structured settlement will pay out over time. By this fact, the use of structured settlements becomes more attractive.
Of course, it’s important with any structured settlement to know the present value of the future payments so the offer can be compared with an immediate cash payment. Also, it is advisable to have the documentation and number crunching done by an expert, because the present cost of a structured settlement depends on the amount of the future payments and their timing.
Annuity payments are only one way to finance the sale of a closely held company, professional practice, or partnership interest. Your accounting firm can provide business valuation services and help structure a sale or merger that generates the best after-tax financial return.