Good news for companies transferring the business to the next generation: annuity contracts for golden years of retirement
As we have pointed out in our previous article, over the next few years many Hungarian family owned enterprises will have to face the challenges of succession within the company, as well as transitioning the business successfully to the next generation. One of the toughest challenges is how to transfer the business to the next generation and also to ensure that the retiring business owner can maintain his or her former lifestyle, even if the successors do not have the necessary funds to purchase the business share at full fair market value.
When the time has come for business owners – whether it is family owned or not – to step out of the business, the retiring generation not only has to transfer the management role, but by transferring its share they also hand down their ownership, wherefore it is a clear and reasonable expectation on their part to receive a consideration in exchange, equivalent to the full fair market value.
However, the financial security of the ‘golden years’ will be far from guaranteed, if the next generation hasn’t got enough capital to pay the price of the business share. The situation is the same if a bank loan is not a viable solution, or the successors do not wish to shoulder the heavy burden of borrowing, and if the parties do not wish to involve third party investors. Furthermore, in cases where the parties exclude the option of transferring the share as a gift, the transferor cannot transfer his or her business share – either as a gift or by sale and purchase – in a way that would guarantee his or her financial security.
Therefore the objectives that business succession planning must fulfil are twofold. On the one hand it must include ways to ensure successful transfer of the business share to the successors, and on the other hand it must secure the safety and continuity of the former lifestyle of the retiring generation without the need to inject considerable further capital in the course of the transaction. The most sophisticated business succession tool to fulfil both of these objectives is the life-annuity contract.
Pursuant to Section 6:497 of the Civil Code, under a life-annuity contract the annuity provider undertakes to provide a specific sum of money or other fungible property to the annuitant periodically and until the death of the annuitant, and the annuitant undertakes to provide compensation. Since the subject of the compensation is not specified, the retiring family member may transfer his proprietary interest in the business to his or her successor. The successor in turn provides periodic annuity payments to his predecessor for the rest of his or her life. This annuity payment enables the retired family member to maintain his or her former lifestyle.
The advantages of this estate planning tool as opposed to the sale of the business share, is that the transferor will be provided with a lifetime income stream, which would not be possible in case of a business share buy-sale even in case of instalment payments. Equally importantly, this tool allows the successors to make the annuity payments from the dividends received upon their share of the business, even though at the time of concluding the contract they might not have sufficient capital to do that. In this way the family business may be transitioned to the new generation without the successors assuming the burden of injecting huge amounts of new capital. Obviously the transferee assumes the risk that his or her payment obligations will remain even at times when the company may not produce sufficient income to meet the annuity payments.
Very few cases dealt with this strategy in the Hungarian judicial practice, but based on the few it is evident that the issue the court would address regarding the transaction could be whether the contract is a sham, entered into for the sole purpose to create tax advantage without incurring higher taxes levied on sale and purchase transactions.
The Regional Court of Borsod-Abaúj-Zemplén County in case no. 23.G.40.054/2010 reasoned that ’based on the declarations of the defendants heard in the case, they had mutual intention to establish a life-annuity contract, each party fulfils its contractual obligations, the primary defendant gave its consent to the transfer of the business share, while the secondary defendant fulfils its contractual obligation of making periodic annuity payments’ therefore ’the court is of the opinion that the fact alone that the contractual parties are close relatives does not render the contract a sham, or null and void as a consequence.’ Thus the above court finding, the correctness of which was later affirmed by the Debrecen Appellate Court in appeal case no. Gf.III.30.712/2010, stated that the transfer of business shares in the framework of a life-annuity contract, even if the parties are close relatives, does not indicate a sham alone, if it can be demonstrated that creating a life-annuity agreement was the parties’ real and actual intent and not only a sham to disguise their actual intent to enter into a sale and purchase, concealed as a life-annuity contract solely to create tax advantages.
An important aspect for distinguishing disguised and real contractual intent is laid down in the verdict given by the Debrecen Appellate Court in case no. Gf.IV.30.417/2012. In this case the court established that ’Based on the personal declarations of the litigants, the testimonies of the witnesses, and the available documents the first instance court correctly established that the real contractual intent of the litigants was not to enter into a life-annuity contract. The life-annuity contract was a sham to disguise the sale and purchase of a business share.’ However, in this case the sham was supported by clear evidence, such as the fact that the parties agreed upon a 48 months’ limited period for annuity payments, whereas this element is clearly contradictory to the legal instrument of the life-annuity contract and indicates that the real intent was a sale and purchase agreement.
In conclusion, life-annuity contracts can be the right solution for companies where the obstacle to handing on company control from one generation to another is the lack of capital on the successors’ part. The major advantages are a possible lifetime income stream to the transferor in the form of periodic annuity payments, which on the whole will correspond with the full fair market value of the business share, and from the perspective of the new generation of business owners, the possibility of fulfilling their payment obligation from the dividends received from the business.