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The IRS Comes Down On Private Annuity Trusts (PATs) By Passing IR-2006-161.

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : Oct 24, 2006

Dear Subscriber:

Life can be so ironic and cruel. Imagine if you built your entire business on one narrow part of the tax law, and then the tax law changed because you became too successful marketing it. That’s exactly what happened to PATs.

How does this sound to you?

Would you like to sell a highly appreciated asset and “avoid” the current capital gains taxes and any depreciation recapture? Would you like to have the money you would have paid to the IRS or state in taxes in an account that would grow for your benefit and where that money would be used to pay you a lifetime income stream? Would you also like a plan where once the highly appreciated asset has been transferred, it is out of your estate for estate tax purposes?

For many clients with highly appreciated assets, the answer was “yes.”

The plan clients could use to accomplish the above goals is the Private Annuity Trust (PAT). PATs have been around for years in the advanced community; however, the average advisor (CPA/accountant/EA, attorney and financial planner) had no idea PATs even existed.

A few firms discovered PATs and decided to mass market them to advisors around the county in a fairly high-profile manner. Advisors were given education on PATs so they could go “sell” them through to clients with appreciated assets. Attorneys like the topic because they could charge significant fees, and insurance agents really like the topic because they were told to sell equity indexed annuities in the trusts using the money from the sale of the highly appreciated asset.

It seemed like a win win win all the way around, right?

Wrong. The first problem with PATs is that they are not the best solution for the majority of clients who have highly appreciated assets. Charitable Remainder Trusts (CRTs) or Intentionally Defective Grantor Trusts are many times a better option. But like many topics, if a PAT is the one topic an advisor learns, and if the advisor doesn’t know the other solutions, you guessed it; the tool always recommended to a client when dealing with appreciated assets is a PAT. (This is a significant flaw when working with an advisor on any advanced plan. Most have limited knowledge, and therefore, clients get solutions their advisors know, not necessarily the best solutions available.)

The second problem, and now the most glaring problem with PATs, is that with the new proposed IRS and Treasury regulations that came out on October, 17 2006, PATs are a “dead” topic. I won’t go into chapter and verse on exactly what the regulations say, just know that they are DEAD. If you would like a summary on the proposed regulations (IR-2006-161), please e-mail info@trustmakers.com.

Why did the IRS act? It’s simple: mass marketing by the select vendors who recently created businesses to exploit the fact that PATs were not widely known. It happens all the time in the advanced community, and why I indicated in the first part of this newsletter that life can be so ironic and cruel. I’m serious when I say that several firms were created for the sole purpose of exploiting the benefits of PATs. They mass marketed the topic in such a manner that the IRS could not help but notice. The IRS has never liked PATs, but because they were not prevalent in the marketplace, the IRS never turned its eye to the topic to create negative regulations. When the mass marketers came out, the IRS decided to act.

Other alternatives.

As I indicated, about 80 percent of the time I do not recommend PATs to help clients with their capital gains tax problems. What other solutions are available and viable? 1) Charitable Remainder Trusts (CRTs). With a CRT a client receives a current income tax deduction, actually reduces the capital gains taxes due over time (something a PAT does not), provides a life time income stream, and if set up properly, can leave a lasting legacy for the children. 2) Intentionally Defective Grantor Trust (IDGT). With an IDGT a client could pay the entire capital gains tax at the current fixed rate and receive a completely tax free income stream for life. With a PAT, there is an income tax component to each payment for the life of the client, and if the client lives long enough, 100 percent of the income that comes from the PAT is income taxed.

I will be doing upcoming articles on both CRTs and IDGTs.

Summary

The new proposed law reminds us that we should not take a legal deferral topic and flaunt it in the face of the IRS. Doing so will surely make the IRS act to shut down the topic. You should also remember that if you are using quality advisors, they will have multiple solutions to most of your problems and will not use the “one” or “hot” topic that they just learned (which is what happened to PATs). By using a quality advisor, you are assured that you will receive the best advice and advice that should last the test of time.

Roccy M. DeFrancesco, JD, CWPP™, CAPP™

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