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Alternatives To Private Annuity Trusts (PATs) Now That The IRS Has Killed Them.

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

Date : Nov 07, 2006

Dear Subscriber:

As you may have read in my most recent Trustmakers newsletter, the IRS came down hard on PATs when it issued proposed regulations 2006-161.

For those who didn’t see my last newsletter, the following is a brief review:

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.”

IRS Issues New Negative Regs With 2006-161
While PATs were legal and a nice planning tool, many large marketing entities turned an otherwise unknown topic into one that thousands of advisors became aware of and ended up marketing due to a high-profile nationwide marketing campaign. Like with any “advanced” tax planning/estate planning tool, when it is not well known, it stays alive for years. However, when firms mass market it, the IRS takes notice and eventually will shut it down. This is what happened to PATs with proposed regs in notice 2006-161.

Other Alternatives Now That PATs Are Dead
Now that PATs are not a viable tool to “defer” capital gains taxes on the sale of highly appreciated assets, we must look to alternatives. Ironically, some of the alternatives I consider to be better than the PAT. This newsletter will focus mainly on charitable planning as an alternative. Also, I will follow up with an explanation of how Intentionally Defective Trusts are a nice option as well in my next newsletter.

How can Charitable Remainder Trusts (CRTs)* help mitigate capital gains taxes? With a CRT, you would gift highly appreciated assets to a CRT, receive a current income tax deduction, and the capital gains taxes due over time would be reduced (neither of which was a benefit of a PAT). Like a PAT, a CRT will provide a lifetime income stream for the client, and the asset is immediately removed from the client’s estate. If set up properly, a CRT can also leave a lasting legacy for your children by using some of the money from the lifetime income stream to fund a life insurance policy owned by an irrevocable life insurance trust (ILIT) (also called “wealth replacement”). *This can also be done with a charitable gift annuity.

Example:
Assume that 60-year-old Dr. Smith has an estate of $5 million. Assume Dr. Smith owns a rental property worth $500,000. The rental property has a basis of $100,000. Assume Dr. Smith still works as a surgeon where he makes $400,000 a year.

1.) Dr. Smith gifts the property to a charity in exchange for a CRT.
2.) Dr. Smith receives an immediate income tax deduction ($60,925).
3.) The capital gains tax is not immediate and is lessened (the capital gains tax will be paid pro rata as each payment is made from the CRT).
4.) Dr. Smith receives $28,000 a year as income for life (taxed similar to PAT payments).
5.) Dr. Smith gifts to an ILIT $4,500 a year, and the ILIT buys a $500,000 life insurance policy to “replace” the asset he just gave away to the CRT.

The benefits of the previous example, in my opinion, are better than a client could receive with a PAT. With a PAT, the client did not receive an income tax deduction, and there is NO discount on the capital gains tax due.

Intentionally Defective Grantor Trust (IDGT).
While I will cover IDGTs in my next newsletter, I did want to briefly describe some of the benefits. With an IDGT, the client would pay the entire capital gains tax now, which seems counterintuitive to those looking to defer or avoid tax. The main benefit an IDGT has over a PAT and a CRT is that the income stream from the IDGT, if set up correctly, can be completely income tax free. With a PAT and CRT, the income stream has a capital gains tax component at the rate when the payment is received (which could be much higher than 15 percent for the current longterm rates) and an income component. The longer a client lives, the more the income component to the payment.

After a client lives to the age of assumed death, the entire income stream from a PAT or CRT is 100 percent income taxable. With an IDGT, the client transfers the asset to the trust where the asset is sold. The client pays capital gains taxes upon the sale at the current capital gains tax rates. Then the IDGT properly invests the proceeds after tax, the lifetime payments to the client (grantor) can be income tax free for life. The longer a person plans on living, the more tax favorable an IDGT is over a CRT or a PAT.

Summary
The new proposed PAT regulations remind 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 in order to be a quality advisor in the advanced markets, you have to have multiple arrows in your quiver in order to provide the best advice to your clients. If you can learn CRTs and IDGTs, that will go a long way towards helping you provide the best advice to your clients when dealing with the problems of highly appreciated assets.

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

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