Close Close

Regulation and Compliance > Federal Regulation > IRS

Uncle Sam May Take His Cut

Your article was successfully shared with the contacts you provided.

Were private annuity trusts (PATs), popular tools for estate planning in retirement, just a flash in the pan, now that the Internal Revenue Service (IRS) is set to rule on their validity?

Yes, say most retirement professionals, and as they’ve come under the IRS’s microscope, many advisors also say that PATs were actually not so kosher to begin with. It will not be surprising, they say, if these vehicles are no longer used for estate planning at all following a planned February 16 ruling by the IRS.

“I have always thought that PATs were too aggressive, and basically marketed as a way to tell people they could avoid paying taxes,” says David Hayes, a CFP in Mount Juliet, Tennessee.

The PAT had gained popularity in the past couple of years as it allowed individuals to defer capital gains taxes on the sale of highly appreciable assets–namely real estate–while receiving a regular income stream. The concept of the PAT was quite cutting edge, says Tere D’Amato, director of advanced planning and wealth management at Commonwealth Financial Network in Waltham, Massachusetts. It blended two concepts, the private annuity and the trust, but “anytime you take two concepts and take the tax law that one or the other is based on, it may or may not be accepted by the IRS,” she says.

PATs were always a bit fuzzy and loosely structured, advisors like Hayes believe, and their popularity was due mostly to the work of clever attorneys and real estate organizations, who convinced people that they could transfer their assets into a trust and, well, avoid paying taxes on the assets.

The IRS caught up, though, and last October issued a proposed rule that would basically tax the person transferring a real estate asset into a private annuity trust in the same way he or she would have been taxed if that property was sold for cash and the cash used to purchase the annuity. That means the tax rules for PATs would be the same as those applied to commercial annuities, thereby removing any advantages.

As such, PATs are no longer a viable tool for those seeking to do estate planning, says I. Jay Safier, CPA and principal at New York-based accounting and consultancy firm RSSM & Company. Organizations like the Irvine, California-based National Association of Private Annuity Trusts (NAPAT) have not been recommending them since the IRS proposal was issued.

Alternatives: Installment sales, charitable trusts

Yet the concept behind a PAT, notably the idea of transferring an asset into a trust, can still work for estate planning, and “there are other alternatives that should be considered with more seriousness,” Safier says. The regular installment sale, for instance, which involves the sale of an asset with payments over time and the recognition of the gain over time, is a good alternative, he says, as the seller still keeps some portion of his annual receipts.

An installment sale will work better than a PAT because it is an “arm’s length” economic transaction, planner Hayes agrees. He also advocates setting up a charitable trust for those who can, because these structures follow strict rules to protect the donor from complications.

“An installment sale meets the requirements of a seller who wants to defer taxes while creating a stream of income to himself/herself,” Hayes says. “It’s not quite as tax-advantaged as the PAT is on paper, but more likely to make it through an audit. The rules for an installment sale and for a charitable trust are both well defined, and the more definition you have, the better you are.”

Advisors do expect to see installment sales, charitable trusts, and other kinds of trust structures become more popular for estate planning, but D’Amato believes that to avoid any problems, all trust structures “need to be set up in a very clear-cut manner, and not as though they have been set up to evade taxes.”

The IRS–which was to issue a ruling on the validity of private annuity trusts on February 16–previously stated that it will grandfather all PATs in existence as of October 18, 2006, but while the proposed ruling has set in motion challenges for those that came after that date, it is likely that all PATs, regardless of when they were structured, will be treated the same way. Warns Hayes: “I would treat this as a warning that [the IRS] intends to challenge those set up before October 18 as well.”


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.