The Fine Print

A PAT is not flexible. If the annuitant runs into a financial emergency, he cannot receive a lump sum from the trust. Some PAT marketers infer that the annuitant has a great deal of flexibility through loans received from the trustee. This may lead to the annuitant viewing the trust as a holding tank for retirement funds. It is just this type of misunderstanding that costs estate owners millions of dollars in taxes when the courts ignore their family limited partnerships. A better alternative might be to pledge the annuity payments as collateral for a loan from a commercial bank.

Another disadvantage is that the annuitant does not have a secured interest in the trust assets, and there is a possibility that the annuity payments can bankrupt the trust. Remember that a PAT is basically an installment sale. The amount of the payment is based partly on the seller's age (or the joint age of the seller and spouse), the value of the asset at the time of the sale, and an IRS-specified interest rate. The annuitant can expect to recover the asset's purchase price by the time he reaches full life expectancy.

This results in much larger payments than the newly diversified portfolio can earn. If the annuitant lives past normal life expectancy, the trust is obligated to continue the payments. In the best case, the trust investments will earn more than the IRS interest rate and create a reserve. In the worst case, the trust will run out of money. For this reason, commercial annuities provide a safety net for the trustee. Unfortunately, the price of commercial annuities is based on historically low interest rate assumptions and provide limited opportunities to benefit the remaining beneficiaries.

An issue often glossed over is that the trust is responsible for the taxes on interest, dividends, and capital gains earned by the trust assets. The trust does not get a corresponding tax deduction when it pays out the annuity payments. This effectively ends up as double taxation–at the trust level and in the hands of the annuitant.

There is some uncertainty about how potential depreciation recapture may be treated. Normally, the owner of rental or commercial real estate will depreciate the property every year to reduce income taxes. The depreciation is recaptured at a 25% tax rate when the property is sold. There is some debate among tax professionals as to whether the recapture is taxed when the trust sells the property or is deferred under the annuity rules.

PATs are sold as a panacea for capital gains taxes and often assume that capital gain rates will remain at today's levels. If tax rates increase in the future–or revert in 2008 to ordinary income tax rates–the annuity payments from the trust will be subject to the higher rates. In the end, the increased taxes may not be offset by the tax deferral of the PAT arrangement.

Finally, it is hard to find an attorney independent of the PAT marketing organizations to write the legal documents or give a legal opinion on the technique. Some marketers only provide specimen documents to graduates of their own educational programs or in exchange for a share in the commissions of an annuity product. Moreover, the legal opinion letters provided by PAT marketers can only be relied upon by the organizations themselves. If the client cannot find independent legal counsel familiar with PATs, he should consider applying for a Private Letter Ruling applicable to his situation.

Only clients who are willing to accept the risk of a negative tax outcome should undertake the PAT. While the strategy relies on tried-and-true income and estate tax techniques (cited as legal authority by PAT marketers are Revenue Rulings 55-119, 80-80, and 69-74; GCM39503 (5/19/86); TD-8754 (1998); and LaFargue v. Commissioner, 689 F. 2d 845 (1982), the IRS can challenge the PAT on the basis that the trust has no real purpose other than to avoid income taxes. Considering that a client can spend from $5,000 to $10,000 to set up a PAT–and thousands more in annual management fees–an adverse IRS decision on the income tax benefits of the PAT could generate additional taxes and legal fees.

We only have to look back at reverse split dollar as an example. Reverse split dollar was marketed as a way for business owners to shift corporate income to the stockholder without taxation. The IRS ignored this twist of the traditional split-dollar plan for decades before issuing Notice 2002-59. While reverse split dollar may have its place in executive benefits planning, the IRS is clearly not favorably disposed toward this method of minimizing taxation.

Legal commentators also warn that the IRS could challenge the PAT as a "step transaction," which occurs when a taxpayer tries to disguise a normally taxable transaction by inserting an intermediate step. In other words, a seller cannot exchange a piece of real estate for a portfolio of stocks, bonds, or annuities without recognizing capital gains on the real estate. Creating a trust solely to transact the sale and avoid capital gains taxes will not necessarily be accepted as valid. The IRS has attempted with some success to attack other intermediaries, like family limited partnerships, when they served no purpose other than to minimize taxes.

The PAT is one of several strategies to consider when the time comes to liquidate a highly appreciated asset to generate a stream of income. The PAT strategy should only be undertaken by someone who understands its risks and who is willing to pay the additional cost of independent legal advice to determine if it is appropriate.

Tere D'Amato, CLU, ChFC, and CFP, is director of advanced planning, wealth management, for Commonwealth Financial Network in Waltham, Massachusetts. D'Amato earned her MSFS with an emphasis on estate planning through the American College in 2003. She can be reached at [email protected].