IRS to Shut Down Tax Avoidance Technique

Everyone loves a good tax break. In the past, one popular way to avoid paying “immediate” capital gains taxes on an appreciated property was to set up what’s called a PAT – a Private Annuity Trust. However, in recent weeks the U.S. Treasury Department released proposed regulations that reverse both the IRS and Treasury positions regarding private annuities (REG-141901-05).

“It’s clear that if the proposed regulations pass, for those private annuity trust transactions not funded and completed prior to October 18, 2006, they will not be allowed capital gains deferral by the IRS,” says Eileen Sheridan, CPA for Bartlett, Pringle & Wolf, LLP.

This development may effectively shoot an arrow through any plans people might have been making to set up a PAT before year’s end. But not all hope is lost. If the new regulations pass, there are other ways to obtain similar capital gains tax breaks.

In recent years, PAT’s have increased in popularity as a tax and estate planning tool among high net worth individuals. They’re basically an unsecured promise to make periodic payments for a specified length of time in return for cash or property. Usually the process is handled this way: Typically, the individual wanting to avoid immediate capital gains taxes on an appreciated property like real estate, a business or a stock portfolio “exchanges” the property for a private annuity. This would be like “exchanging” one rental property for another under a 1031 Tax Exchange, but in this case you’re exchanging any appreciated property for a PAT.

Rather than pay the capital gains at the time of the “exchange,” the person is allowed to spread out the capital gain and resulting tax over the life of the annuity. Often, the “technique” is used by parents. They place the highly appreciated property into a PAT, in exchange for a promise of lifetime income payments from their children via the PAT. The PAT then sells the property without incurring capital gains taxes. The proceeds are then invested by and large into stocks and other instruments that are designed to outpace in growth the “promised” income stream. The income stream paid to the parent is a taxable event. This transaction is reminiscent of an “installment sale.” At the death of the parents, with this program, the proceeds typically avoid estate taxes as well. For these reasons, the PAT has been an attractive discussion piece, primarily promoted by the stock brokerage industry to convert real estate assets into securities. On paper, the technique could provide substantial income and estate tax benefits. However, the parent and the child (trustee) would normally have to invest the money into higher risk investments such as equities to make the numbers “work.”

Regarding the proposed tax law changes, the Treasury did not give advance notice of the proposed modifications nor did it allot a grace period for transactions in process. It did note that taxpayers had inappropriately relied on previous revenue rulings (Rev. Rul. 69-74) in a number of transactions that were designed to avoid U.S. income tax. One bright side to the announcement is that the Treasury and IRS did not rule that existing private annuity transactions are illegal.

“There are other ways under current regulations that will essentially allow a client to end with the same result (as they would under a PAT),” says John Ambrecht, a Montecito estate planning attorney with Ambrecht, Arnold, Tokuyama & Brittain, LLP. “It may be possible to utilize alternative structures to steer clear of the annuity classification, thereby avoiding the immediate recognition of gain on a transaction. The public will need to stay tuned for coming developments.”