The Demise of the Private Annuity Trust or PAT

Private Annuity Trusts, or PATs for short, were sometimes used (prior to 2007) to defer capital gain taxes upon the sale of highly appreciated real estate or personal property.  The Private Annuity Trust allowed taxpayers to transfer property, whether it be real property or personal property, into a Private Annuity Trust by conveying or transferring it to the Trustee of the Private Annuity Trust.  The conveyance or transfer of the property had to be completed prior to the sale of the asset. 

Sale of Real or Personal Property

The Trustee of the Private Annuity Trust would then sell the real or personal property to the end buyer and deposit the sale proceeds into the PAT.  The taxpayer was the Beneficiary of the Trust, which was part of the reason for the demise of the PAT that will be discussed shortly. 

Capital Gain Deferred Into Future

Capital gains from the sale of the real or personal property were deferred into the future since the Beneficiary (Taxpayer) did not receive any of the funds from the sale of the asset.  The Beneficiary would only recognize a portion of his or her capital gain as they received principal payments from the Private Annuity Trusts. 

IRS Rules Against PAT

The IRS ruled against the Private Annuity Trust on October 17, 2006.  The IRS ruled that “Private Annuity Trusts or PATs have been relied upon inappropriately in a number of transactions that are designed to avoid U.S. income tax,” according to an IRS press release.

In Buckmaster vs. CM TC Memo 1997-236, there were four (4) elements used to determine whether or not a trust of any type was actually a "sham trust".  These four (4) elements were the Taxpayer’s relationship to the property or asset in question; the independence of the Trustee; whether or not an economic interest was transferred to other beneficiaries of the trust; and restrictions placed on the taxpayer by the trust.

Private Annuity Trusts can not meet this test, and therefore can no longer be used to defer the payment of a taxpayer's capital gain taxes after October 17, 2006.  Transactions which have been properly structured under the old rules prior to October 18, 2006 will be permitted to stand, but the Internal Revenue Service will not recognize future transactions structured as Private Annuity Trusts for income tax deferral purposes.

However, Private Annuity Trusts can still provide some important estate planning benefits when used appropriately, so consult with your estate planning professional for further details.