Common Questions About the PAT Income Stream

A few entries ago I wrote about my friend who is selling her auto repair business, probably through a PAT. One of the things she may have to negotiate is whether she continues to work in the business for a period of time after the sale. If she does continue to work in the business, she may have the financial flexibility to defer the trust payments. This really isn’t a problem – payments from a PAT can be deferred until she’s 70 (70 technically) – but what if she wants to make other arrangements with the income stream? What if she ends up needing more or less money than she thought? Questions about the flexibility of the income stream out of a PAT are quite common, and important given that the primary purpose of a PAT is to generate income, so I thought I’d take some time to address them.

One question that comes up often is whether annuity payments can be graduated so that they increase as time goes on. This is sensible, particularly for my friend who may not need as much income from the annuity at first. As I mentioned above, if she doesn’t need any extra income at all, then fine, we just defer the payments for a while. But if she’s working in the business after the sale, she may not take home as much on a monthly or annual basis as she did when she owned the business. In that case, she may need to supplement her earned income with payments from the trust. If she’s supplementing income, she may not want to receive as large an annuity payment as she would if it were her only source of income. So what are the options?

Well, payments from a private annuity trust are fixed and cannot be graduated. Once you determine the amount of the periodic payments, they must remain the same size from the first payment to the last. One possibility is to hold back some cash from the sale. If she does that, however, she will be immediately responsible for the proportionate share of capital gains taxes. The trust could lend her money, but the loan would have to be structured as any third-party loan. This means that the trust must receive market interest rates on the loan, there must be formal loan documents, and there must be a realistic payment schedule that is enforced by the trustee. Similarly, she could use her annuity payments as collateral for a loan or line of credit from an actual third-party lender.

There are other ways to augment the income stream. For instance, a PAT can be cancelled. When a PAT is cancelled, the principal is immediately distributable to the person who placed the asset in the trust. Assuming my friend sets up a PAT, if she were to later terminate it, the funds within would be paid to her. However, a PAT can’t just be cancelled on a whim. Remember that you are no longer in control of the asset or of the trust or the terms of the trust. The trustee is the one who decides whether a trust should be terminated based on what he or she believes is in the best interest of the annuitant and the other beneficiaries. As well, canceling the trust invalidates any tax deferral up to the point of cancellation, so the full amount of capital gains tax and penalties and interest would have to be paid to the I.R.S.

What would happen if my friend decided to defer payments until she was 60 years old, but then decided she wanted to receive them at the age of 55 instead? Could she shorten the deferral period? At first it seemed clear that the I.R.S. allowed annuitants to change the deferral period, after all, the sooner you receive your payments, the sooner the I.R.S. receives its tax revenue. However, now it is not so clear that the I.R.S. would allow this. Based on the simple logic above, it would seem that they would, but if my friend did decide to shorten the deferral period, her legal counsel or trustee may seek something called a private letter ruling to ensure that the I.R.S. approves the move.

So you see, even though PATs have some significant restrictions built in, there is a certain amount of flexibility to them. This flexibility makes them ideal for use in many situations involving the sale of capital assets. If you think you might be interested in generating income through a PAT, give me a call for a free consultation. My phone number is 760-917-0858.

Paula Straub
Save Gains Tax


This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are meant for informational use only. The information contained on this site does not constitute advice on tax or legal issues. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

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