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 ½ 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
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