Taking the Ax Out of Tax

When investors, particularly wealthy ones, approach retirement, they often embark on a process that sends financial advisors' salivary glands into overdrive: the sale of highly appreciated assets. An advisor with such a client knows a big payday is in the offing if he can prove himself indispensable in this moment of truth. A shortcut to that goal is figuring out how to get the client the money he

When investors, particularly wealthy ones, approach retirement, they often embark on a process that sends financial advisors' salivary glands into overdrive: the sale of highly appreciated assets.

An advisor with such a client knows a big payday is in the offing if he can prove himself indispensable in this moment of truth. A shortcut to that goal is figuring out how to get the client the money he needs while helping him cut his tax bill — not an easy task, to be sure.

The investor selling his assets has several options. He could take cash up front, which would trigger an immediate loss of 20 percent of the capital gain to taxes. If the asset is real estate, he could sell it under an installment sale or land contract. But if the buyer defaults, the original owner could get the property back at a lower value than the initial sale price.

A Better Way

There is another appropriate vehicle of which most clients probably are not aware. It's called a “private annuity trust.” Executed properly, it can delay capital gains taxation for decades, avoid gift and estate taxes and even delay depreciation-recapture taxes (ask the client's CPA if this is going to be an issue). Most important, it can substantially increase an advisor's odds of bringing the sales proceeds under his management.

Although private annuity trusts are relatively obscure, they are hardly unheard of. The National Association of Financial & Estate Planning has branded its own version of them as the “Premier VI Annuity/Trust.”

To create one, the owner first establishes a trust, complete with desired beneficiaries (such as the owner's children or grandchildren). Then the asset is transferred to the trust. The trust pays the original owner for the asset with a private annuity contract — an arrangement that differs from the annuities issued by insurance companies. Because the private annuity contract represents payment to the owner, there will be no gift taxes when the asset is moved into the trust.

Next, the trust sells the asset to an outside party. The sales proceeds are reinvested according to the direction of the trustee.

The Payments

When to begin

The original owner can begin taking payments from the trust whenever he desires, as long as he starts by age 70. If he is over 70 when the asset is transferred, he must begin taking payments within one year of the transaction date.

Payment amount

The money he receives is a fixed figure, determined by his age, the net selling price of the asset and his life expectancy according to IRS tables.

Taxation of payment

Once the payment amount is calculated and commenced, the original owner's tax liability begins. Part of the payment is the asset's original cost basis, part is the capital gain from the original sale and the rest is interest credited to the principal while the money was in the trust (the rate is not what the principal earned, but is instead the “Annual Federal Mid-Term Rate” as determined by the IRS under Section 7520).

For instance, if the owner has a 20-year life expectancy when the cash starts coming, an annual payment would be structured as follows:

Categorization Taxation
1/20 of the basis Tax-free
+
1/20 of the capital gain Capital gains rates
+
AFMR credited rate Ordinary income rates

If the client's life exceeds the number set by the IRS (in this case, 20 years), all remaining payments are taxed at ordinary income rates.

The conclusion

All good things must come to an end, and the private annuity arrangement is no exception. The cash flow from the trust will stop when the original owner dies, or when the assets in the trust are depleted under the annuitization schedule.

If the owner/annuitant's life runs out before the money does, the private annuity is declared null and void, and whatever is left in the trust goes to the beneficiaries — with no estate or gift tax liability — and it's removed from probate. If the trust's assets are gone before the annuitant dies, both the advisor and the client can sleep well knowing they may have saved a good chunk of money by deferring taxation on the original sale.

Potential Risks

Needs exceed speed of proceeds

Once the payment stream to the annuitant begins, it cannot be raised or lowered. And since the proceeds from the sale of the asset are still in the trust (and therefore inaccessible to the annuitant), the client may find himself considerably short of funds if he can't live on the annuity payments alone.

Higher future tax brackets

Today taxpayers are hit with a maximum long-term capital gains tax of 15 percent at the federal level, the lowest percentage since World War II. If income and capital gains tax rates are higher in the years the client receives payments from the private annuity, the outcome of the whole deal could be just a wash — or worse.

Hands off

The original owner cannot serve as the trustee or have any control over the management of the trust (but an adult child of the owner can). It can be nearly impossible to unwind the transaction, regardless of the original owner's circumstances.

The advisor and his client-with-the-highly-appreciated-asset obviously would be wise to consult an attorney and a tax advisor before deciding if a private annuity is all it's cracked up to be.

For more background, the NAFEP provides a free detailed analysis of the concept, written well enough that even the most ADD-addled financial advisor can get his or her arms around it. Get a copy at www.nafep.com/estate_planning/pvtannbooklet.PDF.

Writer's BIO:
Kevin McKinley
is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.
kevinmckinley.com

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