Benefits and risks
What a Deferred Sales Trust may do, and what can go wrong
Every strategy has downsides. These are potential benefits, not guaranteed results, and the risks below deserve equal attention.
Potential benefits
Primary benefits of the Deferred Sales Trust
Capital gains tax deferral
Tax is deferred until installment payments of principal are received. Opting to receive future payments in lieu of an immediate lump sum delays the recognition of capital gains, so the taxpayer can enjoy the benefit of the pre-tax proceeds for an extended period. Managing the amount and frequency of principal distributions can also let the seller benefit from lower marginal tax rates in the years the gains are recognized.
More capital potentially available to invest
Tax on the full gain is not paid up front, so the trust can invest the pre-tax proceeds rather than the after-tax proceeds.
Liquidity and diversification
Can potentially convert an illiquid asset, like a business or commercial real estate, into a diversified portfolio of liquid investments. This can help reduce risk and volatility by preventing overexposure to a single asset class.
Potential retirement income
Can provide a stream of income for retirement based on the pre-tax proceeds from the sale instead of the after-tax proceeds, which are likely to be substantially less.
Flexible payment options
The repayment terms and schedule can be structured in a variety of ways, from minimal repayment of principal to rapid amortization, subject to applicable tax rules. Payments can start immediately or be delayed into the future.
Tax planning flexibility
Planning can be spread over several years.
No 1031 replacement property requirement
The proceeds do not have to be invested in like-kind property in a very short timeframe to achieve tax deferral.
Can sever partnership interests
Each individual owner can have their own Deferred Sales Trust, managed to their own risk tolerance and preferences.
Maintains family wealth
By avoiding a massive drain of equity at the time of the sale, by potentially providing significant estate planning benefits, and by providing estate liquidity so that significant family assets do not have to be liquidated under less than ideal circumstances.
Estate planning coordination
The seller can exchange direct ownership responsibilities for an agreed upon note obligation. Combined with additional planning, the DST can help accomplish an estate freeze for estate tax purposes and help avoid the delays and expense of probate.
Asset protection
Subject to state specific laws, and in conjunction with additional planning, the taxpayer can potentially secure asset protection by utilizing the DST.
Risks
The risks a seller should weigh
- IRS challenge: The IRS may challenge an intermediary arrangement that lacks genuine economic substance and business purpose. If a challenge succeeds, the deferral can be lost.
- Trustee or intermediary default: The seller depends on the trust's ability to repay its promissory note.
- Investment losses: Trust assets may decline in value, which can impair future note payments.
- Liquidity: The seller generally cannot withdraw trust assets at will.
- Fees and expenses: Trustee, legal, administrative, investment and transaction fees may reduce returns.
- Interest is taxed as ordinary income: Interest paid on the note is taxed as ordinary income.
- Interest charge on large sales: Under Section 453A, installment obligations over $5 million in aggregate can trigger an annual interest charge on the deferred tax.
- Tax law can change: Future tax rates could change.
- Depreciation recapture: Ordinary income recapture generally must be recognized in the year of sale, even with installment reporting.
- Mortgage over basis: Debt in excess of the seller's basis may be taxable in the year of sale.
- Business sales: Inventory and certain other components of a business sale cannot receive installment treatment.
- At death: Death does not eliminate the deferred gain. The note may remain an estate asset, and the unrecognized installment gain generally remains taxable to the heirs.
Michael recommends that every seller have independent tax counsel review the exact transaction and compare it with other alternatives.
See whether a Deferred Sales Trust may fit your sale
An introductory call explains the structure and answers your questions. Your own tax and legal advisors are welcome to join.