As a CERTIFIED FINANCIAL PLANNER™, former advisor and portfolio manager for one of the nation’s largest wirehouses, Andy understands what it is like to sit across from a client during good times, but more importantly, during bad times when markets are down.
The Deferred Sales Trust, or DST, is sometimes used by people who want to sell a highly-appreciated asset, but who may face significant capital gains taxes if they sell directly. Set up by an attorney, a DST is single stand-alone, irrevocable entity.
With a DST, a buyer is already lined up for the asset, and the seller agrees to accept an installment contract from the trust for payment, thus spreading out and potentially mitigating capital gains taxes owed on installments over a period of years, depending on how the original cost basis is calculated.
Inside the trust, the money from the sale is invested and assets are managed by a third-party trustee.
The term Deferred Sales Trust is a “common law” trademark that refers to a financial structure that includes an irrevocable trust and an installment sales contract.
Specifically, a DST is an irrevocable trust that utilizes installment sale treatment under Internal Revenue Code §453 in order to defer the taxes due on the sale of a capital asset such as a business, investment real estate, a primary residence or personal property such as an art collection, antiques, jewelry, and the like.
How It Works
An irrevocable Deferred Sales Trust is created and the seller sells their appreciated asset to the trust in exchange for an installment payment note. The seller gets paid by the trust based on the installment payment contract terms—often a monthly or annual amount. Typically, the note is spread out over 10 years or a similar timeframe and a 5% interest amount is common.
NOTE: The seller is not an owner nor a beneficiary of the trust. The seller effectively becomes a creditor and installment note-holder, with some influence over the third-party trustee’s investment approach and installment note terms, but not actual control. This is mandated by the IRS under Internal Revenue Code §453.
The trust sells the asset to the buyer at the trust’s inception for the exact amount the seller sold it to the trust for, with $0 gain or loss to the trust. The money from the sale goes into the trust to be invested.
A financial advisor or CPA is established as the third-party trustee of the Deferred Sales Trust, and invests the proceeds. The trustee is responsible for investing prudently and using the gains to pay the seller back per the installment note terms.
The trustee decides how the trust’s assets will be invested based on the seller or note-holder’s risk tolerance. Often a risk tolerance questionnaire provides the information needed for a written investment statement of the trust which must be adhered to. The seller or note-holder may be apprised or have access to software which allows monitoring of the investment portfolio.
It is important for the seller / note-holder to be aware that if the proceeds of the sale are invested in the market, the proceeds may be subject to market risk, and a market downturn may endanger the payouts or schedule.
The actual investments in the trust’s portfolio are chosen and managed by the DST trustee, but the seller can also request virtually any type of “prudent” investment that matches their risk tolerance, such as the following:
- Stocks, bonds or commodities
- Cash investments
- Real estate
- A business
- Life insurance
The Potential Benefits
The Deferred Sales Trust is sometimes used to sell a business or highly-appreciated asset to family members, mitigating potential capital gains and estate taxes and avoiding probate.
A DST can potentially spread your capital gains tax burden over several years rather than your client having to pay it all in one lump sum. When structured properly, the seller only pays capital gains tax on principal payments when they are received from the DST.
A Deferred Sales Trust can be an alternative to a 1031 exchange of investment real estate that requires neither a “like-kind” exchange nor adherence to strict timeframes.
Even though fees can be high, there can be a subtle tax advantage with DSTs. The trust pays its own taxes and the fees are expenses of the trust. This means that its fees reduce your client’s gross return rather than passing through to them as unusable deductions.
The Potential Downsides
Because the seller is not an owner or a beneficiary of the trust, the seller effectively becomes a creditor or installment note-holder. The seller’s only collateral is the trust’s underlying investment portfolio. The seller has some influence over the investment approach and installment note terms, but not actual control. While this is necessary to meet IRS requirements, it relies on the underlying investments being managed correctly to ensure that the gains inside the trust will cover the installment payments.
There is the potential for market loss depending on the investments chosen by the trustee, which could negatively impact installment note payments or timeliness of payments.
Setup and maintenance fees may be higher than with other tax deferral strategies. There is usually a fee by an attorney to set up the trust, often 1.5% of the asset’s value of the first $1 million and 1.25% of anything in excess of $1 million. Additionally, the trustee’s fee may be 0.5% and there may be an additional investment advisor’s fee ranging from 0.5% to 1% of assets under management, although these fees may be negotiable.
Once the face value of the installment note reaches or exceeds $5 million, the DST becomes less advantageous to clients as they have to pay interest on the deferred tax attributable to amounts over $5 million.
While some industry experts worry that the IRS may disallow the legitimacy of some DSTs, they have been used for 20+ years with no negative tax court decisions so far.
Careful selection of the drafting attorney and the third-party trustee is paramount to the success of the DST, as there can be issues regarding the transfer of a highly-appreciated asset without any retained interest by the seller. Additionally, investor control issues and proper receipt and distribution of sale proceeds are of concern to clients.
Be leery of signing non-disclosure agreements (NDAs) when discussing possible Deferred Sales Trusts with tax attorneys and other professionals. These may limit your ability to fully apprise your client of information they need to make good decisions. If it sounds too good to be true, it probably is.
FOR ADVISOR USE ONLY, NOT FOR USE WITH THE GENERAL PUBLIC
The information provided in this article does not, and is not intended to, constitute legal advice or tax advice. All contents are for general informational purposes only. Readers should contact their attorney and/or accountant to obtain advice with respect to any particular legal or tax matter.