A Deferred Sales Trust is a powerful tax-deferral tool if you are considering the sale of a business, corporation, or real estate. Sales of highly appreciated assets of this type will most likely incur capital gains taxes associated with a sale, but a Deferred Sales Trust gives investors the option to defer capital gains when they sell their assets, and to redirect the sale proceeds into cash or whichever types of investments suit their needs, income requirements, and objectives.
Let’s take the example of an elderly couple who has lived on their family farm for several decades. They have been successful farmers, and the value of their land, livestock, crops and equipment has increased steadily over the years. Now they have decided to sell and move several hundred miles away from their farm so that they can be close to their children and grandchildren. Selling their assets outright would incur heavy capital gains. A Deferred Sales Trust, however, will give them many different investment alternatives as they will not have to pay high capital gains tax for as long as they choose not to, assuming of course that they comply with the myriad rules involved.
The Deferred Sales Trust structure is attractive, but quite complicated, and in order to receive all possible benefits from this tax-deferral structure, there are numerous rules that must be strictly complied with in order for the IRS to accept the Deferred Sales Trust as legitimate.
A Deferred Sales Trust is a legal contract between the seller and an independent third-party trust in which the seller sells assets or a business to a Deferred Sales Trust in exchange for the Deferred Sales Trust’s contractual promise to pay the seller a certain amount over a predetermined future period of time in the form of an installment sale note or promissory note. The Deferred Sales Trust allows the seller to control capital gains tax exposure, reinvestment terms, and installment payments made from the trust.
The first step is to create a trust through a completely independent third-party company. To qualify for capital gains tax deferral, the Deferred Sales Trust must be considered a bona fide, third- party trust with a legitimate, third-party trustee. If the trustee is not truly independent from the owner, the IRS will flag it as a sham trust set up to illegally avoid taxes. In addition to being completely independent, the trustee must manage the trust according to applicable laws, the installment contract that has been drawn up, and in compliance with the owner’s risk tolerance and investment objectives.
Once the Trust has been set up properly, the property or business owner transfers assets into the Trust. Asset ownership must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax. An installment contract is drawn up between the trust and the owner, which contract provides flexible options on when and how payments are made. If the owner does not need to start receiving installment payments immediately, this can be written into the contract, and income and capital gains taxes will be deferred. If an owner wants income but does not want to pay capital gains taxes, the installment contract can be set up to pay interest-only payments from the reinvested sales proceeds, thus deferring capital gains taxes almost indefinitely.
Finally, the trust will sell the asset for the owner, and manage and distribute sales proceedings as per the installment contract. In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not directly receive any sales proceeds. Sales proceeds can be held in cash, reinvested, and distributed pursuant to the installment contract. The trust does not pay any taxes on the sale, since the trust purchases the property from the owner for the same price for which it is sold. The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The owner then is able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract.
This complicated but powerful tool can be used to control and extend income throughout retirement, deferring taxes for a very long period of time, thus providing peace of mind in retirement.