Recently, a manager of a private equity fund mentioned that the seller of the business was complaining about the amount that the seller will have to pay in commissions, fees and capital gains taxes. The manager asked if I knew of a way of selling a business to a trust with an installment sale and having the trust sell the business and reinvest the proceeds to generate a yield higher than the installment payments. What this is called is a deferred sale trust.

Deferred sale trusts (DSTs) have gained attention as a sophisticated estate planning tool for deferring capital gains taxes on the sale of highly appreciated assets, offering another option for high-net-worth individuals alongside established structures such as charitable remainder trusts (CRTs) and charitable lead trusts (CLTs). This article will provide a comprehensive look at how DSTs operate, their benefits, risks and a comparison with CRTs and CLTs in terms of tax efficiency.

Understanding Deferred Sale Trusts
A deferred sale trust is essentially a form of installment sale structured as a trust. In a typical DST arrangement, the property owner sells the appreciated asset to the DST in exchange for a promissory note, which pays the seller a predetermined installment plan over time. The DST subsequently sells the asset to a buyer, allowing the trust to receive the sales proceeds. Since the property owner sold the asset to the trust as an installment sale, they do not immediately recognize capital gains. Instead, capital gains are deferred if payments meet the requirements for election of installment sale treatment by the IRS.

Key Components Of A DST
• Promissory Note: The seller receives periodic payments through a promissory note, spreading the capital gains over several years and reducing the immediate tax burden.

• Independent Trustee: A third-party trustee, often a bank or professional fiduciary, must manage the DST to ensure compliance with IRS requirements.

• Installment Sale Method: Gains are recognized only as payments are received, which can lower the total tax paid if the taxpayer falls into a lower tax bracket in future years.

Benefits Of A Deferred Sale Trust
DSTs offer several benefits to individuals with highly appreciated assets, including real estate, privately held business shares, and high-value collectibles.

1. Deferral Of Capital Gains Taxes: Unlike a standard sale, the capital gains tax in a DST is spread out over time, which can reduce the seller’s immediate tax burden and provide more investment flexibility.

2. Income Stream: The installment payments create a steady stream of income, which can be particularly attractive for retirees or those looking to diversify their income sources.

3. Flexibility In Estate Planning: DSTs can be tailored to align with estate planning goals, allowing asset sales without incurring immediate tax obligations, which can help in maintaining asset values within the estate.

4. Potential For Asset Growth: Since the proceeds from the sale are retained within the trust, they can be invested in various assets. This reinvestment can potentially yield higher returns, compounding the deferred amount and possibly providing a net benefit even after future capital gains taxes are paid, to the beneficiaries of the trust.

Risks Of A Deferred Sale Trust
While DSTs offer appealing benefits, they also come with notable risks and potential downsides:

1. Complexity And IRS Scrutiny: DSTs are relatively complex and require careful structuring and adherence to IRS guidelines. If not correctly set up, the IRS could disallow the DST, resulting in immediate tax liabilities. Moreover, the IRS has been known to scrutinize these arrangements closely.

2. Costs And Fees: The administrative costs of establishing and managing a DST can be significant, often involving setup fees, trustee fees, and ongoing advisory costs. These expenses can detract from the tax savings benefits, particularly for smaller estates.

3. Market Risks: The DST must invest the sales proceeds to generate income for the promissory note principal and interest payments. If investments perform poorly, the trust may not generate the anticipated yield, impacting the seller’s income stream and the trust's ability to make the required installment payments. This risk is increased as the amount deferred increases, so that if 100% of the sale price is deferred, it is likely that there will be significant issues due to market risks.

4. Limited Liquidity: DSTs are not well-suited for individuals who may need immediate access to a lump sum of cash, as the trust holds the assets and makes payments according to the installment plan, often restricting flexibility in accessing funds.

Comparison With Charitable Remainder Trusts (CRTs) And Charitable Lead Trusts (CLTs)
DSTs, CRTs, and CLTs all offer tax-deferred growth options but operate differently in terms of asset control, charitable impact, and tax efficiency.

Charitable Remainder Trusts
• Mechanics: A CRT is an irrevocable trust that pays the grantor (or designated beneficiaries) an income for a specified period or for life. Upon termination, the remainder passes to a designated charity.

• Capital Gains Tax Benefits: Contributions to a CRT can avoid immediate capital gains taxes, as the trust itself, being a tax-exempt entity, can sell appreciated assets without incurring capital gains. The donor receives a charitable deduction based on the remainder interest left to charity.

• Income Tax Deduction: Donors can receive a partial income tax deduction based on the present value of the remainder interest passing to charity. This is usually equal to approximately ten percent of the sale price.

• Drawbacks: CRTs are irrevocable, and the assets are ultimately donated to charity, meaning they do not stay within the family’s control or estate. Also, the assets must be transferred into the CRT before the sale of the assets is finalized. The charity is designated when the trust is created, but the Donor or the beneficiaries can retain the right to change the charity in the future. CRTs are best suited for individuals who have both philanthropic intent and a desire for tax efficiency.

Charitable Lead Trusts
• Mechanics: In a CLT, the trust makes payments to a charity for a specified period, after which the remaining assets return to the donor or their heirs. This structure can be useful for transferring wealth to future generations with reduced estate or gift taxes.

• Capital Gains Deferral: CLTs are generally subject to immediate capital gains taxes when the trust sells appreciated assets. If the Donor retains the right to receive the remainder of the trust at the end of the term, then the Donor will get an income tax deduction equal to the value of the annuity to charity in the year the trust is funded, offsetting up to 100% the capital gains.

• Estate And Gift Tax Efficiency: If the Donor gives the remainder to others, such as children, then the gift tax or estate tax due on the funding of the trust is reduced by the value of the annuity up to 100% of the value of the assets.  The CLT does get taxed on the capital gains on the sale of the asset, so this is most commonly used when the assets are sold as an installment sale or at the Donor’s death when the assets receive a stepped-up basis. CLTs allow individuals to transfer significant wealth to beneficiaries at a potentially reduced tax cost, as the charitable deduction can reduce the taxable estate.

• Drawbacks: CLTs, like CRTs, are irrevocable and require a genuine commitment to the charitable contributions, which can reduce overall family wealth if not carefully balanced.

Tax Efficiency Comparison: DSTs Vs. CRTs And CLTs

Conclusion
For individuals looking to defer capital gains taxes, each of these structures offers distinct advantages and drawbacks. DSTs provide income deferral and asset control, but come with higher administrative costs, market risks and potential IRS scrutiny. CRTs and CLTs, in contrast, are highly tax-efficient for capital gains and estate planning purposes, especially for those with philanthropic goals. However, the irrevocable nature and charitable commitments can limit their applicability for those wishing to retain assets within their family.

Ultimately, the choice between a DST, CRT, and CLT depends on one’s objectives regarding control, philanthropic intent and tax efficiency. Consulting with an experienced tax advisor or estate planning attorney can help identify the best strategy to meet these specific financial and legacy goals.

Opinion: While DSTs can be appealing for clients focused on flexibility and income deferral, I find that CRTs and CLTs offer unmatched benefits for those with a dual goal of tax efficiency and charitable giving, provided the irrevocable nature aligns with their long-term goals. Each tool has its place, but for those willing to part with control in exchange for substantial tax benefits, the charitable trusts often provide a more robust, tax-efficient legacy plan.

Matthew Erskine is managing partner at Erskine & Erskine.