A Deferred Sales Trust is a tax-deferral strategy that can allow an individual to defer capital gains taxes on the sale of an appreciated asset. In this article, we will walk through what Deferred Sales Trusts are, how they work, and some of the benefits and risks (including key legal questions). We’ll also present a case study to demonstrate how the returns compare to other tax strategies.

What is a Deferred Sales Trust?

A Deferred Sales Trust (DST) operates as a tax-deferral strategy that allows individuals to sell appreciated assets such as real estate or businesses, while deferring capital gains taxes. That deferral is the result of a five-step maneuver:

1. Initial exchange. The individual sells the asset to a trust in exchange for a promissory note. The promissory note requires that the trust pay the seller back (plus interest) in installments over a number of years (typically 10 years) as long as the trust has enough money to cover the payments.
2. Taxable payments. The seller pays taxes on the installment payments as they are received, rather than owing all of the taxes up front. This is the key to the DST’s tax deferral value proposition.
3. Asset sale. Meanwhile, the trust sells the asset to a third-party buyer. This is the buyer who the seller would have otherwise sold the asset to, and the buyer pays the same price he or she would have paid anyway, which is typically the same value as the installment note.
4. Reinvestment. The proceeds from this sale are then reinvested inside the trust in income-generating assets, whether it is stocks, bonds, etc.
5. Distributions. The income that the trust generates is distributed to the seller, who pays tax on that income. After the installment note is paid off, the remaining trust assets go to the trust beneficiaries, which is typically the same as who is benefitting from the installment note.

This is all great in theory. The seller spreads the sale proceeds — and the resulting capital gains taxes — out over time, the buyer purchases just as they would have absent a trust, and the seller reaps the gains from reinvesting the deferred taxes. As we’ll explain here, though, DSTs exist in a legal gray area, and, considering the alternatives available, the risk may not be worth the reward.

What Is the Primary Use Case for a Deferred Sales Trust?

DSTs are a potentially useful strategy in situations where an individual is looking to sell an asset that has appreciated significantly. It’s most commonly used for selling businesses or real estate. The main objective is to defer the capital gains tax that would typically be due upon the sale of the appreciated asset. By deferring some of that tax, the seller — via the trust — can keep and reinvest a larger portion of the proceeds than would otherwise be possible.

Benefits of a Deferred Sales Trust

There are two major benefits of DSTs:

1. Tax Deferral. The most significant benefit is the ability to defer capital gains tax, allowing the seller to reinvest a larger portion of the proceeds and create more wealth.
2. Tax Smoothing. Receiving the proceeds of the sale over many years — instead of concentrated in a single year — can potentially lower the seller’s marginal tax rates, as they’ll receive many smaller payments instead of one large payment, further reducing taxes.

Who Benefits from the Upside (or Downside) of the Trust’s Investments?

It is important to understand who benefits and carries the risk from the trust’s post-sale investment returns. Unfortunately, the seller doesn’t benefit from the upside of DST investments but does carry the downside of poor investments. When a DST is established, the seller receives an installment note from the trust, outlining a specific interest rate and payment schedule. The interest rate on the installment note is usually conservative, often based on prevailing rates plus a small premium. This rate determines the payments the seller will receive over time.

If the investments within the trust perform well and generate returns above the interest rate specified in the installment note, the excess returns (or upside) remain within the trust; the seller still just receives the installment notes. On the other hand, if the trust’s investments do worse than expected, the trust may not be able to pay back the principal and interest it owes the seller under the installment note.

DSTs and Legal Gray Areas

A DST is a type of “installment sale.” Installment sales are legal, but they have been under increased IRS scrutiny in recent years. The IRS even placed a type of installment sale known as a monetized installment sale on its “dirty dozen” list alongside things like Conservation Easements.

The potential legal issues that DSTs face are:

• The Economic Substance Doctrine: Codified in IRC Section 7701(o), this doctrine requires transactions to have “economic substance” beyond the tax benefits. DSTs may be challenged as lacking a true business purpose other than tax deferral.
• The Step Transaction Doctrine: Courts may collapse the multiple steps of a DST (sale to trust, trust sale to buyer) into a single transaction, potentially negating the intended tax deferral.

Other Risks and Trade-Offs of a Deferred Sales Trust to Keep in Mind

1. Complexity and Costs. Setting up and managing a DST can be complex and expensive, often resulting in lower net returns than other strategies. Typically, DST fees will be 2% of the asset value upfront and 1.5% of the trust value on an annual basis for administration and investment support. This can add up quickly and is significantly more expensive than many other tax-deferral alternatives.
2. IRS Scrutiny. As discussed above, DSTs are a variation on the “installment sale” tax strategy, which has been under increased scrutiny in recent years. Moreover, the IRS has never formally blessed the specific approach that DSTs take, which is a unique spin on the installment sale approach. This lack of formal guidance creates significant uncertainty around the legal status of DST transactions.
3. Illiquidity. Once assets are transferred to the trust, a portion of the principal is inaccessible to the seller.
4. Market Risk. The investments made by the trust carry market risk. If the investments perform poorly, the trust may not be able to pay back the seller.
5. Lack of Industry Recognition. Some entities, such as Qualified Intermediaries in 1031 exchanges, may not recognize DSTs as a valid exchange alternative. This can create issues if the Qualified Intermediary refuses to release funds to the DST trustee.
6. Investment Risk: You don’t get the upside of trust investments but carry the downside risk of poor investment performance.

What are the Steps to Set Up a Deferred Sales Trust and the Costs to do So?

Setting up a Deferred Sales Trust involves several key steps:

1. Trust Formation. The trust is created by an attorney. The trust is structured to receive the proceeds from the sale of the appreciated asset.
2. Sale and Transfer. The appreciated asset is sold, and instead of the seller receiving the proceeds directly, the proceeds are transferred into the trust. The trust then provides an installment note to the seller, which outlines the payment schedule, interest rate, and other terms.
3. Investment Management. The trust invests the proceeds into income-generating assets. The investments can be diversified across various asset classes, depending on an individual’s goals and risk tolerance.
4. Ongoing Administration. The DST requires ongoing management, including investment oversight, tax filings, and distributions to the seller according to the terms of the installment note.

Alternatives to Deferred Sales Trusts

1. 1031 Exchange. A 1031 exchange allows an individual to defer capital gains taxes on a real estate sale by reinvesting the proceeds into a similar property.
2. Opportunity Zones. Investing in Opportunity Zones allows an individual to defer and potentially reduce capital gains taxes by reinvesting in areas that the government has designated as economically distressed.
3. Charitable Remainder Trust (CRT). A CRT allows an individual to donate appreciated assets to a trust, receive income from the trust, and ultimately benefit a charity. This option can provide tax benefits and support charitable causes. It also has much lower fees (sometimes 10% of a DST’s fees) and can defer taxes over a longer period, such as your entire lifetime (the longer you can defer taxes, typically the higher the returns).
4. Direct Sale with Tax Planning. For some, the simplest approach might be to sell the asset directly and employ strategic tax planning, such as utilizing capital losses or charitable gifting strategies, to offset gains.

How Do the Returns Compare with Alternative Tax-Deferral Strategies?

Let’s take a scenario where a family based in California is selling their business for $1.4 million. They started the business from scratch, so their cost basis is zero. Because they are selling a business, they can’t use an Exchange Fund, so we’ll compare a Deferred Sales Trust, Opportunity Zone, and Charitable Remainder Trust (CRT). We’ll assume the family doesn’t need distributions for the first three years and then in year 4 they plan to take out enough distributions to have about $65,000 after taxes. That amount will increase by 5% a year until they pass away.

The Charitable Remainder Trust outperforms the other strategies significantly, providing the highest net distributions. Compared to the Deferred Sales Trust, the CRT boasts significantly higher returns because it has much lower upfront costs and allows the user to benefit from the trust investments’ growth. The Opportunity Zone also has high fees and offers no liquidity for the first few years.

Conclusion

A Deferred Sales Trust can be a powerful tool for those looking to defer capital gains taxes and create a flexible income stream from the sale of appreciated assets. However, it is a complex strategy that carries some risk and high fees that usually make it less appealing than most alternatives. Before proceeding with a DST, it’s essential to consider the costs, risks, and alternatives to determine the best approach for your situation.

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