Using a Deferred Sales Trust in a Business Transaction

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Deferred Sales TrustThe incoming presidential administration has indicated its desire to tax certain earners’ capital gains at the same rate as their personal earnings.  That has led to us getting more questions here at Apex about ways to reduce exposure to capital gains.  One of these ways is called a deferred sales trust.

What is a Deferred Sales Trust?

Simply put, this is a vehicle one can use to defer capital gains taxes.  This is something that must be set up prior to a sale and, unlike the well known 1031 Exchange which is for real estate transactions, a deferred sales trust does not impose strict, short-term time limits on your proceeds.

How Does it Work?

The trust buys the business from the seller (this can be set up in a contract to be concurrent with the purchase from a buyer).  The seller can set up a contract that allows the trust to pay for the business over time.  In a sense, it’s seller financing…for yourself.  As you withdraw from the trust (on a timetable that you set up, that can be modified) then you will be taxed at that time, and only on those amounts.  Even better?  Those funds can be used to make investments which are not subject to the capital gains that you incurred on the original transaction.

Some conditions include:

  • A third party must be the trustee
  • The trustee can invest those funds in new investments
  • The trustee is responsible for making your disbursements or making modifications to the disbursement schedule
  • Capital gains are to be paid on any principal amount the seller receives from the installment payments.  As we noted above, the trust can make investments and earn income and hence could also be “saddled” with non-taxable (to you) interest on your payments.

What’s the Catch?

We’ve always said that it’s key to not fall afoul of the IRS.  You shouldn’t look at this vehicle solely as a way to “avoid capital gains.”  You won’t be able to.  All you can do is adjust the time of paying those taxes to your choosing, but that also means not taking all the gains from your sale at once.  If getting your proceeds in an installment fashion suits your lifestyle, this might be an ideal way to go.  You can also negotiate the payment amounts, so if you need a lump sum up front before moving to smaller payments, that’s possible.

The main “catch” involved is picking the right trustee.  This isn’t just because this person will be in charge of the proceeds of possibly the largest transaction of your life, but because he/she will also oversee investing that money.  Remember that capital-gains-free earning of new income via investments is a major benefit of this vehicle, so as much as you might want to just ask a family member to “help you with this one thing” you’re probably going to need to bring in a professional who can help you optimize your investments.

Speaking of professionals, that’s who you’re going to want to consult to help you examine a deferred sales trust: a lawyer in consultation with your financial team.  This sort of vehicle isn’t for everyone, but as tax conditions change in Washington, people should examine their options and be prepared to have different ways to execute their transaction, should they wish to do so.

We don’t create trusts at Apex, but we know great people who do.  If you need a referral, give us a call and we’ll connect you.