Editor’s note: Mallon FitzPatrick is a longtime columnist with Rethinking65. Read more of his articles here.
Key Points • The trust can help control the amount and timing of tax liabilities. • It’s often used when selling businesses or real estate. • The seller avoids credit risk and gets tax deferrals from an installment sale.
Mallon FitzPatrick
Understanding a Deferred Sales Trust
In the ever-evolving landscape of wealth management, advisors continually seek innovative strategies to meet their clients’ financial planning objectives.
One such approach that has gained traction recently is the Deferred Sales Trust (DST), especially as discussions around tax deferral strategies flourish. These discussions are often sparked by media coverage that emphasizes the specific advantages of DSTs in certain scenarios. However, while a DST offers potential benefits, its appropriateness depends on the individual situation.
The Deferred Sales Trust is a tax deferral mechanism that utilizes a Section 453 installment sale to help control the amount and timing of tax liabilities. It’s typically used when selling significant assets like businesses or real estate. Unlike direct installment sales, DSTs provide sellers with enhanced control over structuring their payment terms. This allows the seller to defer tax liabilities while strategically investing the entire proceeds of the asset sale.
In a traditional installment sale, the asset owner typically sells directly to a buyer. However, in the DST model, the asset is first transferred to an irrevocable trust in exchange for an installment note; the trust then finalizes the sale with the buyer.
The trust reinvests the proceeds, and payments are distributed to the seller over time, as specified in the installment note. The seller incurs taxes only upon receipt of the payments.
Through this strategy, sellers not only sidestep direct buyer-seller interactions that pose credit risks, but they also can take advantage of the tax deferral benefit offered by an installment sale.
When Does a DST Make Sense?
Implementing a DST can be valuable under the right conditions. Here are some key motivations for considering a DST:
Mitigating Default Risk: DSTs effectively reduce and likely prevent the risk of payment defaults by eliminating direct transactions with the buyer. The trust serves as the intermediary, which helps preserve the financial integrity of the transactions.
Customized Control: Although ultimate control rests with an independent trustee, sellers can influence the investment direction by advising on asset allocation. This flexibility allows sellers to align investments with their overall financial objectives.
Tax Efficiency: Many clients appreciate the ability to determine the timing of their tax obligations. DSTs enable sellers to tailor the receipt of payments, potentially aligning themwith lower tax periods or strategic financial planning objectives.
Risks to Be Aware Of
Despite the enticing benefits, using a DST demands careful consideration of several risks:
Fees: The management fees and trustee fees associated with maintaining a DST can range significantly and should be weighed against potential tax savings.
Legitimacy Concerns: While a credible tax planning tool, the DST lacks explicit IRS endorsements, which may concern some clients. This opacity, compounded by nondisclosure agreements, requires trust in the credibility of promoters.
Investment Performance and Non-Recourse: The trust’s assumption of ownership means that poor investment choices could deplete funds, with sellers having limited recourse. Conversely, any surplus from successful investments remains with the trust.
Considering Alternatives
DSTs are not a one-size-fits-all solution. Clients should compare them with other strategies, such as:
1031 Exchanges and Delaware Statutory Trusts: These strategies offer investment continuity while deferring capital gains taxes, making them excellent for real estate-focused investments.
Structured Installment Sales: They provide tailored solutions for spreading income over time, simplifying tax obligations.
Opt to Sell and Pay the Tax: Some clients may prefer a straightforward sale if the projected tax liability fits within their financial planning framework.
Conclusion
Deferred Sales Trusts represent an innovative approach to managing tax obligations while maintaining investment potential. However, like all financial planning tools, they require a thorough analysis of the client’s financial situation and objectives. As a wealth manager, leveraging tools like DSTs can help ensure clients preserve their wealth and efficiently manage income taxes.
Mallon FitzPatrick, CFP, is a principal and managing director at Robertson Stephens and heads the firm’s financial planning center. For more information about Mallon or Robertson Stephens, please visit www.rscapital.com or email info@rscapital.com. Advisory services are offered through Robertson Stephens Wealth Management LLC. Opinions presented are those of the author and not necessarily Robertson Stephens.Please read important disclosures.
