Monetized Installment Sale Risks Are Much Lower Than Deferred Sales Trust
Updated: Apr 12, 2020
Today I will briefly discuss why a participant in a monetized installment sale risks far less, in terms running afoul of the IRS, compared to a deferred sales trust.
We often receive inquiries from people selling capital assets who have been researching ways to avoid or defer large amounts of anticipated capital gains tax, and they have first been delving into the strategy known as a Deferred Sales Trust (DST). Subsequently, they discover our offering, the monetized installment sale, and we begin discussing with them the pros and cons of each. Frequently, these individuals have been warned by promoters of DSTs about monetized installment sale risks, claiming that it has no legal basis. They then go on to state that the DST is IRS-sanctioned.
Nothing could be further from the truth.
The DST is based on the idea of transferring ownership of an asset to a trust that the owner causes to be formed, and then the trust sells the asset to a third party. The capital gain for the original owner is deferred as long as they have not received sales proceeds. The sales proceeds are then invested by the trust, which agrees with the trustor (original owner of the asset) to make payments to the trust beneficiary over time. Eventually the original owner recognizes capital gains tax as principal payments from the trust are received, providing significant tax deferral.
DST promoters may claim that this arrangement has been cleared with the IRS, and at one point touted the existence of an IRS Deferred Sales Trust Private Letter Ruling (which did exist for a short time, then was rescinded by the IRS). At present, there is no formal guidance from the IRS at all concerning deferred sales trusts.
Deferred Sales Trust Risks
From a tax standpoint, DSTs create a considerable amount of compliance risk for those using this strategy. Trusts are subject to a variety of complex tax rules, and the IRS examines trusts closely for compliance.
For example, a DST should not be formed in a way that has a trustee who is related by family or business to the person or entity who has set up the trust, or else it will risk being considered a sham trust by the IRS.
Nevertheless, we hear of this rule potentially being violated from time to time when people contact us and discuss their thinking on how they expect to implement their DST. Their thinking is that “it’s their trust” and they expect to be able control it, such as by directing the investment policy or withdrawing funds when desired. However, that’s not actually permitted under the regulations. Surprise! There are a variety of other “gotcha’s” associated with DSTs that are beyond the scope of a short blog post. You can get a flavor for the potential problems by listening to a recording of a panel discussion conducted by the American Bar Association. The recording may be found near the bottom of this page.
That said, a prudent and careful taxpayer, with proper legal guidance, could successfully implement the DST strategy, but it would be easy to inadvertently diverge from the safe path and risk losing all the tax benefits. For example, the taxpayer might decide to put pressure on the trustee to adjust the investment strategy or distribution of funds from the trust, driven by unexpected future needs for cash. These would be in violation of trust rules, because the trustor is not allowed to direct the investments of the trust. That is the duty of the independent trustee.
Monetized Installment Sale Risks are Far Less Than Deferred Sales Trust Risks
With a monetized installment sale, risk related to tax compliance of this sort is eliminated, because there is no trust to manage and therefore no trust rules to follow. The outcome of the transaction is up-front receipt of a non-taxable lump sum of cash, a pair of long-term interest-only loans whose payments fully counterbalance each other, and liability for capital gains tax after 30 years have elapsed.
The ongoing structure, compliance burden and risk, as well as the maintenance costs associated with DSTs are virtually non-existent with a monetized installment sale. Thus, the deferred sales trust disadvantages, from a tax compliance risk standpoint, are significant, while with a monetized installment sale risks and problems of this type are negligible.
For a fuller comparison of the monetized installment sale vs. deferred sales trust, click here.
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How to Defer Capital Gains Tax for 30 Years and
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