How Does a Deferred Sales Trust Work?

A Deferred Sales Trust (DST) is a financial arrangement designed to defer capital gains taxes on the sale of highly appreciated assets. It provides a strategic alternative for individuals looking to sell assets such as real estate, businesses, or certain investment portfolios without incurring an immediate, substantial tax liability. This structure leverages specific provisions within tax law to spread the recognition of capital gains over an extended period.

The primary objective of a DST is to facilitate the sale of an asset while allowing the seller to postpone the payment of capital gains taxes. Instead of receiving the full sale proceeds directly and triggering an immediate tax event, the seller utilizes the trust to manage the transaction. This arrangement enables the seller to maintain control over the timing and amount of taxable income recognized. This article will detail the operational mechanics of a Deferred Sales Trust, from its initial formation to the management and distribution of its assets.

Structuring the Deferred Sales Trust

Establishing a Deferred Sales Trust involves a preparatory phase, setting the foundation for the subsequent asset sale and tax deferral. This stage requires the original asset owner, who becomes the trust’s beneficiary, and an independent trustee. The trustee is a third-party entity responsible for managing the trust’s affairs and ensuring compliance with legal and tax regulations. The trustee’s independence from the asset owner is required to prevent the IRS from classifying the trust as a “sham.”

The Deferred Sales Trust Agreement formalizes the trust’s creation. This legal document outlines the trust’s terms, the independent trustee’s responsibilities and powers, and the beneficiary’s rights. It serves as the governing blueprint for the trust’s operation, including asset management and distributions. Proper drafting of this agreement is necessary for the DST to function and qualify for tax deferral benefits.

A step in structuring the DST involves the original asset owner selling their appreciated asset directly to the newly established Deferred Sales Trust. This transaction is governed by an Installment Sale Agreement, where the trust purchases the asset from the owner in exchange for a promissory note. This note represents the trust’s promise to pay the original asset owner a specified amount over a predetermined period.

The promissory note details key terms, including its principal amount, which typically equals the asset’s fair market value, and a stipulated interest rate. This interest rate must be set at an arm’s length rate, meaning it should be comparable to what would be charged in a transaction between unrelated parties, to satisfy IRS requirements. Adhering to or exceeding the IRS’s Applicable Federal Rates (AFR) is important to avoid imputed interest issues.

The Installment Sale Agreement also provides flexibility regarding the payment schedule. The original asset owner, now the beneficiary, can negotiate terms for receiving payments over time, such as fixed monthly, quarterly, or annual installments, or discretionary payments based on their financial needs. This flexibility in payment timing is an important feature of the DST, allowing capital gains tax deferral until payments are actually received. The deferral relies on Internal Revenue Code Section 453, which permits gain recognition from a sale to be spread out over the period that installment payments are received.

The trust structure, including the installment sale agreement, must be completed before the asset’s actual sale to a third-party buyer. This ensures the trust legally owns the asset at the time of its disposition. The asset owner must transfer all rights, title, and interest in the asset to the trust, avoiding any actual or constructive receipt of the sale proceeds.

Executing the Asset Sale through the Trust

After the Deferred Sales Trust has been structured and the asset legally transferred into it via the installment sale agreement, the next phase involves the asset’s sale to an unrelated third-party buyer. The Deferred Sales Trust acts as the legal seller of the asset, not the original asset owner. The trust enters into a standard purchase agreement with the third-party buyer.

Upon closing, the third-party buyer remits the purchase price directly to the Deferred Sales Trust. The sale proceeds flow into the trust, forming the pool of funds from which the beneficiary will eventually receive payments. The important aspect here is that the original asset owner does not directly receive the sales proceeds at this stage.

This direct payment of proceeds to the DST, rather than to the original asset owner, is key to tax deferral. Because the original asset owner sold the asset to the DST in an installment sale, they only recognize taxable income as they receive payments from the trust. This defers the capital gains tax liability, which would typically be due immediately upon the sale of an appreciated asset. The trust itself generally does not incur capital gains tax on the sale to the third-party buyer, as it acquired the asset from the original owner at fair market value and sold it for the same amount.

This tax deferral is permissible under Internal Revenue Code Section 453. This section allows a taxpayer to spread the recognition of gain over the period during which installment payments are received. The gain is recognized proportionally as payments are received, based on the gross profit ratio of the original installment sale between the asset owner and the DST.

For larger transactions, Internal Revenue Code Section 453A may impose an interest charge on the deferred tax liability. This charge is a fee for deferring taxes over time and is calculated annually. This provision ensures the government recoups some revenue for the extended deferral period.

The process relies on the original asset owner not having “constructive receipt” of the sale proceeds from the third-party buyer. Constructive receipt means funds are available to the taxpayer, even if not physically in their possession. By channeling the sale through an independent trust, the funds are legally held by the trust, insulating the original owner from immediate tax recognition.

Managing and Distributing Trust Assets

After the asset sale and the Deferred Sales Trust’s receipt of cash proceeds, the focus shifts to managing and distributing these funds. The independent trustee manages and invests the sale proceeds held within the trust. The trustee’s objective is to invest these funds to generate income and preserve the principal, aligning with the beneficiary’s investment objectives and risk tolerance.

The trust agreement provides the beneficiary with options regarding how the sale proceeds are invested. While the trustee makes final investment decisions, they consult with the beneficiary to ensure the investment strategy supports the trust’s long-term goals and the beneficiary’s financial needs. Invested assets can include various instruments, such as stocks, bonds, mutual funds, or other income-generating vehicles, offering flexibility not typically found in other deferral strategies.

An advantage of a DST is the flexibility it offers in distributing payments to the beneficiary. The original installment sale agreement dictates the terms of these distributions. Beneficiaries can structure scheduled payments, such as regular monthly, quarterly, or annual disbursements, providing a predictable income stream. This can be beneficial for retirement planning or managing cash flow over an extended period.

Beyond scheduled payments, the trust agreement allows for discretionary payments. Under certain conditions, the beneficiary may request additional distributions to meet unforeseen financial needs. The ability to adjust payment terms over time provides adaptability to changing life circumstances.

Each distribution payment received by the beneficiary from the trust has a tax characterization. According to the original installment sale terms and IRC Section 453, each payment is composed of three components: a return of the asset’s basis (tax-free), a portion of the deferred capital gain (taxable), and an interest component (taxable as ordinary income). This gradual recognition of the capital gain means the deferred tax liability is realized incrementally over many years, rather than all at once.

The annual fees associated with managing a Deferred Sales Trust include legal and setup costs, an independent trustee’s fee, and investment advisor fees. Setup fees can range from 1.25% to 1.5% of the asset’s value. Ongoing annual fees, covering trustee services and investment management, range from 0.5% to 1.5% of the assets under management. These costs should be weighed against the potential tax savings and investment growth achieved through the deferral.