What Is an Installment Sales Trust and How Does It Work?

An installment sales trust is a legal arrangement that allows a person to sell an appreciated asset, such as a business or real estate, while deferring capital gains taxes. Instead of receiving a single lump-sum payment and facing an immediate tax liability, the seller transfers the asset to a trust and receives payments over a predetermined period, spreading the tax obligation across multiple years.

The Transaction Mechanics

The process begins when the owner of a valuable asset, known as the grantor, decides to sell it. Before a sale to an outside party occurs, the grantor first sells the asset to a newly created, irrevocable trust. This initial transaction is not for cash but is an exchange for a promissory note from the trust. This document, called an installment note, represents the trust’s legal obligation to pay the grantor for the asset over a specified term.

Once the trust legally owns the asset, the trustee, who manages the trust, sells it to an unrelated third-party buyer, typically for a lump-sum cash payment. The cash from this final sale is paid directly to the trust, not to the original owner. Because the trust sold the asset, the immediate capital gain is realized by the trust itself, not the grantor.

With the sale proceeds held within the trust, the trustee invests the cash in various assets, such as stocks and bonds, to generate income and growth. These investment returns provide the funds for the trust to make the scheduled payments to the grantor as dictated by the installment note. The grantor receives these payments over time, deferring the recognition of their capital gain until the years they receive the funds.

Key Components and Requirements

A properly structured installment sale depends on several foundational elements. Each component has specific requirements to ensure the arrangement is recognized by tax authorities and that the tax deferral is valid.

The Trust Document

The trust document is a legal instrument that must be drafted by a qualified attorney. This document outlines the specific terms, powers, and limitations of the trust. It names the trustee and beneficiaries and details the trustee’s fiduciary responsibilities. The language must be precise to establish the trust as a separate legal entity from the grantor.

The Independent Trustee

An independent trustee must be appointed. This individual or institution cannot be a related or subordinate party to the grantor, such as a close family member or someone under the grantor’s control.

The trustee has the fiduciary duty to manage the trust assets for the beneficiaries. The grantor cannot retain direct control over the trust or its assets, as this could cause the IRS to disallow the installment sale. The trustee’s responsibilities include managing assets, ensuring legal and tax compliance, and making payments to the grantor per the installment note.

The Beneficiaries

The beneficiaries are the parties designated to receive the trust’s assets. The grantor cannot be a beneficiary; these are often the grantor’s children or other family members. Their role is passive until the installment note is paid. After the note is satisfied, any remaining assets belong to the beneficiaries, and the trustee will manage or distribute them as the trust document specifies.

The Installment Note

The installment note is the contract between the grantor and the trust that formalizes the sale. It must contain commercially reasonable terms, including the principal amount (the asset’s sale price) and the payment schedule. The schedule might be structured as interest-only payments followed by a final balloon payment. The interest rate must be at least the Applicable Federal Rate (AFR) for the month of the sale, as published by the IRS, to substantiate the transaction as a legitimate sale.

Establishing the Trust and Executing the Sale

Creating and implementing an installment sales trust involves a sequence of actions that must be executed in the correct order. Once decisions about the trustee, beneficiaries, and note terms are made, the process moves to the formal legal and financial steps.

The first action is to assemble a team of professionals, including an experienced attorney to draft the trust document and a tax advisor to ensure compliance. These professionals guide the grantor through the complexities of the transaction.

With professional guidance, the next step is the formal creation of the trust. The attorney drafts the trust document, and the grantor signs it, officially establishing the trust as a legal entity. The grantor may also “seed” the trust with a small cash gift, separate from the asset sale, to demonstrate its economic substance and provide funds for expenses.

Once the trust is established and funded, the grantor executes a formal sale of the appreciated asset to the trust. In exchange, the trustee provides the grantor with the executed installment note. This transfer must be properly documented through a purchase and sale agreement to solidify its legal standing.

Immediately following the sale to the trust, the trustee sells the asset to the third-party buyer. The trustee negotiates the final terms and executes the transaction, receiving the cash proceeds directly into the trust’s account. This two-step sale process facilitates the tax deferral, as the grantor is now owed a debt by the trust rather than having received the cash directly.

Tax Reporting and Implications

Completing the sale initiates annual tax reporting obligations for both the seller and the trust. These requirements must be handled accurately to maintain the tax-deferred status of the transaction, as the tax implications are spread over the life of the installment note.

Seller’s Tax Reporting

The seller reports the transaction to the IRS using the installment method by filing Form 6252, “Installment Sale Income.” This form is filed for the year of the sale and for each subsequent year a payment is received. Each payment is divided into three parts for tax purposes: a non-taxable return of basis, a capital gain, and interest income taxed as ordinary income. Form 6252 is used to calculate the gross profit percentage that determines the taxable portion of each principal payment.

The Trust’s Tax Obligations

The installment sales trust is a non-grantor trust and must file its own annual federal income tax return on Form 1041. The trust reports all investment income and can deduct expenses, including the interest paid to the grantor on the installment note.

A non-grantor trust can deduct income it distributes to beneficiaries. This income is reported on a Schedule K-1, and the beneficiaries are responsible for the tax. The trust itself only pays tax on the income it retains.

This distinction is important because trust tax rates are compressed. For 2025, the highest federal income tax rate of 37% applies to a trust’s taxable income over $15,650.