What Is the IRS Ruling on a Deferred Sales Trust?

A Deferred Sales Trust (DST) is a financial strategy used to postpone capital gains taxes on the sale of a highly appreciated asset, like a business or real estate. The arrangement converts a single taxable event into a series of smaller payments over time, deferring the tax liability. The Internal Revenue Service (IRS) has a specific view on these trusts, focusing on the transaction’s mechanics, the tax law it relies on, and areas that attract scrutiny.

The Mechanics of a Deferred Sales Trust

The DST process begins when the owner of a highly appreciated asset decides to sell. Instead of selling directly to the buyer, the owner sells the asset to a specially created third-party trust. This sale is not for cash but is in exchange for a promissory or installment note from the trust.

The installment note obligates the trust to make payments to the original asset owner over a predetermined period. Its terms, including the interest rate, payment schedule, and duration, are negotiated during the initial transaction. The note is secured by the asset held within the trust.

Once the trust owns the asset, the independent trustee sells it to the end-buyer for cash. The buyer pays the full market price directly to the trust, not the original owner. The trust then holds the cash proceeds from this final sale.

The trustee then invests the cash proceeds into financial instruments like stocks and bonds, as outlined in the trust’s documents. The original seller receives payments from the trust according to the installment note. A portion of the deferred capital gain is recognized and taxed only when these payments are received.

The Underlying Tax Principle

The tax concept behind the DST is the installment sale method, governed by Section 453 of the Internal Revenue Code. This provision allows a taxpayer to report a gain from a property sale only as payments are received, deferring the tax liability to future years. This applies when at least one payment is received after the tax year of the sale.

Using the installment method, the gain is recognized proportionally with each payment. Each payment includes a tax-free return of the seller’s original investment (basis), interest income, and a portion of the capital gain. The gross profit percentage, found by dividing the gross profit by the contract price, determines the amount of each principal payment that is a taxable gain.

This method can be used for most property sales, including private businesses and real estate, but not for publicly traded stocks and bonds. Additionally, any gain from the recapture of depreciation deductions cannot be deferred. This portion must be reported as ordinary income in the year of the sale.

Proponents of the DST argue that the initial transfer of the asset to the trust for a promissory note is a legitimate installment sale. They contend the subsequent cash sale by the trust is a separate transaction. This interpretation is the basis for claiming the capital gains tax is deferred until the original seller receives payments from the trust.

IRS Guidance and Rulings

The IRS has not issued a public Revenue Ruling that formally approves the DST as a legitimate tax deferral strategy. This lack of specific, favorable guidance means taxpayers cannot be certain of the IRS’s acceptance of these arrangements.

Promoters may point to Private Letter Rulings (PLRs) as evidence of IRS acceptance, but these are not reliable. A PLR is a response to a specific taxpayer’s situation and cannot be cited as precedent by others. The IRS has also rescinded some PLRs that were previously cited in support of these trusts.

While not ruling on DSTs directly, the IRS has acted on similar arrangements. In August 2023, it issued proposed regulations identifying certain monetized installment sales as listed transactions, which are considered potentially abusive tax schemes. These involve a seller getting cash through a “loan” from an intermediary funded by the sale proceeds, giving the seller immediate cash while claiming tax deferral.

This action signals the IRS’s willingness to challenge complex arrangements that circumvent installment sale rules. The IRS’s focus on substance over form is clear. Taxpayers considering a DST must recognize they are operating in a gray area of the tax code without explicit IRS approval.

Areas of IRS Scrutiny

If the IRS examines a DST, it will likely use several legal doctrines to challenge the transaction’s validity.

Constructive Receipt

This doctrine states that a taxpayer must recognize income if it is credited to their account or set aside for them, giving them control over it. This applies even if they have not taken physical possession of the funds. The IRS may argue that a seller who exerts excessive control over the trust’s investments has constructively received the sale proceeds.

Sham Transaction Doctrine

The IRS can use this doctrine to disregard transactions that lack a legitimate business purpose beyond tax avoidance. It could contend that the trust serves no purpose other than to defer taxes. This argument is stronger if the sale to the end-buyer was pre-arranged before the asset was transferred to the trust, suggesting the trust was just a conduit for funds.

Economic Substance Doctrine

Codified in Internal Revenue Code Section 7701, this doctrine requires a transaction to meaningfully impact the taxpayer’s economic position and have a substantial non-tax purpose. If a DST does not genuinely alter the seller’s economic risk and reward, or if its only motivation is tax deferral, the IRS can disallow the tax benefits.

Trustee Independence

The independence of the trustee is a major factor in an IRS analysis. If the trustee is not independent and acts at the direction of the seller, the IRS will likely argue the seller never relinquished control of the asset or its proceeds. This lack of an arm’s-length relationship can undermine the structure and lead to immediate recognition of the entire capital gain and penalties.