For many years, I have been interested in a tax strategy designed to defer the payment of capital gains taxes, to preserve wealth, to create reliable, predictable streams of income and to aid in effective intergenerational wealth transfer. This strategy is known as the Deferred Sales Trust™ or “DST” (not to be confused with the Delaware Statutory Trust per IRC §1031, also known as a “DST”). By this point in my journey with the DST, I have acted as the attorney for sellers curious about this strategy but uncertain as to whether or not it is a bona fide transaction (the “tax risk”), whether or not they can trust the various parties who take the seller through the process (the “defalcation risk”) and/or whether or not the proceeds of the sale will be invested properly and the principal preserved for ultimate recognition (the “market risk”). I have guided many such sellers through the process and every single seller whom I have advised has been thrilled with the outcome. This article will describe the transaction in the most general terms, address the three risks just noted and will identify the myriad of prospective users and professionals for whom this strategy holds tremendous value and utility.
In a DST, the seller is someone (an individual, a couple, a family, a partnership, a corporation or other entity, with a highly-appreciated asset (a business, a real estate holding (commercial or residential, investment or personal), artwork or other collectible) that the seller wishes to sell. However, in doing so, the seller is subject to federal capital gains taxes, state capital gains taxes (where applicable), the ACA tax, likely depreciation recapture and other burdens that may leave the seller with only half of the sale proceeds after all taxes and related obligations have been paid to the government. This is especially frustrating to the seller because he or she or the entity has been paying taxes on the business or the real estate holding year in and year out for many, many years in most cases. At the time of sale, this amounts to multiple levels of taxation. In other words, the seller is unable to recognize the full value of the sale after nurturing the asset along over time and paying taxes annually on the income derived from the asset in the hope that, at the time the seller is ready to sell, he or she will be able to enjoy the fruits of his or her labor. I call this “the reluctant seller.”
In the case of the DST, the seller identifies a prospective buyer for the asset but does not travel down the road too far toward consummating the transaction. The seller contacts an advisor who is licensed to employ the DST strategy and the seller negotiates how and when he wants his principal returned, how she wants her money invested, what type of return he desires and numerous other essential and ancillary terms. Once there is an agreement, a contract is formed and the trustee contacts the ultimate purchaser of the asset and agrees on the purchase price. The trustee then purchases the asset from the seller and simultaneously conveys the asset to the end buyer, taking possession of the sale proceeds. The trustee then works with the seller’s investment advisor to ensure that the proceeds are invested in accordance with the terms of the trust and in accordance with the seller’s risk tolerance and preference for certain types of managed accounts, securities, alternative investments, insurance products, etc. The trustee then delivers to the seller a note. The seller is now the “note-holder” and enjoys all of the legal rights and privileges, including the right to call the note, that anyone holding a note possesses.
At the end of the transaction, the note-holder has the note. The buyer has the asset. The trustee, acting on behalf of the note-holder, oversees all investment decisions made by the note-holder’s financial advisor. No capital has been received by the note-holder. No taxes are due. 100% of the sale proceeds are invested in accordance with the note-holder’s wishes by the note-holder’s trusted advisor(s) and the note-holder may take principal (and pay pro-rata capital gains taxes on same) pursuant to a predefined schedule. The note-holder will receive annual income at the predefined rate of return. This ordinary income (from the investments) will be subject to taxation at the note-holder’s applicable income tax rate. Ultimately, when the principal is delivered to the note-holder, in periodic payments or in a balloon payment at the conclusion of the trust (such that the note-holder can maximize the annual return during the course of the trust), the capital gains taxes are paid accordingly. It is a winning situation for the seller / note-holder, a winning situation for the buyer and even a winning situation for the government (state and federal), as the taxes are ultimately paid (unlike when there is a step-up in basis at death in a like-kind exchange). However, the taxes are paid on the taxpayer’s schedule, not the government’s, and at a time when it is most advantageous for the taxpayer. Thus, the reluctant seller is not so reluctant anymore (making real estate brokers’, business brokers’, financial advisors’ and other investment professionals’ lives a bit less stressful in the process).
To return, as promised, to the three main concerns on the part of prospective DST users, I will address them in order. The first concern is tax risk, the risk that the IRS will not recognize the transaction. This is a bona fide installment sale per Section 453 of the Internal Revenue Code. If the seller engages the DST professionals in a timely manner and adheres to their advice, the transaction will be fully respected by the IRS. Furthermore, counsel for the trust will handle any audit they may arise in relation to the sale and use of the DST free of charge and will pay any penalties assessed against the taxpayer (somewhat in theory, as this has never happened after billions of dollars of DST transactions). The IRS actually favors the DST and IRC § 453 transactions more generally, as the government actually receives the capital gains taxes on the appreciated property at some point in time, unlike other transactions with a step-up in basis where the government may never see any tax revenue.
In terms of defalcation risk (that is attorney language which means the risk that the DST professionals will run away with the seller’s proceeds). There are multiple documents that make each and every move that is undertaken with respect to the corpus of the trust and the investments made therefrom subject to multiple signatures by unrelated parties at multiple financial institutions, each with a fiduciary relationship to the trust and the beneficiary of the trust – the seller / note-holder. Moreover, all of the parties involved in these transactions have undergone substantive background checks and all have been found to be committed professionals with impressive pedigrees who are beyond reproach. Finally, the seller / note-holder is able to monitor his or her investments, undertaken by the trust, and the performance of these investments in real time from a computer, a tablet, a phone or other mobile device. In other words, the seller / note-holder always knows where the sale proceeds are and how the investments are performing.
Finally, in terms of market risk, the seller must distinguish a specified risk tolerance after completing a risk tolerance questionnaire prior to the transaction. This provides for the formation of the investment statement of the trust. The trust must adhere to the investment statement at all times. Under no circumstances can the sale proceeds be invested into any instrument that is purely speculative in nature, no matter the appetite for risk. That said, within the conservative boundaries of what is permissible, some degree of risk will produce a higher return. In all cases, a fully diversified portfolio of non-correlated investments is created in order to provide some degree of protection against normal market fluctuations. Ultimately, there is less risk in a DST portfolio than in a single mutual fund, precisely because of the diversification (and the likely inclusion of annuities and other insurance products that carry minimal to nonexistent risk).
This strategy works best for (1) the reluctant seller concerned about the onerous capital gains obligations at disposition; (2) sellers desiring the benefits of a Section 1031 exchange but are not qualified in terms of the like-kind provisions; (3) a backstop for a failed Section 1031 exchange in which the qualified intermediary is instructed to direct the sale proceeds to the DST instead of the taxpayer should the like-kind exchange fail, thereby avoiding a major taxable event; (4) sellers of going concern businesses with ample goodwill which cannot be part of a like-kind exchange; and (5) all others who seek to sell a concentrated highly-appreciated asset and reinvest the proceeds of the sale in a diversified, tailor-made basket of stocks, bonds, mutual funds, alternatives and other investments in a tax-deferred manner wherein 100% of the sale proceeds are deployed to produce income at a set annual rate over a predefined period of time.
For the reasons described above, adding the DST strategy is beneficial for real estate brokers, business brokers, financial advisors, insurance professionals, qualified intermediaries, accountants and a host of other professionals who seek to retain and “wow” their high-net-worth clients and customers. Both as a tax and estate planning attorney who has guided numerous parties through the DST process and as a DST trustee, engaged in buying and selling highly-appreciated assets, I am happy to assist you whether you are a prospective user of the DST or whether you fall into one of the categories listed above as a trusted advisor having clients with highly-appreciated assets.