How Can I Offset or Defer the Sale of Capital Gains on a Business?

Posted by Amr Tenney on Oct 11, 2022

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are a number of ways to save on capital gains taxes when selling a business or asset. We're going to look at two tax-advantaged ways to structure the sale of a business. One is called the deferred sales trust (DST), and the other is the charitable remainder trust (CRT). Both offer capital gains tax advantages but serve different goals.

Deferred Sales Trust (DST)

This DST is not to be confused with a Delaware Statutory Trust, which also uses the acronym DST. They are very different.

The deferred sales trust is used to defer the capital gains on the sale of an asset or business.

To create a DST, the investor/client will sell an asset to a trust unrelated to the investor. The trust is irrevocable. This means the seller can't be the trustee or beneficiary or have any ownership or ability to control the trust. Otherwise, the IRS will classify the trust as a "sham trust." This wall between the seller and trust creates a third-party transaction. The trustee must also be independent. That usually means a corporate trustee. In some cases, the client will also select an investment trustee.

Once the trust is created, it will function according to the original agreements. Because the client (grantor) will have zero control over the trust, it's important to ensure the trust is created exactly as the client intends. Once it is created, it’s too late to change anything.

After the trust receives the business, it sells it to a third party, receiving cash from the transaction. From the client's perspective, the business is only sold to the trust. Once the trust receives the sale proceeds, it makes regular payments to the client.

The tax deferment comes from an installment sale (Internal Revenue Code 453). By using installment payments, the capital gain is spread out proportionately. The gain is taxed only on installments rather than a lump sale (i.e., an outright sale). The client can specify how much the installments should be.

Note that a DST can only defer capital gains and not recapture taxes.

The trust can have beneficiaries such as family or a charity. In the case the grantor passes, the beneficiaries will receive the installments.

The trust can invest the proceeds from the sale (of the asset). How it invests depends on the agreements when the trust was created.

Note that it is too late to initiate a DST if the investor is already under contract to sell their business.

Charitable Remainder Trust (CRT)

A DST and CRT have similarities. But if an investor’s goal is to eventually leave their proceeds to a charity or foundation, the CRT is a better fit.

A CRT is tax-exempt. To create a CRT, an Owner gifts an asset or business to the trust. The donor receives an immediate tax deduction for the amount donated. However, the charity may not see the proceeds for many years.

The trust then sells the business to a third party. The trust is not taxed on the sale of the business. But any gain or ordinary income recognized in the sale is taxed upon distribution to the grantor (i.e., investor or business owner).

There are two options for distributions from a CRT — fixed or unitrust (i.e., variable). The CRT requires these distributions. Once some form of distribution is chosen, it is locked in (basically, the trust becomes an annuity at this point). Like a DST, the CRT is an irrevocable trust.

Unlike DST, the CRT allows tax advantages on recapture taxes.

A CRT isn't restricted to charities. The trust can also be a private foundation created by the donor, such as a family foundation. Note that the donor cannot later decide to donate to a non-charitable entity such as a family member.

The donor is entitled to tax-favored income from the CRT. This arrangement creates sizeable initial and ongoing tax savings.

The trust may not donate the proceeds to a charity immediately. But at some point, a charity will receive the asset. 

Let’s look at an example of how a CRT works. An investor donates their business for $1MM. The full $1MM goes into the CRT. The client receives a charitable deduction and an annual 5% distribution from the $1MM. The distribution will continue until the charity receives the remaining amount. Payments cannot exceed 20 years.

As mentioned above, there are two ways to distribute funds — a CRAT (i.e., fixed payments) and a CRUT (i.e., percentage payments)

CRAT —  charitable remainder annuity trust. Must pay at least 5% of the initial value. Payments are fixed dollar amounts.

CRUT - charitable remainder unitrust. Payments are a fixed percentage of all trust assets (5-50%). The percentage option can be better for hedging against inflation if assets in the trust increase. But if the assets don’t increase in value, payments will continue to decrease as the value of the trust decreases due to distributions.

Like a DST, the donor creates the trust rules so long as they fit with Internal Revenue Code rules. Because the trust is irrevocable, the rules cannot be changed once the trust is created. 

A DST and a CRT are two examples of tax deferral on the sale of a business or asset. Each requires an attorney to set up. Otherwise, the trust could be set up incorrectly, which will be very costly due to penalties and interest when the improper trust is unwound. It's best to work with an estate attorney with a strong tax background.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Examples shown are hypothetical and for illustrative purposes only.

A DST or CRT transaction is irrevocable. Please consider all fees and expenses prior to pursuing a DST or CRT. Costs associated with these transactions may impact investor's returns and may outweigh the tax benefits.

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