There are multiple strategies to minimize capital gains taxes while selling a business or asset. This article will explore two tax-efficient approaches for structuring a business sale: the Deferred Sales Trust and the Charitable Remainder Trust (CRT). Although they provide capital gains tax benefits, they have distinct purposes.
What is a Deferred Sales Trust?
A Deferred Sales Trust is utilized to postpone capital gains on asset or business sales. It is crucial to note that the DST should not be confused with a Delaware Statutory Trust (DST) as they are distinct entities.
To establish a Deferred Sales Trust, the investor or client sells an asset to a trust that is unrelated to them, and the trust becomes irrevocable. It is critical to ensure that the seller cannot be the trustee or beneficiary or have any control or ownership of the trust to prevent the IRS from classifying it as a "sham trust." This separation creates a third-party transaction, and a corporate trustee, usually an independent third party, manages the trust. The client may also choose an investment trustee in some cases.
Once a Deferred Sales Trust is established, it will operate based on the original agreement. As the client or grantor will have no control over the trust, it is vital to ensure that the trust is created precisely as intended, as it will not be possible to make any changes once established.
The trust sells the business to a third party and receives payment in cash, but from the client's perspective, the business is only sold to the trust. The trust will then make regular payments to the client. The tax deferment is achieved through an installment sale, as per the Internal Revenue Code 453.
The installment payments enable the capital gain to be proportionately spread out, and taxes are only applied to installments instead of a single lump sum sale. The client can specify the amount of the installment payments.
It is important to understand that a Deferred Sales Trust can only delay capital gains taxes and not recapture taxes.
A Deferred Sales Trust can have multiple beneficiaries, including family or charitable organizations. In the event of the grantor's passing, the beneficiaries receive the installment payments.
The trust can invest the proceeds from the sale of the asset, as per the agreements established during the creation of the trust.
However, it is crucial to note that a Deferred Sales Trust cannot be initiated if the investor is already under contract to sell their business, as it must be established before the sale of the asset or business.
What is a Charitable Remainder Trust (CRT)?
While Deferred Sales Trust and CRT share some similarities, a Charitable Remainder Trust (CRT) is a more suitable option for investors who aim to eventually donate their proceeds to a charity or foundation.
A CRT is a tax-exempt trust that is created when an owner donates an asset or business to the trust. The donor receives an immediate tax deduction for the value of the donation. However, the charity may not receive the proceeds for a long time.
The trust sells the business to a third party, and it is not taxed on the sale. However, any gain or ordinary income recognized in the sale is subject to taxation upon distribution to the grantor, i.e., the investor or business owner.
A Charitable Remainder Trust (CRT) has two distribution options: fixed or variable (unitrust). Once the distribution option is chosen, it cannot be changed, making the CRT similar to an annuity. Additionally, like a Deferred Sales Trust, a CRT is an irrevocable trust.
Unlike Deferred Sales Trust, a CRT also offers tax advantages on recapture taxes.
A CRT is not limited to charitable organizations; it can be a private foundation created by the donor, such as a family foundation. However, the donor cannot change their mind and donate to a non-charitable entity, like a family member. The donor receives tax-advantaged income from the CRT, resulting in significant initial and ongoing tax savings.
While the trust may not donate the proceeds to a charity right away, a charity will eventually receive the asset at some point.
To illustrate how a CRT works, consider an example: An investor donates their business, which is worth $1 million, to the trust. The full amount of $1 million goes into the CRT, and the client receives an immediate tax deduction for the amount donated. The trust then sells the business to a third party and invests the proceeds.
The investor can choose between two options for distributing the trust's income: a CRAT, which provides fixed payments, or a CRUT, which provides variable payments based on a percentage of the trust's value. In either case, the investor receives an annual distribution of 5% of the initial amount donated, until the charity eventually receives the remaining amount.
It's important to note that the payments cannot exceed 20 years. Also, the trust can be set up to benefit not just charities but also private foundations, as long as they are tax-exempt. Finally, the CRT offers tax advantages on recapture taxes and creates significant initial and ongoing tax savings for the donor.
A CRAT is a charitable remainder annuity trust that requires fixed dollar amount payments and must pay at least 5% of the initial value.
A CRUT is a charitable remainder unitrust that offers payments as a fixed percentage of all trust assets, ranging from 5-50%. While the percentage option may help hedge against inflation when trust assets increase, payments may decrease if trust assets decrease due to distributions.
Like a Deferred Sales Trust, the donor establishes the trust rules as long as they comply with the Internal Revenue Code. Once established, the trust rules cannot be changed due to the irrevocable nature of the trust.
Both the Deferred Sales Trust and CRT offer tax deferral options for the sale of a business or asset but require an attorney for proper setup. Failure to set up the trust correctly may result in costly penalties and interest, so it's best to work with an estate attorney with a strong tax background.
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