Denny and Marie run a successful business manufacturing and retailing aluminum sliders. After the hassles of the pandemic – supply disruptions, PPP loans and employee turnover – they’re ready to retire. As they start to look at the prospect of endless weekends, they’re envious of their friends who are retiring as employees. These friends have built up sizeable 401(k) accounts and will be able to spread out their retirement income – and their taxes – over many years. Denny and Marie don’t have this luxury. Their business is their retirement, so they will first have to sell their business – and satisfy the taxman – before they can enjoy their retirement savings. It’s not like they can sell their business in bits and pieces over their retirement, so understandably they worry about paying all the tax on their retirement capital upfront.
Business owners typically face an extra step in retirement planning. They first need an exit plan – a way to convert their highly illiquid business equity into a stream of retirement income while still keeping in mind the tax implications. While a traditional installment sale of the business can help spread out income taxes over a period of years, these transactions incur two challenges. First, the buyer may insist on paying for the business in a lump sum, negating the opportunity for the seller to benefit from installment sale treatment. Second, if the buyer does want to pay in installments, the selling business owner suddenly becomes a creditor. The installment payments are usually made out of the business revenue, so if the business fails under the new owner, there is the risk of default. The seller’s biggest retirement asset will now be a note from the buyer, collateralized by the very business the seller wants to leave.
An Alternative Approach
In the right situation, it may be possible to sell your business for a lump sum yet spread out the gain for tax purposes. Take the situation described above with Denny and Marie (we’ll call them “D&M”). They’re in their 60s, getting ready to sell, and are confident that there are large, well-financed companies interested in buying their aluminum slider business. These companies will likely want to pay the purchase price up front, which is great – except for taxes. Since D&M will use the sale proceeds for their retirement income planning, it’s costly for them to have to pay all of the income tax on the sale in just the first year of their retirement.
By using what’s called a “deferred sales trust” or “installment sale trust” (I’ll call it a “DST”), D&M may be able to sell their business up front yet spread out most of their taxes. The transaction design can vary among advisors who create these arrangements, but here’s the basic blueprint: D&M create an irrevocable trust and appoint an independent trustee to oversee the assets. They then sell their business to the trust for its fair market value, taking back an installment note that pays out the proceeds monthly, with interest, over 20 years. This allows for D&M to use IRC Sec. 453 to spread out their taxes over the installment period.
How does the trust come up with the money to pay D&M each month? The trust sells the business to an outside buyer for a comparable fair market value, receiving the sales proceeds in a lump sum. Because the trust bought the business from D&M, creating a tax basis equal to the fair market value, it will incur little if any income tax on the sale of the business to the third party. Once the sale of the business to that third party closes, the trust has the proceeds and can use an appointed investment manager to direct the management of the trust portfolio’s assets. To D&M, this transaction has the potential to be the best of both worlds. The sale has been secured and paid for, with cash in the bank (though it is in the trustee’s custody, not D&M’s possession), and both payments and taxes are being spread out over D&M’s retirement. They now have a retirement income paid monthly for 20 years.
Will It Fly?
On its face, this concept addresses an important planning challenge. Deferred Sales Trust™ Trustee Garrett Griffin puts it this way: “You want to safeguard your financial future—but it’s difficult to be certain you’re making the right choices to protect and leverage your assets. Rather than experiencing the debilitating drain from a fully taxable sale when a business owner is prepared to exit, the DST concept permits the seller to generate a potentially higher rate of return by leveraging the pre-tax proceeds from the sale, which can be significantly greater.”
Still, anytime a taxpayer hears about a “best of both worlds” tax opportunity, they should be skeptical. With the DST concept, there is clearly a risk that the IRS will not look kindly upon the transaction. In sum, if it lacks economic foundation, and is being undertaken purely for tax leverage, assume the IRS will come hunting. And if they do object, they have a number of legal weapons they can employ, such as calling it a sham transaction, step transaction, constructive receipt, or other court-tested tax argument.
What should D&M do to avoid the wrath of the IRS? A guiding principle is to be thorough and be fair. Consider who the parties to this transaction would be, and how they can contribute to making this exit plan work for the couple.
- Start with Denny and Marie. This is a sale, not a chance to monetize their business interests while they continue to run operations. When D&M sell their business to the trust, they must exit stage left, and become retirees. Their involvement with the business ceases.
- The trust is the center of attention in the DST concept. First, the attorney drafting the trust and sale arrangement must not only be competent, but skilled, in this area. D&M shouldn’t use their general counsel to structure this transaction any more than a heart surgery patient uses their family physician. Next, the trustee must be truly independent – preferably an institutional trustee. The IRS has an impressive string of court victories where they have successfully challenged trust arrangements involving trustees who were related to or otherwise under the grantor’s control.
- The third-party buyer must buy the business from the trust, not the grantor. With D&M, they may know viable candidates who are potential buyers, but they cannot have the sale in hand when they set up the trust. D&M sell the business to the trust; the trust sells the business to the third-party buyer. Anything less could be attacked as a sham transaction.
Is It Worth It?
Does it make sense for you?
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John Leonetti, author of “Exiting Your Business, Protecting Your Wealth,” offers that “deferring the tax on sale may sound appealing but, if I were selling my business and looking to enjoy the immediate gratification of not paying taxes upon the sale, I would seriously evaluate two critical components: first, the future of tax rates given the level of national debt, and second, the rate of return that I expect to receive on the amount of tax ‘savings’ I receive through the deferral.” In other words, will tax rates go up – erasing the benefit of deferral – or will there be sufficient return on investment to make it worth the effort?
Something additional that must be factored into the equation is expenses. Like any sophisticated sales transaction, there are a lot of moving parts. And that means there is the potential for significant costs associated with hiring professional advisors. Further, there are many opportunities to make mistakes, therefore compounding expenses. Still, if successful, the DST approach has several advantages:
- Retirement planning. This arrangement creates an exit plan that transitions a taxpayer from a business owner into a retiree. With D&M, they are getting out while they can so they can enjoy the good life, and all without having to worry about how the ultimate buyer of their old business is doing.
- Asset diversification. Different from a traditional installment sale, the retiree, through the sale to the trust, has assets that are in a diversified portfolio of investments. Rather than holding a note from a third-party buyer who may succeed or fail, the trust has an investment portfolio backing up its ability to make payments to the seller. D&M created a trust with an investment direction that suits their style. While they can’t control the assets in the trust, they have had a say in who does.
- Assets are converted into a stream of income. When a business owner retires, control of the business is lost. The DST turns business equity into a stream of monthly payments generated by a diversified portfolio of investments – every retiree’s dream. Best of all, the use of the trust eliminates the risk of default. D&M now enjoy a predictable retirement income and may even have some flexibility to revise payment terms with the trust if necessary.
- Tax efficiency. While this transaction can’t be created solely to save taxes, it does have the potential to address a common business owner challenge – spreading out payments without paying taxes upfront. D&M are now on tax parity with their friends who were employees. They’re taxed on their income as it’s paid to them. Even better, much of that income is potentially taxed as long-term capital gain.
As compared to the typical employee, a business owner has both more options and more challenges in retirement planning. The DST concept is one more option to examine when planning your exit and contemplating your retirement. In considering this option, factor in timing. Because of the complexity and expense of the DST transaction, as well as the need to sell your business directly to a trust you’ve created, it’s important to get an early start on your planning. Your planned exit from your business can lead to a successful retirement.