ESTATE PLANNING
installment payments also create a steady stream of income , which can be particularly attractive for retirees or those looking to diversify their income sources .
The trusts also offer estate planning advantages . Since these asset sales come without incurring immediate tax obligations , they can also help the seller maintain asset values within an estate . And since the proceeds of the trust can be reinvested , they can be put into various assets , possibly ones yielding higher returns . That would compound the deferred amount , providing a net benefit , even after future capital gains taxes are paid , to the trust ’ s beneficiaries .
The Risks
While deferred sale trusts offer appealing benefits , they also come with notable risks and potential downsides .
Because they ’ re relatively complex and require careful structuring , they can draw close attention from the IRS . Like conservation easements , the deferred sale trust has been promoted aggressively enough that the agency listed the tactic among its “ Dirty Dozen ” tax scams in 2021 . So expect IRS scrutiny — if the trusts are not correctly set up and operated , the agency could disallow them , which would create immediate tax liabilities .
Meanwhile , the administrative costs of establishing and managing these trusts can be significant . They often involve setup fees , trustee fees , and ongoing advisory costs , all of which detract from the tax savings , particularly in smaller estates .
There are market risks , too , since the trusts must invest the sales proceeds to generate income for the promissory note principal and interest payments . If the investments perform poorly , the trust may not generate the anticipated yield . That would weaken the seller ’ s income stream and the trust ’ s ability to make the required installment payments . This risk increases as the amount deferred increases . If 100 % of the sale price is deferred , the market risks become starker .
And finally , these vehicles offer limited liquidity . They ’ re not well-suited for people who need immediate access to a lump sum of cash , since a trust holds the assets and pays only in installments .
Stacking Up To Other Trusts
The three trusts that we discuss here all offer tax-deferred growth options , though they operate differently in their charitable impact and tax efficiency and how much they allow the donor or seller to control the assets .
Charitable remainder trusts . This is an irrevocable trust that pays the grantor ( or designated beneficiaries ) an income for a specified period or for life . When it terminates , the remainder passes to a designated charity . The contributions you make to this trust allow you to avoid immediate capital gains taxes , since the trust itself , being a tax-exempt entity , can sell appreciated assets without incurring those capital gains . The donor receives a charitable deduction based on the present value of the remainder interest left that ’ s charity . This is usually equal to approximately 10 % of the sale price .
One drawback of the charitable remainder trust , however , is that since it ’ s irrevocable and the assets are ultimately donated to charity , they do not stay within the family ’ s control or estate . Also , the donor ’ s assets must be transferred into the trust before the sale of the assets is finalized . The charity is designated when the trust is created , though the donor or the beneficiaries retain the right to change the charity in the future . These trusts are best suited for individuals who have both philanthropic intent and a desire for tax efficiency .
Charitable lead trusts . These trusts make payments to a charity for a specified period , after which the remaining assets return to the donor or their heirs . This structure can be useful for those who want to transfer wealth to future generations with reduced estate or gift taxes .
These vehicles are generally subject to immediate capital gains taxes when the trust sells appreciated assets . If the donor retains the right to receive the remainder of the trust at the end of the term , they get an income tax deduction equal to the value of the annuity to charity in the year the trust is funded , offsetting up to 100 % of the capital gains . The trust also boasts estate and gift tax efficiency if the donor gives the remainder to others , such as their children , since the gift tax or estate tax due on the funding of the trust is reduced by the value of the annuity up to 100 % of the value of the assets . The trusts thus allow individuals to transfer significant wealth to beneficiaries at a potentially reduced tax cost , as the charitable deduction can reduce the taxable estate .
The charitable lead trust does get taxed on the capital gains on the sale of the asset , so the trust is most commonly used when the assets are sold as an installment sale or when the donor dies , at which point the assets receive a stepped-up basis .
Like the charitable remainder trust , this one is irrevocable and requires a genuine commitment to the charitable contributions , which can reduce overall family wealth if it ’ s not carefully orchestrated .
Distinctions
Those who hope to defer capital gains taxes can find distinct advantages and drawbacks in each of these structures . Deferred sale trusts offer income deferral and asset control , but come with higher administrative costs , market risks and potential IRS scrutiny . Charitable remainder and lead trusts , by contrast , are highly taxefficient for capital gains and estate planning purposes , especially for those with philanthropic goals , and are less likely to attract negative attention from the IRS if the regulations are carefully followed . But both are irrevocable and require charitable commitments that might run against the desires of clients hoping to keep assets within their families .
Ultimately , the choice of the three depends on how much someone wants to control their assets , save on taxes or give to charity . An experienced tax advisor or estate planning attorney can help identify the best strategy for these specific financial and legacy goals .
MATTHEW ERSKINE is managing partner at Erskine & Erskine .
54 | FINANCIAL ADVISOR MAGAZINE | DECEMBER 2024 WWW . FA-MAG . COM