When small business owners want to step away from their business and retire, many may worry about the tax burden they’ll face from all their potential gains. Our professional colleague, Steve Parrish, Co-Director of the American College Center for Retirement Income, graciously gave us permission to post his article in Forbes that describes a tool called a deferred sales trust that may help to spread out gains over time and lower their tax burden.
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.
Is It Worth It?
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:
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.
We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.