These only work if set up correctly. If all the rules are not followed if will just like the PAT and be deemed a sham trust by the IRS.  See recent article below.

There has been a bit of buzz around the internet this year about a "new" strategy called a Deferred Sales Trust.

As an outlet for professional advisors and sellers of highly appreciated assets... we like to present issues like this from both sides of the coin. 

When I first heard of the Deferred Sales Trust (DST) I actually somewhat ignored it and did not look further into it.  However, after receiving countless questions and calls from sellers and professional advisors asking about the Deferred Sales Trust... I came to realize that it is something that we should look into and report our findings.

At first glance, the Deferred Sales Trust looks very much like the now defunct Private Annuity Trust.   When I say defunct, I do not mean that the Private Annuity Trust is completely obsolete... but it is obsolete from a capital gains tax deferral standpoint as a result of the 10/06 IRS proposed ruling against it.

So, what does the Deferred Sales Trust propose that it can accomplish?

When you look at the Deferred Sale Trust, it looks like it is the "perfect" exit strategy for people selling highly appreciated real estate and businesses.

• It promotes capital gains deferral/reduction
• It promotes estate tax reduction/elimination
• It promotes flexibility in investment choices
• It promotes that family or friends can be the trustee of the trust (which manages the asset)
• It promotes that the seller can borrow from the trust
• It promotes that payment streams can be modified after they begin

Wow, sounds like a pretty darn attractive option for a seller.

But, just like the old saying goes... if it sounds too good to be true... it probably is.

Now, I am not an expert on the Deferred Sales Trust... nor do I wish to be.  However, I am very knowledgeable on the subject and am very familiar with the Private Annuity Trust.

This article is not to discuss the Private Annuity Trust or Deferred Sales Trust in detail... but to give my honest review of the strategy.   If you are looking for transaction details, feel free to browse the net by typing in the name of the strategy.

When you do thorough research on both the Private Annuity Trust and the Deferred Sales Trust, you'll quickly find that they look almost identical and have the same huge risks to the seller.

Big Risks For Sellers with These Types of Trusts -

With both the Private Annuity Trust and the Deferred Sales Trust, there are huge risks involved for the seller.  The main risk is that the transaction may be deemed invalid, or a "sham trust" by the IRS and will leave the seller with a huge tax bill... and a useless trust.

With the Private Annuity Trust, there were court cases that ruled against the seller stating that the trust was a "sham trust", and did not constitute a real transaction.  In other words, the IRS ruled that the trust was set up mainly to help the seller avoid taxes and did not limit the seller from the asset enough.

There are 4 ways a trust can become a sham trust: (from Buckmaster v CM TC Memo 1997-236)

1. The taxpayers relationship to the asset differs little both before and after the transaction takes place.
2. The trustee is not truly "independent" and does not pose "meaningful" restrictions on the taxpayers use of the asset for his/her own benefit or access to the trust account.
3. Whether an economic interest is passed to other beneficiaries of the trust for practically nothing in return (i.e.-passing the asset to a child for nothing in return)
4. Whether the taxpayer felt bound by any restrictions imposed by the trust itself or the laws of the trust

In addition, a trust must be determined to be a legal trust... or it will of course be considered a "sham trust".  (definition of a legal trust in the link above)

Basically, in order for a trust like this to work... the true reason for the trust must contain "economic substance" other than the reason to avoid taxes. 

Now, if you are a seller and are considering a Deferred Sales Trust, you need to sit down and really examine why you are considering this strategy. 

Is it simply because it looks like a good way to avoid estate and capital gains taxes?  If so, I'd tread very lightly before you commit to using this type of strategy.

A Red Flag From a Promoter of the Deferred Sales Trust -

Once again, this article is not out to discredit the Deferred Sales Trust... it is merely to bring to light thoughts and concerns so you as a seller/advisor can use this article as a starting point to spawn on further research on the topic before a decision is made.

While recently browsing a website of a large and prominent promoter of the Deferred Sales Trust (they were large promoters of the Private Annuity Trust as well... and had cases lose in court after they were determined to be "sham trusts" with no economic substance), I found a frequently asked questions page.

NOTE: I do not like to spread ill will about a company... so I am leaving the name out... but you can find them easily when you search for "Deferred Sales Trust" in Google.

In these FAQ's, they mention many things that would make me pause if I were a seller.  Among them (in paraphrase) are:

• These trusts are often "owned by family members or other trusted individuals".  While this alone is not against IRS rules, the fact that the tendancy of a family member is to side with the seller can harm the seller.   This can possibly infringe on the #2 element of a sham trust. Courts may rule that the family member does not place enough "meaningful" restrictions on the taxpayer, nor restrict any access from the asset.  This is one of the faults that brought down the Private Annuity Trust.
• The seller can appoint a manager to manage the investment account in the trust.  While the company does state that the seller cannot be in "direct control", the simple act of having control over the person who manages the asset could be construed as having access to control over the asset.Once again, one fault that helped to bring down the Private Annuity Trust.
• And elsewhere on the site, it mentions that the trust can be set up even if the transaction is already in escrow.  Once again, while this alone is not against IRS guidelines, simply implementing the Deferred Sales Trust while the property is already in escrow may trigger suspicion if an IRS audit were to come about.

Many of the promoters of the Deferred Sales Trust claim that this strategy and the Private Annuity Trust are completely different animals.  However, when you look at these companies who promote the DST, you notice that the great majority of them were heavy into promoting the Private Annuity Trust... and once the PAT was smacked down by the IRS... they smoothly transitioned into this "new" strategy that offers the same benefits with extremely similar mechanics.

Here's another interesting bit of information on the Deferred Sales Trust that you can choose to interpret however you wish.

As you know, the Private Annuity Trust was slapped down on 10/18/2006 by the IRS. 

The name "Deferred Sales Trust" was registered with the U.S. Patent and Trademark office on 11/2/2006 by a former promoter of the Private Annuity Trust... less than 1 month after the PAT was deemed invalid by the IRS.

You can interpret whether or not the Deferred Sales Trust is a "different animal" from the Private Annuity Trust... but in my opinion... it will not be long before the Deferred Sales Trust meets the same demise of the Private Annuity Trust.

So, as a seller or professional advisor, do you want to step out on a limb with a strategy that claims to solve all of your problems (in addition to being extremely fee ridden and expensive), that seems to be simply and old (and defunct) strategy with a new name?

It's up to me to present you with the information... and up to you to decide what is right for you.

In Summary -

In summary... the Deferred Sales Trust is not in itself "illegal".  It is of course too new for the IRS to rule against it as they did the PAT. 

However, as I've shown, the Deferred Sales Trust (DST) does have flaws inherent in its design and seems to be extremely closely related to the now defunct Private Annuity Trust... in both mechanics and history. 

When used for the right purposes and set up correctly, a Deferred Sales Trust can be an effective strategy for some people.  However, you need to remember that the simple reason of decreasing taxes is not a good enough reason to make a DST legitimate.

Anytime something promises you that you can avoid taxes and still reap the benefits of the asset... I'd really look at it with a skepitcal eye. 

So... I'm sure you as a seller or advisor still may be interested in the DST as an exit strategy simply because the benefits it proposes are so great in comparison to other strategies.  Just remember, the IRS is not in business to let people easily legally avoid paying taxes.  If the DST seems like it is an easy way out of paying taxes... you should look at it and the company selling you the DST to find out whether or not it is the best way to go.

The best of luck...

Thank you G. Shepard - I was seriously considering marketing this strategy to my clients. Like you saids, iIt does sound too good to be true.. and like its predecessor .. I am sure the DST will follow in the footsteps of the PAT program and be knocked out by the IRS. Your analysis was very informative and insightful.

The DST structure has been tested by the IRS. The DST has a PLR and is under IRC 453 not under section 72 like the PAT. Your review is not correct the DST because you would have to sign an NDA to get the tax & legal package in order to learn about it. If you have any questions and you would like to understand more on the DST please call our office at 866-779-5339 an I would be happy to answer any of your questions that you have or visit we can speak with your CPA or tax attorney to educate them about your concerns. Robert Binkele CEO of EPT.

Mr. Binkele what is the citation to the PLR (private letter ruling) you are referencing.  A search in the BNA Tax Management database for IRS rulings and publications reveals no hits for the phrase "Deferred Sales Trsut"  the phrase "DST" does have a single hit.   That hit relates to the Delaware Statutory Trust or DST. I ran this search on October 12, 2011.

I am an Oklahoma licensed CPA and an attorney licensed to practice law in three states.  I have an LL.M. in Taxation.  I am interested to learn more about this Deferred Sales Trust but I suspect it is nonsense. 

My problem with this strategy is that the trust itself will be subject to tax unless it is offshore.  A trust created in the United States generally must file a tax return and pay taxes on its DNI (distributable net income) unless it is a grantor trust.  In the case of a grantor trust (most common example being a revocable inter vivos trust), the trust itself does not pay taxes but the settlor or grantor (generally same person) does.  As the comment abouve Mr. Binkele's states, when something is too good to be true, it generally isn't true.