While many are still recovering from another tax season, you may benefit by looking ahead to do tax planning to lower your income tax bill when you sell a business or property. Whether you are an owner of a privately-held business or investment real estate, you may be looking to sell your ownership interest someday. But unlocking the value and turning it into cash can also result in a large tax bill especially if your asset has appreciated since your initial investment.
There are innovative strategies available to you if you want to lower your income tax bill when you sell.
Typically, when a business or real estate owner sells they will need to deal with capital gains tax, state taxes, depreciation recapture and, in some cases, the alternative minimum tax. But through savvy tax and estate planning, you can take advantage of opportunities in the tax code to minimize your current tax liability while allowing you the flexibility to control the sale proceeds.
Real estate investors can use a 1031 Exchange, a provision of the Internal Revenue Code which allows an owner to relinquish property and replace it with a similar type of asset without recognizing gain and deferring taxes.
Other options offer even more flexibility to sell highly appreciated assets like stock in a privately-held business or ownership of residential or commercial real estate while also controlling use of the cash that is freed up from the sale. These include strategies like a Deferred Sales Trust or a variation on an installment sale known as a structured installment sale. Another variation known as a “monetized” installment sale previously referred to as a “collateralized” or C453 installment sale is not a viable option after more recent IRS rulings in 2021.
The Deferred Sales Trust and Structured Installment Sale are based on the installment sale rules contained in Section 453 of the Internal Revenue Code. Both offer options to salvage a failed 1031 Exchange which can occur if a seller of a property cannot locate a suitable replacement property or a closing fails to occur within the 180 days required by law.
Both offer estate planning benefits as well as income tax deferral partly because of the discount that an estate receives for something called ‘lack of marketability.’
Option 1: Deferred Sales Trust
The Deferred Sales Trust strategy is relatively newer and does not yet have any official guidance and apparently only one private letter ruling issued by the Internal Revenue Service. In a Deferred Sales Trust, the seller of a property relinquishes property or a business to a trust which in turn sells the property or business to an end-buyer. The buyer pays the trust the purchase price which in turn invests the net proceeds according to the investment criteria established by the seller and his investment adviser. The original seller then holds a promissory note with the irrevocable trust which pays out cash based on predetermined terms of the note.
Cash flow can then be paid to the investor (now note holder) in the form of principal, interest or a combination. The seller only pays capital gains tax on the principal portion received.
Option 2: Structured Installment Sale
In this arrangement, the buyer delivers cash for the purchase of an asset to a third party (typically a trust) which in turn may use either life insurance or, more typically, US Treasury obligations (notes and bonds) to pay out periodic payments to the original seller. Since the seller is receiving funds in installments, he/she is only going to pay taxes on the portion of the gain received in each period.
Option 3 – Dismissed – Monetized Installment Sale (formerly Collateralized Installment Sale)
Another variation on the standard installment agreement is a monetized installment sale previously called a ‘Collateralized Installment Sale Agreement’ and sometimes referred to as a C453 installment sale. This strategy has a longer track record.
This is how the option is structured:
There are two distinct transactions as part of this strategy. The seller agrees to sell the property or a business to a dealer who resells the property to a final buyer using the original terms. Separately, the seller receives a limited-recourse loan from a lender typically equal to 95% of the resale proceeds. The seller can then take the non-taxable loan proceeds and reinvest however he sees fit. Proceeds can be used to pay off debt, invest in another business or property or in securities without the limitations of a 1031 Exchange. The dealer receives cash from the final buyer in a lump sum or through a lump sum plus one or more installments which offloads the risk of an installment sale onto the dealer. The lender’s loan to the original seller is repaid by automatic payments from the money that the dealer pays to the seller on the installment contract.
Unlike a 1031 Exchange, these installment sale variations can be used for the sale of more than just real estate. It can be used to handle the sale of an interest in an operating business as well offering more flexibility to an investor.
Ultimately, both allow a seller to defer taxes while investing the proceeds to generate replacement income and cash flow. Clients win by deferring taxation of gains and by having full control of the wealth unlocked from the sale of the highly appreciated asset. In the case of a monetized installment sale (or C453 sale), the client has full control of non-taxable loan proceeds. The option as promoted allows clients to win by having more flexibility to invest in other property, businesses or securities that may produce higher income over time than the business or real estate being relinquished.
Over time, this particular option has generated much scrutiny. And as of mid-2021, the IRS finally provided its opinion that this strategy does not pass muster in most situations. (The exception may be related to agricultural and other farm property.)
As the saying goes, a bird in the hand is worth more than a bird in the bush and with some of these strategies investors have more in hand to invest.
Arthur Godfrey, legendary TV personality, reportedly once said,
“I’m proud to be paying taxes in the United States … I could be just as proud for half the money.”
If you’re just as proud to be paying taxes but looking to lower your potential tax bill, you can start by planning ahead with the help of a qualified fiduciary financial advisor (www.FeeOnlyNetwork.com).