When a business owner considers the sale of a business interest or assets held or used in a company, careful income tax planning should be a priority to deal with the capital gain taxes that will be generated by the sale. Capital gain strategies for tax deferral or tax exclusion can be complicated and confusing to many, so it is critical that business owners review their capital gains and depreciation recapture taxes with their income tax advisors—especially the tax-deferred and tax-exclusion options available to them.
The Section 1031 Exchange may not be suitable or appropriate
When real or personal property that has been held for rental, investment or used in a business is sold or disposed of, owners often turn immediately to the tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code ("1031 exchange") in order to defer the payment of their capital gains and depreciation recapture taxes. Though the Section 1031 Exchange is an incredible strategy to defer taxes resulting from the sale of investment real property, it may not be feasible, suitable or appropriate when selling acompany or an asset or property used in a business operation.
The Section 1031 Exchange requires the businss owner or real estate investor to trade equally or up in value by acquiring a like-kind replacement property. Locating suitable like-kind replacement property for the sale of a business can be nearly impossible, and real estate investors may be at a point in their life where they wish to cash out and not reinvest in more real property. Some may opt to sell and pay the capital gain taxes and depreciation recapture taxes in the current year, but many would prefer to implement some kind of income tax planning strategy that would allow them to defer the payment of their capital gain taxes over a period of time.
Deferring Capital Gains Taxes without reinvesting in replacement property
There are a number of strategies that a business owner can use to defer the payment of his or her capital gains taxes and depreciation recapture taxes—if any need be paid—so it is important that the business owner meet with his or her tax advisor to review all of the options. The following are the two most common tax-deferral strategies available:
- Installment Sale through a Seller Carryback Note
- Structured Sale through a Deferred Sales Trust, or DST
The business owner could structure the sale of his or her business by carrying back the financing, which is often referred to as seller financing or a seller carryback note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes are due and paid in the year of sale. The capital gain taxes are partially of fully deferred over the term of the note and are taxed as principal payments are made pursuant to Section 453 of the Internal Revenue Code.
The installment sale strategy has positive and negative features like any income tax deferral strategy does. The obvious positive is that you can sell your business or property and defer the payment of your capital gain taxes by structuring a seller carryback note. However, the risk of buyer default on the installment sale is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer’s ownership.
Deferred Sales Trusts
Deferred Sales Trusts are also referred to as DSTs, and are not to be confused with the Delaware Statutory Trust. DSTs are highly effective capital gain tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default because the Trust receives 100 percent cash proceeds from the buyer at the closing of the transaction, thus removing the buyer from the equation. Default Sales Trusts and provide other great tax and estate planning advantages and sellers do not have to purchase replacement properties as with the 1031 exchange strategy.
Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid. The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust.